Why Companies Issue Bonds

Issuing bonds is a common way for companies to raise funds. A bond functions as a loan between an investor and a corporation. The investor agrees to lend the corporation a certain amount of money for a specific period. In exchange, the investor receives periodic interest payments. When the bond reaches its maturity date, the company repays the investor the principal amount.

Companies may choose to issue bonds over other methods of raising money for several reasons. Comparing bonds with other funding options reveals why bonds are often the preferred choice for financing corporate activities.

Key Takeaways

• Companies issue bonds to raise capital without giving up control.
• Bonds often offer lower interest rates than bank loans.
• Bonds provide greater operational freedom compared to bank loans.
• Issuing bonds doesn’t dilute ownership like issuing stocks.
• Bonds can be structured in various ways with different maturities.

Bonds vs. Banks

When companies need money, borrowing from a bank is a common option. However, issuing bonds is often more attractive. The interest rate companies pay bond investors is usually lower than the rate available from banks.

Minimizing interest expenses is crucial for companies aiming to maximize profits. Even financially healthy companies issue bonds to take advantage of low-interest rates, allowing them to invest in growth and other projects.

Unlike bank loans, bonds do not come with restrictive covenants. Banks often require companies to agree not to issue more debt or make acquisitions until their loans are repaid. Bonds provide companies with funds without these operational constraints, offering greater freedom to manage their business.

Bonds vs. Stocks

Issuing stock is another popular method for raising funds. However, issuing bonds has distinct advantages over issuing new shares. Stock issuance dilutes ownership, meaning future earnings are shared among a larger pool of investors. This dilution can decrease earnings per share (EPS), a key metric investors use to evaluate a company’s health. Lower EPS is generally viewed unfavorably by the market.

Issuing bonds does not affect company ownership or operations. Companies can issue new bonds as long as there are willing investors, avoiding the dilution of existing shareholders’ value.

Benefits of Issuing Bonds

Bonds offer companies the ability to attract numerous lenders efficiently. Record keeping is simplified because all bondholders get the same deal—same interest rate and maturity date. Additionally, bonds provide flexibility in structuring terms such as credit quality and duration.

Types of Bonds

1. Collateralized Bonds: These are backed by company assets, giving investors a claim on the assets if the company defaults.
2. Unsecured Bonds: These are not backed by assets and typically carry a higher interest rate due to increased risk.
3. Convertible Bonds: These can be converted into a predetermined number of stock shares, allowing investors to benefit from rising stock prices.
4. Callable Bonds: These can be redeemed by the issuer before the maturity date, usually to take advantage of lower interest rates.

Why Companies Issue Callable Bonds

Callable bonds allow companies to refinance their debt if interest rates drop. This process is similar to a homeowner refinancing a mortgage. The company can call back the bonds and reissue them at a lower interest rate, reducing the cost of capital. However, callable bonds are more complex and may not suit risk-averse investors.

Corporate Bonds vs. Government Bonds

Corporate Bonds: Issued by corporations to fund business activities. They generally offer higher returns due to higher risk.

Government Bonds: Issued by governments to fund public projects and operations. They are typically safer as governments are less likely to default than corporations, but they usually offer lower returns.

Safety and Taxation of Corporate Bonds

Corporate bonds are generally safer than stocks as they offer a fixed rate of return, providing predictable income. However, they are not tax-free. Investors must pay taxes on the interest income earned and any capital gains.

The Bottom Line

Companies issue bonds to raise capital efficiently without diluting ownership or facing restrictive covenants associated with bank loans. Bonds offer flexibility, various structuring options, and the potential for lower interest rates. Understanding the benefits and types of bonds can help investors make informed decisions and companies achieve their financial goals.