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. What is the difference between a bank guarantee and a bond?

    Understand what a bank guarantee is and what a bond is, and which one is a debt instrument. Learn the differences between ... Read Answer >>
  2. 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 >>
  3. 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 >>
  4. What is the risk of holding a bond trading at a discount until maturity?

    Let’s say a corporate bond who was quoting 95 is now quoting 70 because of increased fear regarding the company. The ... Read Answer >>
  5. 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 >>
  6. Are long-term U.S. government bonds risk-free?

    For any debt obligation to be considered completely risk-free, investors must have full faith that the principal and interest ... Read Answer >>
Related Articles
  1. Economics

    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. Bonds & Fixed Income

    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.
  4. Credit & Loans

    Understanding Credit Risk

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

    Explaining Debt

    Debt is any amount a borrower owes a lender.
  6. Options & Futures

    Financial Statements: Long-Term Liabilities

    By David Harper (Contact David)Long-term liabilities are company obligations that extend beyond the current year, or alternately, beyond the current operating cycle. Most commonly, these include ...
  7. Options & Futures

    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.
  8. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  9. Bonds & Fixed Income

    Convertible Bonds: Pros And Cons For Companies And Investors

    Find out why businesses choose this type of financing and what effect this has on investors.
  10. Personal Finance

    The Banking System: Commercial Banking - How Banks Make Money

    ByStephen D. Simpson, CFA As mentioned before, banks basically make money by lending money at rates higher than the cost of the money they lend. More specifically, banks collect interest on ...
RELATED TERMS
  1. Negative Covenant

    A bond covenant preventing certain activities, unless agreed ...
  2. Bond Covenant

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

    A bond covenant that limits or restricts any additional debt ...
  4. Debt

    An amount of money borrowed by one party from another. Many corporations/individuals ...
  5. Running With The Land

    The rights and covenants in a real estate deed that remain with ...
  6. Acceleration Covenant

    A clause included in certain debt securities and swap agreements ...
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center