Bonds and Loans


There are numerous ways to accumulate debt, including basic loans, syndicated loans, and bonds. Debt, especially large sums of debt, can also be safeguarded through a mortgage or other security interest over some of the debtor's property, in which case the creditor will have some rights to that property in the event that the debtor becomes unable to repay the debt and defaults on the loan. Default occurs when a debtor has not met its legal obligations to a debt contract, such as not making a scheduled payment, or violated a condition of the debt contract.

Basic Loan

A basic loan is the simplest form of debt. It consists of an agreement to lend a base sum of money for a fixed length of time, which must be repaid by a certain date. In commercial loans, interest, calculated as a percentage of the principal sum per year, will also have to be paid by that date. There are two types of basic loans. They are Secured and Unsecured. These types are discussed in better detail below.

Secured

A mortgage is a common debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it. In some instances, the car itself may secure a loan taken out to purchase a new or used car, in much the same way as a mortgage is secured by housing. The duration of the loan period is considerably shorter, often corresponding to the life of the car.
Unsecured

These may be available from financial institutions under many different guises or marketing packages such as credit card debt, personal loans, bank overdrafts, credit facilities or corporate bonds. The interest rates applicable to these different forms may vary depending on the lender and the borrower, and any terms the two worked out. These may or may not be regulated by law.

Syndicated Loan

A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan. In such a case, a syndicate of banks can each agree to put forward a portion of the principal sum. Like insurance, a loan is an assumption of risk. For a certain class of loan, with certain rules, the bank might believe that it is likely that 10% of all borrowers may go bankrupt. If the banks guess that the cost of funds is 10%, it will charge more than 20% interest on the loan to make an attempt at profit. In general, banks and the financial markets use risk-based pricing, charging an interest rate depending on the risk of the loan product in general or the risk of the specific borrower. The problem with larger businesses loans however, is that there are fewer of them. Therefore, if the bank only has one large business loan, if that business happens to be one of the 5% that defaults, then the bank loses all its money. For this reason, it is in the best interest of all banks to split, or "syndicate" their large loans with each other, to prevent the risk of one single bank taking the fall of lost profit singularly, but to also share the wealth of increases and gains in its interest rates. To avoid the borrower having to deal with all syndicate banks individually, one of the syndicate banks usually acts as an agent for all syndicate members and acts as the mediator between them and the borrower.

Bonds

A bond is a debt security issued by certain institutions such as companies and governments. It is a certificate of debt (usually interest bearing or discounted) that is issued to raise money; the issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal.

A bond entitles the holder to repayment of the principal sum, plus interest. Bonds have a fixed lifetime. Bonds are generally issued for a fixed term longer than ten years with long-term bonds that last over 30 years being less common. At the end of the bond's life, the money should be repaid in full.

Interest may be added to the end payment, or can be paid in regular installments throughout the life of the bond. Bonds may be traded in the bond markets, and are widely used as relatively safe investments in comparison to stocks. Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bondholder, or limitations on the behavior of the issuer. U.S Treasury securities issued debt with life of ten years or more is a bond.

New debt between one year and ten years is a note, and new debt less than a year is called a bill. Elsewhere in the market, this distinction has disappeared, and both bonds and notes are used irrespective of the maturity. Market participants normally use bonds for large issues offered to a wide public, and notes for smaller issues originally sold to a limited number of investors.

There are no clear demarcations. Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration, where lower durations have less risk, and are associated with shorter-term obligations. Bonds and stocks are both securities, but the difference is that stockholders own a part of the issuing company, whereas bondholders are in essence lenders to the issuer. In addition, bonds usually have a defined term, or maturity, after which the bond is redeemed whereas stocks may be outstanding indefinitely.

Hopefully, knowledge of these different forms of debt accumulation can and will help you better understand how the debtors system works, and better prepares you for how you can remain in good credit, or recover from a fall in credit history.