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. Who are the key players in the bond market?

    The bond market can essentially be broken down into three main groups: issuers, underwriters and purchasers. The issuers ... Read Answer >>
  2. 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 >>
  3. 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 >>
  4. Do long-term bonds have a greater interest rate risk than short-term bonds?

    The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Answer >>
  5. Why do high profiting sales mitigate credit risk?

    Learn more about credit risk in loaning to individuals and businesses. Understand how credit risk is determined and the impact ... Read Answer >>
Related Articles
  1. Investing

    Why Companies Issue Bonds

    When companies need to raise money, issuing bonds is one way to do it. A bond functions like a loan between an investor and a corporation.
  2. Investing

    Understanding Credit Risk

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

    Why Are U.S. Companies Borrowing in Euros?

    U.S. companies with operations that need funding in Europe are likely to take advantage of lower European borrowing rates.
  4. Investing

    Bond Basics Tutorial

    Investing in bonds - What are they, and do they belong in your portfolio?
  5. Investing

    Explaining Debt Service

    Debt service is a measure of a person or entity’s use of cash to pay interest and principal on debt obligations.
  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.
  7. Investing

    U.S. Corporate Bonds: The Last Safe Place to Make Money

    There aren't many other sources right now for relatively safe, steady income.
  8. Investing

    U.S. Corporate Debt at 10-Year High

    More debt is being assumed by companies with dubious credit ratings, raising the specter of defaults.
  9. Investing

    Why Companies Issue Bonds

    One way for a company to raise money is to issue bonds.
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. Restrictive Covenant

    Any type of agreement that requires the buyer to either take ...
  4. Debt

    An amount of money borrowed by one party from another, often ...
  5. Acceleration Covenant

    A clause included in certain debt securities and swap agreements ...
  6. Acceleration Clause

    A contract provision that allows a lender to require a borrower ...
Hot Definitions
  1. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  2. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  3. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  4. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  5. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  6. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
Trading Center