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Issuing bonds is one way for companies to raise money. A bond functions as a loan between an investor and a corporation. The investor agrees to give the corporation a certain amount of money for a specific period of time. In exchange, the investor receives periodic interest payments. When the bond reaches its maturity date, the company repays the investor.
The decision to issue bonds instead of selecting other methods of raising money can be driven by many factors. Comparing the features and benefits of bonds versus other common methods of raising cash provides some insight. It helps to explain why companies often issue bonds when they need to finance corporate activities.
Key Takeaways
- When companies want to raise capital, they can issue stocks or bonds.
- Bond financing is often less expensive than equity and does not entail giving up any control of the company.
- A company can obtain debt financing from a bank in the form of a loan, or else issue bonds to investors.
- Bonds have several advantages over bank loans and can be structured in many ways with different maturities.
Bonds vs. Banks
Borrowing from a bank is perhaps the approach that comes to mind first for many people who need money. That leads to the question, "Why would a corporation issue bonds instead of just borrowing from a bank?"
Like people, companies can borrow from banks, but issuing bonds is often a more attractive proposition. The interest rate that companies pay bond investors is usually less than the interest rate available from banks.
Companies are in business to generate corporate profits, so minimizing the interest is an important consideration. That is one of the reasons why healthy companies that don’t seem to need the money often issue bonds. The ability to borrow large sums at low interest rates gives corporations the ability to invest in growth and other projects.
Issuing bonds also gives companies significantly greater freedom to operate as they see fit. Bonds release firms from the restrictions that are often attached to bank loans. For example, banks often make companies agree not to issue more debt or make corporate acquisitions until their loans are repaid in full.
Such restrictions can hamper a company’s ability to do business and limit its operational options. Issuing bonds enables companies to raise money with no such strings attached.
Bonds vs. Stocks
Issuing shares of stock grants proportional ownership in the firm to investors in exchange for money. That is another popular way for corporations to raise money. From a corporate perspective, perhaps the most attractive feature of stock issuance is that the money does not need to be repaid. There are, however, downsides to issuing new shares that may make bonds the more attractive proposition.
Companies that need to raise money can continue to issue new bonds as long as they can find willing investors. The issuance of new bonds does not affect ownership of the company or how the company operates. Stock issuance, on the other hand, puts additional stock shares in circulation.
That means future earnings must be shared among a larger pool of investors. More shares can cause a decrease in earnings per share (EPS), putting less money in owners' pockets. EPS is also one of the metrics that investors look at when evaluating a firm’s health. A declining EPS number is generally viewed as an unfavorable development.
Issuing more shares also means that ownership is now spread across a larger number of investors. That often reduces the value of each owner's shares. Since investors buy stocks to make money, diluting the value of their investments is highly undesirable. By issuing bonds, companies can avoid this outcome.
More About Bonds
Bond issuance enables corporations to attract a large number of lenders in an efficient manner. Record keeping is simple because all bondholders get the same deal. For any given bond, they all have the same interest rate and maturity date. Companies also benefit from flexibility in the significant variety of bonds that they can offer. A quick look at some of the variations highlights this flexibility.
The basic features of a bond—credit quality and duration—are the principal determinants of a bond's interest rate. In the bond duration department, companies that need short-term funding can issue bonds that mature in a short time period. Companies with sufficient credit quality that need long-term funding can stretch their loans to 30 years or even longer. Perpetual bonds have no maturity date and pay interest forever.
Credit quality stems from a combination of the issuing company’s fiscal health and the length of the loan. Better health and shorter duration generally enable companies to pay less in interest. The reverse is also true. Less fiscally healthy companies and those issuing long-term debt are generally forced to pay higher interest rates to entice investors.
Types of Bonds
One of the more interesting options companies have is whether to offer bonds backed by assets. These bonds give investors the right to claim a company’s underlying assets if the company defaults. Such bonds are known as collateralized debt obligations (CDOs). In consumer finance, car loans and home mortgages are examples of collateralized debt.
Companies may also issue debt that is not backed by underlying assets. In consumer finance, credit card debt and utility bills are examples of loans that are not collateralized. Loans of this type are called unsecured debt. Unsecured debt carries a higher risk for investors, so it often pays a higher interest rate than collateralized debt.
Convertible bonds are another type of bond. These bonds start just like other bonds but offer investors the opportunity to convert their holdings into a predetermined number of stock shares. In a best-case scenario, such conversions enable investors to benefit from rising stock prices and give companies a loan they don’t have to repay.
Finally, there are also callable bonds. They function like other bonds, but the issuer can choose to pay them off before the official maturity date.
Why Companies Issue Callable Bonds
Companies issue callable bonds to allow them to take advantage of a possible drop in interest rates in the future. The issuing company can redeem callable bonds before the maturity date according to a schedule in the bond's terms. If interest rates decrease, the company can redeem the outstanding bonds and reissue the debt at a lower rate. That reduces the cost of capital.
Calling a bond is similar to a mortgage borrower refinancing at a lower rate. The prior mortgage with the higher interest rate is paid off, and the borrower obtains a new mortgage at the lower rate.
Callable bonds are more complex investments than normal bonds. They may not be appropriate for risk-averse investors seeking a steady stream of income.
The bond terms often define the amount that must be paid to call the bond. The defined amount may be greater than the par value. The price of bonds has an inverse relationship with interest rates. Bond prices go up as interest rates fall. Thus, it can be advantageous for a company to pay off debt by recalling the bond at above par value.
The advantages of callable bonds for issuing companies are often disadvantages for investors. There are many factors to consider before investing in callable bonds.
What Is the Difference Between a Corporate Bond and a Government Bond?
Corporate bonds are issued by corporations to raise money for funding business needs. Government bonds are issued by governments to fund the government's needs, such as to pay for infrastructure projects, government employee salaries, and other programs. Corporate bonds are generally riskier than government bonds as most governments are less likely to fail than corporations. Because of this risk, corporate bonds generally provide better returns.
Are Corporate Bonds Safer Than Stocks?
Generally, yes, corporate bonds are safer than stocks. Corporate bonds offer a fixed rate of return, so an investor knows exactly how much their investment will return. Stocks, however, typically offer a better rate of return because they are riskier. So the money invested in a corporate bond, while it may earn 3%, might also miss out on earning more if the stock appreciates more than 3%; however, the stock also may not appreciate more than 3%. The right investment depends on the investor's risk tolerance and investment objectives.
Are Corporate Bonds Tax-Free?
No, corporate bonds are not tax-free. An investor will have to pay taxes on the interest income earned as well as on any capital gains.
The Bottom Line
For companies, the bond market clearly offers many ways to borrow. The bond market has a lot to offer investors, but they must be careful. The variety of choices, ranging from duration to interest rates, enables investors to select bonds closely aligned with their needs.
This wide selection also means that investors should do their homework. They need to make sure they understand where they are putting their money. They should also know how much they will earn and when they can expect to get their money back.
For investors unfamiliar with the bond market, financial advisors can provide insight and guidance as well as specific investment recommendations and advice. They can also give an overview of the risks that come with investing in bonds. These risks include rising interest rates, call risk, and the possibility of corporate bankruptcy. Bankruptcy can cost investors some or all of the amount invested.
Of course, there are other approaches to dealing with the complexity of the bond market. One can invest in a bond fund, where a mutual fund manager will make all these decisions in exchange for fees. However, fees are generally much lower for aggregate bond ETFs.