Debt is usually in the form of money that one party owes to another. Many kinds of debts are exchanged in our society. Credit card debts to home loans, and auto loans — all of these are forms of debts. The debt arrangement involves a borrower and a lender, with the borrower having to return the sum of money to the lender at a later date. The lender and borrower also agree on the rate of return known as interest.
The rate of return is set in a way that is beneficial to the lender and takes into account the time value of money. There’s a system of debt established in the global economy for a very long time. This system of debt gives way for companies to invest within the system and replicate its mechanism at every scale. One of the units that partake in these systems is debt holders. Debt is essential for the working of any financial system. We will answer the question “what is a debt holder?” and clarify how debt holders function in any economy.
What is a debt holder?
A debt holder is an investor who holds a debt instrument, which is generally a bond. When talking about bonds, people often use the terms bondholder and debt holder interchangeably. If the company or the person goes through bankruptcy, the bonds’ ownership goes to debt holders instead of stockholders. In normal circumstances, debt holders don’t carry the owning right as normal stockholders do.
Businesses and governments issue certain financial instruments like debt securities so they can finance themselves. Creditors or borrowers purchase these debt securities and are rewarded with interest payments until they have received the principal amount. Debt holders may include bonds, commercial paper, or treasury securities.
The debt holder can hold two types of debts: senior or subordinated. A debt holder who has senior debt is in the best place because senior debt obligations are paid before subordinated ones. So, in the case of bankruptcy, the debt holders are generally very secure.
What are some of the features of debt securities?
One of the main features of any loan is its rate of return. Debt securities enjoy both fixed and variable rates of interest. Fixed rates tend to stay the same regardless of loan maturity, which can be a good and a bad thing. It can be good if you wish to invest for a shorter period and bad if you can put yours away for more than a decade. Variable-rate loans adjust the payments according to the current rates. Hence, if there’s a higher rate, you’ll have to pay more, and if it’s at a lower rate, you’ll get away with paying less.
What’s the difference between a debt holder and a creditor?
In the context of finance, a debt holder is the owner of the financial obligation of another party while a creditor is a person to whom the debt is owed. In this way, the debt holder is the third party for a financial relationship between two parties, whereas the creditor is one of the two parties involved in a debt exchange. People often confuse the two definitions as they are hyponyms of each other. However, they are not the same.
Shareholder vs. Debt holder
A shareholder is the owner of a company-managed asset. However, a debt holder is an owner of a financial obligation of another party. The difference between the two is glaringly obvious in terms of ownership. The debt holder foregoes any right of ownership, and debt holders are only present as a function to another party. Shareholders have some say in how the company is run and what shares are traded and the decisions made according to that.
Debt holders vs. Equity holders
Debt is a company’s liability, i.e., the money that they owe and which they need to pay after a while. Money that’s raised by opening up the company to shares that the public owns is called equity. Debt is the fund owed by the company whereas equity is the fund owned by the company. Debt can be kept for a very long period, however, needs to be returned after the expiry of that period, whereas equity is owned by the company and doesn’t need to be returned. Debt is less risky than equity.
Debt is in the form of bonds, debentures, and loans, whereas equity occurs in the form of shares and stock. The return that you owe on debt is termed as interest which is profit, whereas the return on equity is called a dividend, and it’s an appropriation of profit. Debt can exist as secured or unsecured debt, but equity is always unsecured.
What are some of the misconceptions related to debt holders?
People often confuse debt holders with stockholders; however, this is a misconception. Debt holders don’t have a lot of privileges that stockholders have. They don’t have voting rights or ownership related to the financial obligation that they hold. They partake as a third party holding the financial instruments for the creditors. However, they do enjoy asset claims that are superior to shareholders. In case of bankruptcy, they are also the first few to be repaid by liquidating assets.
However, debt holders are at risk of the collapse of the financial system. If any credit crisis occurs, debt holders would be very vulnerable to that.
What is debt security?
We’ve had a significant discussion on debt holders holding debt securities which begs the question, what is a debt security? It is any debt that can be bought or sold between parties in the market before the debt matures. It’s structured in the following way, a debt is owed by an issuer (the government, an organization, or a company) to an investor who acts as a lender.
Debt securities are negotiable financial instruments, which means that their legal ownerships can be transferred readily from one owner to another. You have probably heard of the term savings bonds. Bonds are the most common types of financial securities. These financial securities are a contract between the borrower and lender. The two parties agree upon a rate of return on the principal over a considerable period. The borrower would have to repay the principal with the interest rate after the agreed period.
Bonds can be issued by the government and non-government bodies and are available in differing forms. Two structures for bonds are fixed-rate bonds and zero-coupon bonds. People often think that bank loans are a type of debt security; however, this is not the case. These are non-negotiable financial instruments.
Why should you invest in debt securities by debt holders?
There are many benefits for investing in debt securities by debt holders. Debt holders act as a middle man between the borrower and the lender and protect the interest of both. We have listed the benefits of investing in debt securities below:
1) Return on capital
Investors buy debt securities due to their return on capital. These debt securities are designed so that investors have a substantial benefit to investing in them. These investors receive these benefits in terms of interest and repayment of capital at maturity.
2) Stable income due to interest payments
Depending on the bond, you can get a stable income on a monthly or bi-annual basis. This income is received through interest payments throughout the year until the duration of the bond is complete. These payments are guaranteed and automatically authorized by the debt holder. So, you don’t have to worry about access to them.
3) Diversify holdings
It is likely if the investor is investing in financial instruments, they’re not only investing in one type. If you’re a seasoned investor, you know how important it is to diversify holdings. Thus, debt securities are a fool-proof method of achieving this. Diversifying holdings is also a significant way to reduce risks when it comes to an investor’s portfolio.
Please note that, as a new investor, investing in financial securities is one of the most secure ways to invest your money.
Debt holders are necessary for the company to perform debt financing. People have various opinions on whether debt financing or equity financing is better. It depends on several factors, like rates of return, floatation costs, and all sorts of other things.
However, debt holders take some of the weight of transactions away from the company’s owner providing debt financing. Through debt holders, companies create another instrument that they can hold accountable for their business’ debt financing. Debt holders streamline the process of debt financing for the lender and the borrower, which is in the company itself. They bring in more accountability for all the parties involved. They are often confused with share, equity, and bondholders, but they’re not the same.