What is straight debt? Definition, Example, Components, And Mores

Definition

Straight debt, also known as a plain vanilla bond, is the simplest type of debt finance that a company can obtain. Straight debt bears fixed interest regularly at pre-determined points in time. Straight debt is paid to companies by investors or institutions for a set amount of time. During this time, the investors receive regular payments from the company.

Once the instrument has matured, the company has to pay the principal amount of debt back to the institution.

Straight debt does not carry any special options as compared to some other forms of debt. For example, convertible debt can be converted to common equity shares of the company once maturity is reached.

Straight debt gives the entity providing the debt to the company no other options and at maturity, just the principal amount is paid back. Straight debt is the basis for all other types of debts.

Components of Straight Debt

Straight debt instruments have a periodic interest rate. At the end of every period, the investor who provided the debt receives interest payments also known as coupons.

These interest payments are calculated on the face value or par of the straight debt instrument at the specific fixed rate. These interest payments are made by the company until the maturity date of the straight debt instrument is reached.

Straight debts have a face value or part value. This is the value that the investor pays for every straight debt instrument of the company.

This value is also referred to as the principal amount of the debt and is returned to the investor at the end of the straight debt instrument’s maturity date.

While the face value of the instrument is constant, the issuing company may choose to offer the instrument at a discount or at a premium.

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Finally, straight debt instruments have a fixed maturity date. This is the date on which the original amount of the straight debt instrument or its face value is paid back to the investor. After this date, no further payments are made to the investor whether interest or principal.

Straight Debt Premium and Discount Price

Some straight debt instruments may also have a premium or discount price. The premium price is any price paid for the straight debt instrument above its par value. A discount price is any price paid for the straight debt instrument that is lower than its par value.

At the maturity date, for a straight debt instrument with a premium price or discount price, only the par value is returned to the investor.

This means that if the investor paid a premium price for the instrument, they would have to suffer a loss of the premium amount.

Similarly, if the investor paid a discount price for the instrument, they will receive a profit at maturity.

For example, a company ABC Co. issues a straight debt premium at a face value of $100 to investors. If an investor pays $105 for the instrument, the $5 paid above the face value is the premium price.

At the maturity date, the investor will only receive the face value, $100, and make a loss of $5 ($100 – $105). For ABC Co. it will be a profit of $5 as it has to pay less than the amount it originally received.

However, if the investor pays $95 for the instrument, then the $95 is known as the discount price. At maturity, the investor will receive the face value, $100, and make a profit of $5 ($100 – 95).

For ABC Co. it will be a loss of $5 as they have to pay more than the amount they originally received.

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Risks for Investors

Straight debt instruments provide the debt holder with a fixed rate of interest. As these instruments can span over many years until their dates of maturity, they can expose the debt holders to interest risks and possibly to default risks.

Interest risk is the risk of interest rates changing in the market. This means investors have to receive the same interest rate payments regardless of market conditions.

For example, an investor buys the straight debt instruments of a company, the maturity date of which is after 5 years and provides an interest rate of 5% while the average market interest rate is also 5%.

In the 5 years until the instrument’s maturity date, if the market’s interest rates increase to 7%, the investor is still bound to receive only 5%. This is a risk that investors of straight debt instruments have to face.

Default risk is the risk of default in the payments, either interest or principal, of the straight debt instruments. For example, an investor buys the straight debt instruments of a company that has a maturity date of 5 years.

If the company is liquidated in the next 5 years, there is a chance that the investor doesn’t receive their interest payments and principal amount back.

Example of Straight Debt

A company XYZ Co. issues straight debt equipment at a face value of $100. The instrument’s maturity date is 7 years from the date of its issue. The interest rate or coupon rate on the instrument is 5%.

This means an investor who invests in the straight debt instruments of XYZ Co. will receive annual interest payments of $5 ($100 x 5%) and a total interest payment of $35 throughout the life of the instrument.

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After the 7 years, at the maturity date, XYZ Co. will also pay the investor $100 back, which is the face value of the instrument. Disregarding the concept of the time value of money, the investor will make a profit of $35 ($5 interest x 7 years).

Premium Price

Considering the same example above, if the instrument is issued with a premium of $20, at $120, the investor will still receive $100 (par value) at the end of maturity.

However, in this scenario, the investor will make a profit of only $15 ($35 profit – $20 loss). This is because while the investor made a profit of $35 in interest receipts, the investor was also paid $100 instead of the $120 they paid for the instrument.

Discount Price

Considering the example of XYZ Co. again, the company offers the instrument at a $90 discount price instead of the $100 face value of the instrument. In this case, the investor will make a profit of $45 instead of $35 in the original scenario.

This is because, in this scenario, the investor not only makes a profit of $35 in interest receipts but also makes a profit because they received $100 for the instrument they paid $90 for.

Conclusion

Straight debt is the simplest type of debt instrument that bears regular, periodic interest payments. Straight debt instruments are issued at par value, with a fixed interest rate and fixed maturity date.

At the end of the life of the instrument, the investor receives the face value of the instrument back from the issuing company.

Sometimes companies may issue straight debt instruments at a premium price while sometimes offering them at a discounted price.

In either of the two scenarios, the investor gets only the face value of the instrument repaid alongside the interest payments.