By: Landon H. Johnson
When your company needs to borrow some extra funds to stay afloat, you are left to decide whether to issue bonds or to take out a loan. First, you need to know the difference between these two financial instruments and the markets in which they operate.
A bond is a debt instrument (basically an IOU) used by companies and governments to raise funds when necessary. The “bond market” is a marketplace where buyers and sellers of debt meet and such transactions are processed. The bond market refers to three types of bonds; government bonds, which are the safest bonds, followed by municipal, and then corporate (highest risk bonds). Bonds are known for their liquidity, and the fact that they are relatively, but not totally, “risk-free.” With bonds, there is always the possibility of the borrower defaulting on the debt payments. Bonds are also sensitive to interest rates. This is because there is an inverse relationship between bond value and interest rates. The bond market is often used to indicate changes in interest rates or the shape of the “yield curve.” Yield is the rate of return you get on the bond and the yield curve is simply the measure of the cost of funding. When prices go up, yield goes down and vice versa. According to the U.S. Treasury, currently, there are rather steep yield curve rates of 2.75- 3%, which provides added safety and return potential for the buyer of the bond.
The buyer of a bond is the lender, and the issuer of the bond is the borrower. A bond is basically when a borrower promises to pay a lender back in 10, 20, 30 years. During which time the borrower pays interest on that loan to the lender. When the borrower is ready to pay back the lender, the bond is simply sold back to the borrower by paying them the principal investment. This is referred to as the date of maturity. Bonds can be bought and sold very easily and they are known for their very low risk. Most bond trading occurs between brokers and big institutions. There is always a market for bonds, therefore, a general advantage of bonds is that a borrower would not have to wait 30 years for the bond to mature, and they could just sell it.
In the loan market, however, another type of credit market, the lending tends to be between banks and customers. Loans, unlike bonds, are essentially non-tradable (loans are debt that can only be bought and sold between banks and credit agencies) and both parties must stick to the contract. There is an active secondary trading market in syndicated loans. Loans can have very high and sometimes variable interest rates, which can be unappealing to borrowers.
CFO’s often view loans from banks as a last resort because of the rigorous restrictions placed on the loan, which is manufactured specifically to reduce the risk of the bank. These restrictions are called, “covenants”. One example of a restriction is that the company may not be permitted to merge with any other companies until the loan is completely paid off. While it is true that some loans can have fixed, low-interest rates, which can be very attractive to potential borrowers, most CFO’s tend to issue bonds, or sell a debt rather than go for the more restrictive bank loan. However, high yield bonds also tend to be heavily covenanted.
So, do you want to issue bonds or take out a loan? Let’s compare and contrast. As stated above, loans can have very high-interest rates, are un-tradable, and restrictive. Interest rates are also a major concern with bonds. The interest rates play a big part in the price of the bond. If interest rates go up, the value of the bond will fall. Businesses can normally access lower interest rates and longer-term funding in bond markets than through loans. This is, of course, because the banks want to make sure to reduce their risk as much as possible. However, Reuters reported last year that in the UK, treasurers stated that, ”Bond markets’ exposure to macroeconomic swings was often too great to merit the risk. Over five years of global financial crisis, banks have typically cut back on loans to businesses.” Therefore, there are three key factors in your decision between bonds and loans. First, the interest rates because of how they affect the value of the bond. Second, the state of the global economy, which as stated above, has an inverse relationship with interest rates. Third, the covenants the bank places on the loan.
Thus, if your team of economic analysts predict that the central banks are going to raise interest rates you may want to consider a loan from a bank at a fixed low-interest rate instead of issuing a bond. Now, could some “macroeconomic swings,” as the UK treasurers referred to them, increase the risk associated with the bond? Absolutely. However, currently, most economists are in agreement that while the economy does show slight signs of growth, it will most likely continue to “muddle” along, like it has been for quite some time. It is clear that faith is slowly being restored in banks and that more and more businesses are opting to get loans instead of issue bonds. However, as a responsible CFO, you must make sure that the covenants on the loan do not prohibit you from doing anything that could make your company money in the future, or more importantly cost you. For example, some restrictive covenants state that if the CEO steps down, the interest rate on the loan could increase considerably. You see how this could potentially cost you in the long- run? These restrictions sometimes add more risk to the loan. Therefore, a CFO has to be very careful to understand the exact restrictions attached to the loan. After all, they are created specifically to match the borrower’s business risks, and to reduce the risk for the bank. Bottom line, they are designed specifically in the banks best interest. Therefore, most CFO’s find these covenants to be too risky and are unsatisfied with the restrictions placed on the funds. As a CFO, why would you want money that could prohibit you from possibly making more money? As a general rule of thumb, bonds are suitable anytime you cannot afford to take any chances.
Nevertheless, bonds are not always safer. In loans, you know whom you are dealing with and can negotiate if there is a problem. Whereas, you never know whom your bondholders are. That’s why covenants need to be flexible because you can’t just call them up and ask them to cut you some slack. Lenders are more involved and will understand when you need flex. Bondholders will ignore you and potentially hold you for ransom if the bonds have covenants. Therefore, big companies strive for diversified financing sources. Thus, you may not want all bonds or all loans. When you issue bonds, you’ve got the money and have to pay interest. With loans, you can have a revolver of working capital facilities that allow you to draw when you need it, thereby minimizing debt service costs. The key is to find the right mix of flexibility, maturity and interest rate.