A:

Companies issue bonds to finance operations. Most companies can borrow from banks, but view direct borrowing from a bank as more restrictive and expensive than selling debt on the open market through a bond issue.

The costs involved in borrowing money directly from a bank are prohibitive to a number of companies. In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans. Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed when it gives a large loan to a company. In other words, restrictive covenants protect the bank's interests; they're written by securities lawyers and are based on what analysts have determined to be risks to that company's performance.

Here are a few examples of the restrictive covenants faced by companies: they can't issue any more debt until the bank loan is completely paid off; they can't participate in any share offerings until the bank loan is paid off; they can't acquire any companies until the bank loan is paid off, and so on. Relatively speaking, these are straightforward, unrestrictive covenants that may be placed on corporate borrowing. However, debt covenants are often much more convoluted and carefully tailored to fit the borrower's business risks. Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the chief executive officer (CEO) quit, or should earnings per share drop in a given time period. Covenants are a way for banks to mitigate the risk of holding debt, but for borrowing companies they are seen as an increased risk.

Simply put, banks place greater restrictions on what a company can do with a loan and are more concerned about debt repayment than bondholders. Bond markets tend to be more forgiving than banks and are often seen as being easier to deal with. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.

For more further reading, see Debt Reckoning and Corporate Bonds: An Introduction To Credit Risk. For more about bonds, see Bond Basics Tutorial and Advanced Bond Concepts.

RELATED FAQS
  1. Why might a bond agreement limit the amount of assets that the firm can lease?

    Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on ... Read Answer >>
  2. What is the difference between secured and unsecured debts?

    Learn the differences between secured and unsecured debt; discover how banks buffer risks associated with each type of loan ... Read Answer >>
  3. Why do banks use the Five Cs of Credit to determine a borrower's credit worthiness?

    Learn the five Cs of credit, why they are important and how banks use them to understand and mitigate risks when making loans ... Read Answer >>
  4. What are the advantages and disadvantages of buying stocks instead of bonds?

    This is a common question among investors. Stocks and bonds differ dramatically in their structures, payouts, returns and ... Read Answer >>
Related Articles
  1. Investing

    Understanding Covenants

    A covenant is a term placed in a loan that requires the borrower to either maintain or refrain from certain business activities.
  2. Investing

    Corporate Bonds and the Importance of Covenants

    Any type of investor, private or institutional, should be acquainted with the significance of covenants in corporate bond agreements.
  3. Investing

    Understanding Credit Risk

    Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt.
  4. Investing

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  5. Investing

    Explaining Debt

    Debt is any amount a borrower owes a lender.
  6. Investing

    13 Pre-Issue Corporate Bond Questions For Businesses

    When a company needs more funding, there are many options. Corporate bonds is just one of them.
RELATED TERMS
  1. Bond Covenant

    A legally binding term of an agreement between a bond issuer ...
  2. Debt Limitation

    A bond covenant that limits or restricts any additional debt ...
  3. Affirmative Covenant

    A type of promise or contract which requires a party to do something. ...
  4. Running With The Land

    The rights and covenants in a real estate deed that remain with ...
  5. Debt

    An amount of money borrowed by one party from another, often ...
  6. Issue

    1. The process of offering securities as an attempt to raise ...
Hot Definitions
  1. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  2. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  3. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  4. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  5. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center