CFM11140 - Understanding corporate finance: raising finance: debt securities

Making debt saleable

Some lenders may be content simply to make a loan on defined terms and then remain party to the loan until maturity, at least in the absence of any default event that might accelerate the obligation to repay. A bank will normally lend on this basis and intra-group loans will often be on this basis.

But a simple loan of this type has clear limitations as an investment. The investment in the loan is illiquid; the lender cannot quickly realise the investment. It must normally let the loan run its course unless it can negotiate early repayment or can assign the debt to another party. Neither of these is straightforward or certain; the terms of a bilateral lending agreement may well prohibit or restrict the lender’s ability to assign the debt arising. See CFM11170 for more on transferring debt.

The debt on the loan is much more attractive as an investment if it is freely-transferable and therefore a more marketable asset.

The debt has to be transformed from simple debt, that is, ordinary lending and borrowing between two parties, into a tradeable instrument. At its simplest an instrument is simply a piece of paper which records and provides evidence of an obligation of a person to do something. In the case of a debt instrument, it records the obligation to repay an amount or amounts, for instance six-monthly payments of interest and then the principal on maturity. If the piece of paper can be sold so that someone other than the original lender can collect the debt, we have a tradeable instrument or a security. The ‘issuer’ will be the borrower which creates an instrument recording its obligations. That instrument is in essence unilateral; it is the borrower documenting its obligations to whoever is the holder of the instrument.

The instrument is typically described as a security, but it should be noted that this term (and the related term “debt on a security”) have specific definitions for certain tax purposes, such as capital gains tax.

Simple bilateral loans and entirely freely-transferable securities represent two extremes and may debts will be somewhere on the range between them; there may for instance be restrictions on the transferability of a security or there may be provisions in a bilateral loan agreement that contemplate the possibility of a future assignment of the creditor’s rights under the agreement. See CFM11170.