The different types of debt: understanding their nature and use

In the financial and economic world, the concept of debt is omnipresent. Debt serves as an essential tool for companies, governments, and individuals to finance projects, meet needs, or make investments. However, not all debts are the same. Each type of debt has unique characteristics, advantages, and disadvantages tailored to specific situations. Here is an overview of the main types of debt, how they work, and their implications.

Debt by issuer

Public debt: Public debt is contracted by governments to fund public spending when revenues (taxes, levies) are insufficient. It is issued as government bonds, often considered safe investments, especially in developed countries. The risk is generally low but depends on the country’s economic and political stability.

Example: French Treasury bonds (OATs).

Private debt: Private debt is issued by companies or individuals. It can take the form of bank loans, corporate bond issuances, or peer-to-peer lending. The risk level depends on the issuer’s creditworthiness.

Example: A company issuing corporate bonds to fund an expansion project.

Debt by duration

Short-term debt: this refers to loans or credits with a maturity of less than one year. It is often used to manage cash flow or address immediate needs.

Example: Seasonal credit for agricultural businesses or short-term working capital loans.

Medium-term debt: this type of debt typically ranges between one and five years and is generally used to finance medium-term investments, such as purchasing equipment or vehicles.

Example: Leasing for a corporate vehicle fleet.

Long-term debt: long-term debt extends beyond five years and is often used to fund significant investments, such as infrastructure projects, acquisitions, or real estate developments. Interest rate risks can become significant if economic conditions shift.

Example: Mortgage loans or 10-year bonds.

Debt by repayment structure

Amortizing debt : in this type of debt, the principal is repaid progressively with each installment (monthly, quarterly, etc.), along with interest. This reduces the outstanding principal over time.

Example: A traditional bank loan.

Bullet loan (In-Fine Debt): here, the borrower pays only the interest throughout the loan term and repays the principal in a single lump sum at maturity.

Example: Loans for rental property investments to maximize tax deductions on interest.

PIK Debt (Payment-In-Kind): a PIK debt allows interest payments to be deferred and capitalized. Instead of regular cash payments, interest is added to the principal and paid in full at a later date, often upon the loan’s maturity.

Debt by collateral

Secured debt: this debt is backed by specific collateral, which the lender can seize in case of default. Secured debt often has lower interest rates.

Example: Mortgage loans secured by real estate.

Unsecured debt: this debt relies solely on the borrower’s creditworthiness and is not backed by specific collateral. As it carries a higher risk for lenders, interest rates are generally higher.

Example: Credit cards or personal loans.

Debt specific to businesses

Bond debt: companies issue bonds to raise funds from investors. Bonds can be traded on stock exchanges, allowing them to be sold before maturity.

Mezzanine debt: positioned between debt and equity, mezzanine debt carries high risk but offers attractive returns. It is commonly used in private equity transactions.

Revolving credit: this refers to a credit line provided to businesses, which can be drawn and repaid as needed within a set limit.

Advantages and disadvantages of debt

Advantages:

• Leverage effect: debt enables the financing of ambitious projects without diluting equity.
• Tax benefits: interest payments are often tax-deductible.
• Flexibility: different types of debt provide tailored solutions for various needs.

Risks:

• Over-indebtedness: poor debt management can lead to financial difficulties.
• Default risk: inability to repay debts can result in severe consequences for borrowers.

Debt is an indispensable financial tool, but its use must be thoughtful and well-managed. Whether for individuals, businesses, or governments, understanding the various types of debt and their specificities enables the adoption of tailored financial strategies while minimizing associated risks.