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Why Do Companies Issue Bonds and Other Debt?

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Updated December 10, 2024

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Companies issue bonds to fin💞ance their operations. Most companies could borrow the money from a bank, but♔ they view this as a more restrictive and expensive alternative than selling the debt on the open market through a bond issue.

In fact, the costs involved in borrowing directly from banks are prohibitive to many 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 they place on direct corporate loans.

Key Takeaways

Banks tend to place restrictions on borrowers that limit their business activities.
For the banks, it's a precaution against risk. For companies, it can be a barrier to action.
The bond market places no comparable restrictions on borrowers.

How Covenants Work

Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risks to which a bank is exposed when it gives a large loan to a company. These 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 the company's performance.

Here are a few💞 examples of restrictive covenants that have been placed෴ on companies:

They 澳洲幸运5开奖号码历史查询:can't acquire any more debt until the bank loan is completely paid off
They can't issue any new share offerings until the bank loan is paid off
They can't acquire any other companies until the bank loan is paid off

From the bank's viewpoint, these are reasonable precautions. They have evaluated the company's current financial condition, including its debt level. If that changes overnight, the risk evaluation is no longer valid.

Relatively speaking, these are straightforward, unrestrictive covenants. However, debt covenants can be much more convoluted and carefully tailored to the company's unique business risks.

Some of the more forbidding covenants may state that the interest rate on the debt will increase substantially if the chief executive officer (CEO) quits or if 澳洲幸运5开奖号码历史查询:earnings per share drops within a given period of time.

There are also "positive" as opposed to "negative" covenant restrictions. The bank may require that the company maintain certain levels of financial ratios or maintain its facilities in good working condition.

The Risks to Companies

Thus, covenants are a way for banks to mitigate the risk of holding debt, but for the companies that borrow from🧔 them, they can add new risks♌.

Consider, for instance, a covenant that automatically increases the interest rate if earnings slump. The company's business challenges have just doubled.

Important

Intere🅘st rates on corporate loans can be hiked, just like those 🌺on consumer credit.

Banks place greater restrictions on how a company can use the loan and are more concerned about debt repayment than bondholders. Bond markets te♏nd to be more lenient than banks and are often seen as easier 🌳to deal with. They leave it to the rating agencies to grade the bonds and make their decisions accordingly.

As a result, companies are more likely to finance operations by issuing bonds than b🧸y borrowing from a bank.

Which Bonds Give the Highest Returns?

Bond returns depend on many different factors, such as the issuer's credit profile, the bond's maturity, and the current interest rate environment. The bonds of companies with lower credit ratings generally have higher returns due to the higher risk of default, and thus, higher risk for the investor. Bonds with longer maturities have higher returns to account for more interest rate fluctuations over a longer time frame. Similar to companies with poor credit ratings, emerging market bonds pay higher rates due to the increased economic and political risks of these countries.

What Is an Investment Grade Bond?

澳洲幸运5开奖号码历史查询:Investment grade bonds are bonds that are of the highest quality. They have a lower risk of default than other bonds, and as such, pay out a lower return because of their safety. Bonds rated AAA to BBB by S&P are investment grade. Bonds rated Aaa to Baa3 by Moody's are investment grade.

What Is the Difference Between Corporate and Treasury Bonds?

Corporate bonds are🗹 issued by companies, either public or private, to raise funds to pay for operations, expansion, etc. Treasury bonds are issued by governments to raise money to fund deficits and projects. Treasuries are considered safer investments tha꧂n corporate bonds.

The Bottom Line

Companies need to raise money from time to time for a variety of reasons: expansion, funding operations, paying down previous debt, investing in research an🎶d development, and more. Companies have two avenues to raise money: issuing stock or taking on༒ debt.

Taking on debt can come in a variety of forms, but is usually a loan or bond. Loans can be restrictive as a company has to meet the requirements and condition🥀s the bank sets out. Issuing bonds is generally more flexible and preferred by many companie🍒s.

Article Sources

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