Why Companies Issue Bonds
When the existing shareholders do not want their ownership interests to be diluted by the transfer of shares to new investors.
Money Poise
Companies can raise capital through bond offerings. An investor lends money to a company in the form of a bond. The investor commits to making periodic payments to the company over a set length of time. The investment is rewarded with regular interest payments. The bondholder is repaid when the issue date arrives.
There are a number of possible motivators for choosing to issue bonds as opposed to pursuing alternative funding strategies. Some context can be gained by contrasting the characteristics and advantages of bonds with those of other typical means of acquiring capital. This explains why bonds are a common method of financing for businesses.
KEY POINTS
- Companies can issue stock or bond offerings to the public to raise money.
- Unlike equity financing, bond financing does not require the issuer to give up any ownership in the business.
- A business can get debt financing in the form of a loan from a financial institution or issue bonds to investors.
- Compared to bank loans, bonds offer more flexibility in terms of structure and maturity.
Bonds vs. Banks
For many individuals in need of cash, borrowing from a bank is probably the first option that comes to mind. This begs the query, "Why would a corporation issue bonds instead of just borrowing from a bank?"
Similar to individuals, corporations can borrow from banks; however, issuing bonds is typically a more attractive option. Typically, the interest rate paid to bond investors by corporations is lower than the rate offered by banks. Companies are in business to generate corporate profits, so minimising interest is a crucial factor. This is one of the reasons why sound companies that do not appear to have a need for capital frequently issue bonds. Corporations are able to invest in growth and other initiatives because they can borrow large sums of money at low interest rates.
Additionally, bond issuance provides companies with considerably more operational flexibility. Bonds liberate businesses from the restrictions that are frequently associated with bank loans. For instance, banks frequently require companies to commit not to issue additional debt or engage in corporate acquisitions until their loans have been repaid in full.
Such restrictions can hinder a company's business operations and limit its operational options. By issuing bonds, corporations can raise capital without such restrictions.
Bonds vs. Stocks
Stock shares are issued to investors in exchange for capital, giving them a stake in the company. Companies also frequently use this method to bolster their financial resources. The fact that issued shares do not have to be repaid is arguably the most alluring aspect of stock issuance from a business perspective. However, there are drawbacks to issuing fresh shares, which could make bonds a more appealing option.
As long as there are buyers on the market, companies that need to generate capital can keep issuing new bonds. A company's ownership structure and operations can't be changed due to the issue of new bonds. In contrast, the release of new shares of stock into the market increases the total number of stock shares. This necessitates a wider group of shareholders to benefit from future profits. The monetary benefit to shareholders is reduced if the EPS falls because of a greater number of shares being issued. Investors use EPS as a proxy for a company's overall health together with other metrics. Typically, investors would see a drop in earnings per share as undesirable.
Increasing the number of shares available for purchase likewise increases the number of people who have a stake in the company. The value of the stock held by each owner usually falls as a result. For obvious financial reasons, stockholders do not want their investments diluted. Firms can prevent this result by issuing bonds.
More About Bonds
By issuing bonds, businesses can quickly and easily have access to funding from a vast pool of investors. Since all bondholders are treated equally, keeping records is a breeze. All bonds of a specific type share the same interest rate and expiration date. Also beneficial to businesses is the freedom to provide a vast array of bond options to investors. This adaptability is highlighted by a brief examination of a few of the variants.
Bond interest rates are determined primarily by two fundamental characteristics: credit quality and duration. Companies that have an immediate financial need can issue bonds with a quick maturity date. Loan terms for companies with good credit that require long-term capital can be extended to 30 years. There is no end to the interest payments on perpetual bonds.
The financial stability of the issuing company and the term of the loan together determine the creditworthiness of the loan. When a company is in better financial shape and has a shorter term commitment, it can pay less in interest. It works both ways, too. Companies that are less financially stable, or that issue long-term debt, typically have to pay higher interest rates to attract investors.
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Types of Bonds
Offering asset-backed bonds is one of the most intriguing options available to corporations. These bonds grant investors the right to claim the underlying assets of a defaulting company. CDOs are the acronym for collateralized debt obligations. In consumer finance, examples of collateralized debt include auto loans and mortgages.
Additionally, corporations may issue debt that is not supported by underlying assets. In consumer finance, examples of unsecured loans include credit card debt and utility expenses. This form of debt is known as unsecured debt. Unsecured debt entails a greater risk for investors, so it typically pays a higher rate of interest than secured debt.
Another form of bond are convertible bonds. These bonds begin identically to other bonds, but allow investors to convert their holdings into a predetermined number of equity shares.In the best-case scenario, these conversions allow investors to profit from rising stock prices and provide companies with an interest-free loan.
In addition, there are callable bonds. They function similarly to other bonds, but the issuer has the option to redeem them prior to their official maturity date.
Why Companies Issue Callable Bonds
Callable bonds are issued by corporations so that they may profit from a future decrease in interest rates. Callable bonds have provisions in their terms that allow the issuing business to redeem them before their maturity date. Bonds can be redeemed and reissued by a firm at a cheaper interest rate if interest rates fall. The cost of capital is lowered as a result.
Bond calling is analogous to mortgage refinancing at a lower interest rate. The borrower gets a new mortgage at a reduced interest rate after paying off the old mortgage at a higher rate.
The cost of a bond's early redemption is often spelt out in the bond's terms. The denominated sum may exceed the nominal value. There is a negative correlation between interest rates and bond prices. When interest rates go down, bond prices go up.
A corporation can save money by recalling the bond at a price higher than its face value and using the proceeds to retire debt.
Callable bonds are a more involved financial instrument than traditional bonds. Investors wanting safety in their returns should think twice before putting money into them.
The benefits of callable bonds for issuing corporations are typically offset by their drawbacks for bondholders. Before putting money into callable bonds, you need carefully weigh a number of considerations.
The Bottom Line
The bond market is an obvious resource for corporations seeking financing. Investors can gain a lot from the bond market, but they need to exercise caution. Investors are able to select bonds that are a good fit for their specific circumstances thanks to the options available to them in terms of duration and interest rates. Investors should complete their due diligence because of the variety of options available to them. They should be certain of the safety of their investments. Furthermore, they should be aware of the projected return (both monetary and time-related).
Those who aren't familiar with the bond market can benefit from a financial advisor's advice and recommendations. They are also knowledgeable about the potential dangers of bond investing. Call risk, rising interest rates, and the prospect of business insolvency all belong to this category. Investors may lose some or all of their money if the company declares bankruptcy.
There are, of course, various methods for navigating the bond market's complexities. One option is to have a mutual fund manager handle all of these details for one's bond portfolio. However, costs for bond ETFs as a whole tend to be substantially cheaper.
