Bonds are an alternative to bank loans and are often preferred by larger corporations.
But why is this the case?
Why are companies eager to prepare a prospectus, satisfy specific conditions, hire an investment bank, and deal with multiple investors?
Isn’t it easier to obtain a bank loan?
Well, bonds are more complicated than bank loans but have some significant advantages. The first and most apparent reason is pricing. When all costs are considered, bonds tend to be considerably cheaper than bank loans. The interest rate paid to investors is lower than that offered by bankers because banks can charge higher interest rates for consumer loans, for example, while investors don’t have such options.
Another important reason is that issuing a bond is much less restrictive than borrowing from a bank. Large corporate loans are often accompanied by a set of covenants and rules of conduct that the borrower must respect. These covenants come in the form of maintaining financial ratios or specific behavior that must be respected, like buying insurance or maintaining sufficient levels of liquidity to be successful when issuing bonds.
Companies need scale. You can’t issue bonds if your company needs one or $2 million. A bank loan is preferable since some very high transaction costs will be sustained to issue a bond. Hiring a bank, contacting investors, preparing a prospectus involving sales agents and being compliant with financial regulations can be very expensive. Therefore, bond financing is cheaper only when a company has sufficient scale. You need to sell securities for tens of millions of dollars to cover the associated fixed costs and benefit from the cheaper interest rate you’ll pay to investors. It’s reasonable to conclude that all firms in bond markets want to obtain sizable loans, including 10s of millions of dollars, but much more frequently hundreds and even billions of dollars.
It’s easy to understand why this can be problematic for most banks. Taking such significant exposures on their portfolio is suboptimal from a risk management perspective. Banks look for ways to diversify their loan portfolio. They don’t want to take a huge risk and gamble on a single firm. Therefore, issuing a bond seems like a better alternative for large amounts of money. Debt capital markets are abundant in terms of institutional investors looking to lend their money and earn a decent rate of return.
Are there any drawbacks when issuing a bond?
Yes.
It’s reasonable to expect difficulties when dealing with hundreds of investors, especially if the issuer has problems and needs to renegotiate loan terms. It isn’t easy to obtain a consensus among bondholders simply because so many have competing interests. Another possible disadvantage is complexity. Only large firms have the expertise to prepare and organize the legal and financial framework supporting a bond issuance. These considerations must be made when deciding whether to issue a bond or obtain a bank loan.
But is there an in-between way?
Yes.
