Corporate Finance, 6th Edition

Chapter 20BONDS

Fixing the interest

Unlike equity, for which shares are the legal form of the security, bank and financial debt can take the form of bank loans or debt securities. The predominant form of debt securities is a bond.

A debt security is a financial instrument representing the borrower's obligation to the lender from whom they have received funds. If the initial maturity of the security is over one year, it will be called a bond.

This obligation provides for a schedule of cash flows defining the terms of repayment of the funds and the lender's remuneration in the interval. The remuneration may be fixed during the life of the debt or floating if it is linked to a benchmark or index.

Unlike conventional bank loans, debt securities can be traded on secondary markets (stock exchanges, money markets, mortgage markets, interbank markets, over the counter (OTC) markets). Other than this, their logic remains the same and all the reasoning presented in this chapter also applies for bank loans. Debt securities are bonds, commercial paper, Treasury bills and notes, certificates of deposit and mortgage-backed bonds or mortgage bonds. Furthermore, the current trend is to securitise loans to make them negotiable.

Disintermediation was not the only factor fuelling the growth of bond markets. The increasing difficulty of obtaining bank loans was another, as banks realised that the interest margin on such loans did not offer sufficient return on equity. This pushed companies to ...