Discover Why Companies Issue Bonds
Corporate bonds are issued by companies to the finance and/or expand their operations. For a better understanding of What a Corporate Bond is, we have explained it here “Corporate Bonds”
Companies often borrow from banks, but borrowing from a bank can become expensive and restrictive, whereas selling debts by issuing a bond in the open market is a more convenient option.
Issuing bonds is one way a company can raise money. Bonds act as loans between an investor and the corporation availing the loan. The loan is granted to the corporation for a limited tenure, in return of certain interest, charged at defined intervals and as the maturity period arrives, the investor’s loan is finally repaid.
For many companies, the added costs of borrowing money from a bank directly makes this method very traditional, which makes the absolute omission of this method. It is because of the banks’ restrictive debt covenants placed on direct corporate loans that many chief financial officers usually don’t consider taking the loan from a bank and even if so, is the last resort.
Restrictive Covenant’s are written by lawyers to protect the bank’s interest and reduces the risk that a bank can face when it sanctions a large loan amount to a company.
Listed below are few examples of restrictive covenants faced by companies:
1. Until and unless the entire loan amount outstanding to the bank is cleared, it cannot issue any other debts.
2. Only when the entire loan amount to the bank is cleared, can it participate in any share offerings.
3. Likewise, no companies can be attained until the bank loan is cleared and settled.
These are quite simple unrestrictive covenants that may be placed on corporate borrowings but debt covenants are more complex and need careful execution to be in accord with the borrower’s business risks.
These restrictive covenants can also tell whether or not the chief financial officer should withdraw when the interest rates on debts increase substantially or the earnings per share drops during a particular time frame.
In the case of banks, these covenants acts are risk mitigates but for the borrowing companies these act as increased risk. In another way it can be clearly stated that a bank is more concerned about debt repayment than the bondholder, imposing greater restrictions on the borrowing companies. In simple words, the bank makes a list of memorandums of do’s and don’ts.
This makes bond markets simpler and lenient to deal with. Hence, it is more convenient for the borrowing company to avail loan by issuing bonds than borrowing from a bank.
Listed below are few of the reasons as to why companies issue bonds for money raising purpose.
1. Bonds Vs Banks:
Borrowing money from the bank is possibly the first thing that strikes every mind but companies as a last resort borrow money from the bank. Issuing bonds are more is often a more profitable bargain for companies rather than borrowing from the bank. The interest paid to the bond investors is relatively less than that paid in banks to avail the loan.
A proper decision must be made while availing loan since the money paid as interests are from that of the company’s profit. Hence companies issue bonds when the interest rate is extremely low to maintain the proper functioning of any company.
Thus the save they make in availing huge loan paying very low interests is used for the company’s other concerns, like infrastructure, development and other projects.
Loan borrowed from banks have a lot of restrictions attached to it for the borrowing companies which in the case of issuing bonds is not applicable. The company is hence free of the restrictions and is in a much better place, as its growth is not hindered.
2. Bonds Vs Stock:
In many cases, the corporation grants proportional and partial ownership in the company to the investors, i.e. issuing stocks, to raise money. Issuing bonds are probably the most attractive way to raise money since the revenue generated from the sale of stocks need not be repaid.
Though a few negative aspects are involved in stock issuance, it is, however, an attractive proposition for corporates.
When bonds are issued, the companies can keep issuing new bonds to raise more money till the time the investors are willing to lend. Unlike stock issuance, when new bonds are issued it has no effect on the ownership of the company or how that particular company operates.
In case of stock issuance, the revenue generated by the company has to be shared amongst all its shareholders and investors which results in lesser earning per share (EPS). This in the other word means the owner of the company shares on the profit earned by the company.
Decreasing EPS is not favorable for any company since the investors’ measure the EPS while analyzing the development and health of the company. Thus issuing more shares mean the company’s ownership is split amongst multiple investors which lead to a decrease in the profit margin per owner.
This situation is not likeable for any of the owners who had invested in the company hoping to make more money which does not happen when bonds are issued. More lenders are attracted when bonds are issued by a company and keeping track of the record is also simple.
All bondholders get the exact same details with the same interest and maturity date. Companies feel flexible because of the different variety of bonds offering open to them.
A brief discussion of these variation flexibilities:
The rate of interest set on a bond depends primarily upon its basic features, i.e. its time period and credit quality.
When the matter comes to the bond duration department, companies needing a short-term loan can issue bonds for which the maturity period is short, while companies opting for long-term funding can avail loan for a tenure of 10, 30, 100 years and more, as per the need. Bonds which are for a real long-term are known as perpetual bonds and interest is paid forever since there is no maturity date.
Another appealing fact for companies opting for bonds is whether or not to offer bonds back by assets.
Collateralized debts are bonds that give investors the sole right to claim the underlying assets of the company when the borrowing company fails to repay the loan amount or the demanded interest amount.
Speaking in terms of consumer finance, car loan and home mortgages are appropriate examples of collateralized debts. A company can also issue debts which are not backed by any assets. Likewise, credit card debts and utility bills fall under the consumer finance’s uncollateralized loans.
Such loans are termed as “unsecured” debt and pose a greater threat for the investors. This results in paying a higher rate of interest than that for the collateralized debts.
Also, taken into consideration are the convertible bonds which are very similar to the other bonds but ensures investors the opportunity to convert their holdings into a set number of stock shares.
The best possible situation is when conversions allow investors to benefit from the rising stocks prices and sanctions loan to the companies, which they don’t have to repay.
Callable Bonds issued by Companies:
Callable bonds function similarly like other bonds but the issuer can clear of the loan amount even before the maturity term. Callable bonds issued by companies help them to take advantage of the periods when there is a drop in the interest rates.
The company issuing can clear off the callable bonds prior the maturity date. If interest rate drops, the outstanding callable bond can be redeemed and the debts can be reissued at a much lower rate.
Just like in the case of mortgaging where the borrower can issue a new mortgage at a lower rate after the prior mortgage is clear off with higher rates of interest.
The price of the bond and the rate of interest have an inverse relationship- when the interest rate falls, the price of the bond increases. This creates an advantageous situation for the company to clear off debts by recalling the bond at a value more than the face value of the bond. Issuing callable bonds can be dangerous for investors looking for a fixed low of income.
Must know for Investors:
Investors receive premium interest rates for the risk attached with callable bonds. Owners of callable bonds are at risk of the bond being called early and in such situations, they are left with no option but forced to invest in other bonds at a much lower rate.
Options on the bond are written by the bond investors. Premiums are received beforehand by the investor for the written options but risks having the bond called.
Callable bond investors ought to keep in track two products, unlike the normal bond, which deals with only one product. Yield to call and yield to mature are the two products dealt in callable bond.
In case of yield to call, it is the amount the bond will produce before being possibly called while for the yield to mature is the expected amount the bond will produce if continued till its maturity term, in consideration of the bond’s market value. When yield to maturity is taken into account, it depends on the time value of the money.
An investor should consider both the yields before buying them. In case the rate of interest decreases the valuation of the callable bonds will not increase like the normal bonds. In such circumstances, most of the time, the bond is called which results in fewer investors opting for these bonds.
In Callable bonds, one is entitled to various types of call options. For American calls, the issuer can recall the bond at any given time after the callable date stated, also known as continuously callable. Calls for European allows the issuer the right to call the bond on a given specific date only, also called the one-time-only call.
Many options are provided by the bond market to the borrowing companies to raise money and investors should consider a lot of things while buying the bond.
From different types of bond to time period and rate of interests, investors efficiently select one according to his/her requirement.
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