Why Do Companies Create Bonds
Bonds are one method businesses could get capital. Between an investor and a company, a bond serves as loan. The investor commits to provide the company a particular sum of money over a designated period of time. The investor gets paid monthly interest in return. The corporation returns the investment when the bond reaches its mature date.
There are several reasons why one should decide to issue bonds rather than choosing another way of funding. One can get some understanding by contrasting the features and advantages of bonds with other typical ways of obtaining money. It helps to explain why firms commonly issue bonds when they need to finance company activities.
Bonds vs. Banks
Borrowing from a bank is arguably the technique that springs 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 humans, firms can borrow from banks, but issuing bonds is generally a more tempting prospect. The interest rate that firms pay bond investors is frequently smaller than the interest rate available from banks.
Businesses exist to make money, so minimising the interest is a top priority. That is one of the reasons why healthy corporations that don’t seem to need the money typically issue bonds. The capacity to borrow big sums at cheap interest rates gives firms the ability to invest in growth and other projects.
Issuing bonds also allows corporations substantially greater leeway to act as they see proper. Bonds liberate enterprises from the constraints that are sometimes tied to bank loans. For example, banks often require corporations pledge not to issue new debt or conduct major acquisitions until their debts are returned in full.
Such limits might impede a company’s capacity to do business and limit its operating options. Issuing bonds enables corporations to raise money with no such strings attached.
Bonds vs. Stocks
Issuing shares of stock offers proportional ownership in the corporation to investors in exchange for money. That is another popular technique for corporations to raise money. From a corporate standpoint, perhaps the most enticing feature of stock issuing is that the money does not need to be repaid. There are, however, drawbacks to issuing fresh shares that may make bonds the more attractive alternative.
Companies that need to raise money can continue to issue new bonds as long as they can find willing investors. The issue of fresh bonds does not impact ownership of the firm or how the company runs. Stock issuance, on the other hand, puts extra stock shares in circulation.
That means future earnings must be shared among a broader pool of investors. More shares might cause a fall in earnings per share (EPS), placing less money in owners' pockets. EPS is also one of the variables that investors look at when analyzing a firm’s health. A falling EPS number is often considered as an undesirable development.
Issuing more shares also means that ownership is now shared among a wider number of investors. That often reduces the value of each owner's shares. Since investors acquire stocks to make money, diluting the value of their investments is highly undesirable. By issuing bonds, firms can avoid this outcome.
More About Bonds
Bond issuing enables firms to attract a wide number of lenders in an effective manner. Record keeping is simple because all bondholders get the same deal. For every given bond, they all have the same interest rate and maturity date. Companies also profit from flexibility in the significant variety of bonds that they can offer. A short glance at some of the variations demonstrates this flexibility.
The main properties of a bond—credit quality and duration—are the principal determinants of a bond's interest rate. In the bond length category, organizations that need short-term capital might issue bonds that mature in a short time period. Companies with sufficient credit quality that need long-term capital can prolong their loans to 30 years or even longer. Perpetual bonds have no maturity date and pay interest eternally.
Credit quality arises from a mix of the issuing company’s fiscal soundness and the term of the loan. Better health and shorter duration often enable corporations to pay less in interest. The reverse is also true. Less fiscally stable corporations and those issuing long-term debt are often required to pay higher interest rates to entice investors.
Read Also: How One Should Purchase Alternative Investments
Types of Bonds
One of the most fascinating options corporations have is whether to provide bonds backed by assets. These bonds allow investors the ability to seize a firm’s underlying assets if the company defaults. Such bonds are known as collateralized debt obligations (CDOs). In consumer finance, vehicle loans and home mortgages are instances of collateralized debt.
Companies may also issue debt that is not secured by underlying assets. In consumer finance, credit card debt and utility bills are instances of loans that are not collateralized. Loans of this nature are called unsecured debt. Unsecured debt poses a larger risk for investors, hence it frequently pays a higher interest rate than collateralized loans.
Convertible bonds are another sort of bond. These bonds start exactly like conventional bonds but offer investors the ability to convert their holdings into a predetermined number of stock shares. In a best-case scenario, such conversions enable investors to benefit from growing stock prices and offer corporations a loan they don’t have to return.
Finally, there are also callable bonds. They function like conventional bonds, but the issuer might opt 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 prospective decline in interest rates in the future. The issuing business can redeem callable bonds before the maturity date pursuant to a schedule in the bond's terms. If interest rates decline, the corporation can redeem the outstanding bonds and reissue the debt at a cheaper rate. That reduces the cost of capital.
Calling a bond is analogous to a mortgage borrower refinancing at a cheaper rate. The former mortgage with the higher interest rate is paid off, and the borrower obtains a new mortgage at the reduced rate.
The bond terms frequently define the amount that must be paid to call the bond. The defined amount may be larger than the par value. The price of bonds has an inverse connection with interest rates. Bond prices go higher as interest rates fall. Thus, it can be profitable for a firm to pay off debt by recalling the bond at above par value.
The advantages of callable bonds for issuing corporations are typically disadvantages for investors. There are several variables 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 meet the government's needs, such as to pay for infrastructure projects, government employee wages, and other initiatives. Corporate bonds are often riskier than government bonds as most governments are less likely to fail than firms. Because of this risk, corporate bonds often yield superior 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 yield. Stocks, however, often offer a better rate of return because they are riskier. So the money placed in a corporate bond, while it may earn 3%, might also miss out on earning more if the stock appreciates more than 3%; yet, the stock also may not appreciate more than 3%. The right investment relies on the investor's risk tolerance and investing objectives.
Are Corporate Bonds Tax-Free?
No, corporate bonds are not tax-free. An investor will have to pay taxes on the interest income produced as well as on any capital gains.
The Bottom Line
For firms, the bond market plainly offers several opportunities to borrow. The bond market has a lot to offer investors, but they must be careful. The range of alternatives, ranging from length to interest rates, allowing investors to select bonds precisely linked with their demands.
This large range also means that investors should do their study. They need to make sure they understand where they are placing their money. They should also know how much they will make and when they may expect to get their money back.