Question on Debt
I was hoping to get some clarification on the stuff related to debt. I've just realized I don't know shit about debt / the banking system.
If a company wants to raise $1 million of debt, hypothetically, in class we'll usually just be given some type of interest rate and use that to calculate the annual interest payments on the debt.
I was wondering - where does this interest rate come from? How does something like the overnight rate affect this interest rate?
Also, what exactly is the company doing to raise the debt - would it typically be getting loans from a bank or issueing bonds on the market? I guess this question is basically the same as the first I posed.
Hopefully I don't sound too retarded - I appreciate any/all help offered!
Hi
From what I understand, the interest rate is usually based on LIBOR + a previously agreed upon margin. The LIBOR that is quoted should be equivalent to the period of the loan: 3 month loan you would use 3 month LIBOR and the margin as per the contract between the company and the bank.
To raise debt, the company can get loans from banks (which is the problem now since banks don't lend as much as they should) or issue debt into the market in the form of bonds. The bonds can be in different levels: senior secured, subordinate etc.
Hope this helps!
rane84 has the basic outlines of it, just want to clarify a few things here:
1) You can have fixed or floating debt, floating is usually based on a 3M LIBOR because the coupon resets every quarter, so to price a floating bond you need the forward 3M LIBOR curve (or you can half-ass it and use the LIBOR rate for the time to maturity). Fixed is just that.
2) The yield on the debt is the real point here - coupon can be adjusted to fit the issuer's needs - e.g. a subpar credit can issue at say L+600 at or near par or L+200 at a significant discount. However, yield should be same in both cases. The yield depends on where the debt sits in the capital structure as rane84 described; senior secured > senior > senior sub > sub. Therefore, the yield is dictated by 1) place in the cap structure and 2) credit-worthiness of the issuer.
This is of course ignoring the distinctions between bank loans and notes, but since loans can be traded, it's not that important to distinguish; the claim on assets is more relevant.
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