When companies need to raise money, issuing bonds is one way to do it. A bond functions as a loan between an investor and a corporation. The investor agrees to give the corporation a specific amount of money for a specific period of time in exchange for periodic interest payments at designated intervals. When the loan reaches its maturity date, the investor’s loan is repaid.
The decision to issue bonds instead of selecting other methods of raising money can be driven by many factors. Comparing the features and benefits of bonds versus other common methods of raising cash provides some insight into why companies often look to bond issuances when they need to raise cash to fund corporate activities.
Bonds versus Banks
Borrowing from a bank is perhaps the approach that comes to mind first for many people who need money. This leads to the question, “Why would a corporation issue bonds instead of just borrowing from a bank?”
Like people, companies can borrow from banks, but issuing bonds is often a more attractive proposition. The interest rate companies pay bond investors is often less than the interest rate they would be required to pay to obtain a bank loan. Since the money paid out in interest detracts from corporate profits and companies are in business to generate profits, minimizing the interest amount that must be paid to borrow money is an important consideration. It is one of the reasons that healthy companies that don’t seem to need the money often issue bonds when interest rates are at extremely low levels. The ability to borrow large sums of money at low interest rates gives corporations the ability to invest in growth, infrastructure and other projects.
Issuing bonds also gives companies significantly greater freedom to operate as they see fit because it releases them from the restrictions that are often attached to bank loans. Consider, for example, that lenders often require companies to agree to a variety of limitations, such as not issuing more debt or not making corporate acquisitions until their loans are repaid in full.
Such restrictions can hamper a company’s ability to do business and limit its operational options and issuing bonds enables companies to raise money with no such strings attached.
Why Companies Issue Bonds
Bonds versus Stock
Issuing stock, which means granting proportional ownership in the firm to investors in exchange for money, is a popular way for corporations to raise money. From a corporate perspective, perhaps the most attractive feature of stock issuance is that the money generated from the sale of stock does not need to be repaid. There are, however, downsides to stock issuance that may make bonds the more attractive proposition.
With bonds, companies that need to raise money can continue to issue new bonds as long as they can find investors willing to act as lenders. The issuance of new bonds has no effect on ownership of the company or how the company is operated. Stock issuance, on the other hand, puts additional stock shares in circulation, which means that future earnings must be shared among a larger pool of investors. This can result in a decrease in earnings per share (EPS), putting less money in owners' pockets.
EPS is also one of the metrics that investors look at when evaluating a firm’s health. A declining EPS number is generally not viewed as a favorable development.
Issuing more shares also means that ownership is now spread across a larger number of investors, which often makes each owner’s share worth less money. Since investors buy stock to make money, diluting the value of their investments is not a favorable outcome. By issuing bonds, companies can avoid this outcome.
More about Bonds
Bond issuance enables corporations to attract a large number of lenders in an efficient manner. Record keeping is simple, because all bondholders get the exact same deal with the same interest rate and maturity date. Companies also benefit from flexibility in the significant variety of bond offerings available to them. A quick look at some of the variations highlights this flexibility.
The basic features of a bond – credit quality and duration – are the principal determinants of a bond's interest rate. In the bond duration department, companies that need short-term funding can issue bonds that mature in a short time period. Companies that need long-term funding can stretch their loans to 10, 30, 100 years or even more. So-called perpetual bonds have no maturity date and pay interest forever.
Credit quality stems from a combination of the issuing company’s fiscal health and the length of the loan. Better health and short duration generally enable companies to pay less in interest. The reverse is also true, with less fiscally healthy companies and those issuing longer-term debt generally being forced to pay higher interest rates to entice investors into lending money.
More Bond Options
One of the more interesting options companies have is whether to offer bonds backed by assets. Bonds that give investors the right to lay claim to the company’s underlying assets, in the event the company is unable to make its promised interest payments or repay its loan, are known as “collateralized” debt.
In consumer finance, car loans and home mortgages are examples of this type of debt. Companies may also issue debt that is not backed by underlying assets. In consumer finance, credit card debt and utility bills are examples of uncollateralized loans. Loans of this type are called “unsecured” debt. Unsecured debt carries a higher risk for investors, so it often pays a higher interest rate than collateralized debt.
Convertible bonds are also a consideration. This type of bond starts off acting just like other bonds, but offers investors the opportunity to convert their holdings into a predetermined number of stock shares. In a perfect scenario, such conversions enable investors to benefit from rising stock prices and give companies a loan they don’t have to repay.
Why Companies Issue Callable Bonds
Companies issue callable bonds to allow them to take advantage of a possible drop in interest rates at some point in the future. The issuing company can redeem callable bonds prior to the maturity date according to a schedule of callable dates identified in the bond’s terms. If interest rates decrease, the company can redeem the outstanding bonds and reissue the debt at a lower rate, thereby reducing the cost of capital.
This is similar to a mortgage borrower refinancing at a lower rate. The prior mortgage with the higher interest rate is paid off, with the borrower obtaining a new mortgage at the lower rate.
The bond often defines the callable amount to recall the bond that may be greater than the par value. The price of bonds has an inverse relationship with interest rates. Bond prices go up as interest rates fall. Thus, it is advantageous for a company to pay off debt by recalling the bond at above par value.
Callable bonds are more complex investments than normal bonds. They may not be appropriate for risk-averse investors seeking a steady stream of income.
What Investors in Callable Bonds Need to Know
Investors are paid a premium interest rate as compensation for the additional risk of a callable bond. Owners of callable bonds risk the bond being called. If that happens, they will be forced to invest in other bonds at a lower rate. The bond investor is essentially writing an option on the bond. The investor receives the premium for the written option up front, but she risks having the option exercised and the bond called.
Investors in callable bonds need to track two yields—unlike a normal bond with only one yield. Callable bonds have a yield to call and a yield to maturity. The yield to call is the amount the bond will yield before it has the possibility of being called. The yield-to-maturity is the expected rate of return on a bond if it is held until maturity, which takes into account the bond’s market value, the par value, the coupon interest rate and the time to maturity. Yield to maturity considers the time value of money, whereas a simple yield calculation does not.
Both yields should be acceptable to an investor before they buy them. If interest rates ultimately decline, the value of callable bonds will not increase as much as normal bonds. In this scenario, the likelihood of the bond being called increases and as a result, there's often less investor demand for these bonds.
There are different types of call options embedded in callable bonds. An American call allows the issuer to recall the bond at any time after the callable date. In this case, the bond is known as continuously callable. For European calls, the issuer only has the right to call the bond on a specific date. This is known as a one-time only call.
Callable bonds may offer attractive premiums over normal bonds, but investors need to understand their risks.
The Bottom Line
For companies, the bond market clearly offers many ways to borrow. From an investor’s perspective, the bond market has a lot to consider. The variety of choices, ranging from bond types to duration and interest rates, enable investors to select investments closely aligned with personal funding needs. The wide variety of choices also means that investors should do their homework to make sure they understand where they are putting their money, how much it will earn and when they can expect to get it back.
For investors unfamiliar with the bond market, financial advisors can provide insight and guidance as well as specific investment recommendations and advice. They can also provide an overview of the risks that come with investing in bonds, such as rising interest rates, call risk and, of course, the chance that a corporate bankruptcy will cost you some or all of the amount you invested.