Bonds are debt instruments created and issued to raise capital. Bonds are essentially an agreement for a loan between the investor and the issuer of the bond, wherein the issuer of the bond is obligated to pay periodic interest payments to the bondholder and pay back the principal amount at the time of maturity.
Bonds have a predetermined rate of interest and maturity period which is communicated at the time of issuance of the bond. Bonds are also a form of fixed-income security for investors.
When corporates need to raise capital, issuing bonds is one of the many options it opt for. The investors agree to loan a certain amount of money to the corporation at a predetermined rate of interest, maturity period and predetermined interest at regular intervals.
The corporation pays the investor interest or coupon payments, either half-yearly or yearly and is required to repay the bondholder the principal amount at the time of the maturity of the instrument.
Corporates have multiple avenues to raise capital, such as issuing equity, bank loans, issuing preference shares, bonds, debentures and much more. Various factors can influence the decision to issue bonds over selecting other means of raising capital.
Bonds vs Bank Loans
When it comes to borrowing money, banks are the first thing that comes to our minds. So, why don’t companies approach a bank or a financial institution for a loan instead of issuing Corporate Bonds?
Corporations can borrow money from banks but issuing Corporate bonds can often appear to be a much more attractive option for the firm.
The rate of interest corporates need to pay to bondholders is lower than the interest on bank loans. As the purpose of a business corporation is to maximise profitability, by reducing their interest expenses, a corporation can enhance their profitability.
Further, issuing bonds offer corporates significant freedom to operate as they deem fit as Corporate Bonds do not impose any form of restrictions on the company.
Bank loans can come with significant conditions and restrictions. For instance, bank loans can come with limitations which can restrict the company from raising further debt, making new acquisitions and might require the consent of their bankers before taking any major decision.
These restrictions can hamper the ability of the company to do business, limits operational and growth options whereas issuing bonds do not come with such restrictions and limitations.
Bond vs Stock
Issuing stock means offering a proportional ownership of the firm to the investor in order to raise capital. While the corporate is required to pay dividends to the shareholders, dividend payment is not fixed, and also there is no obligation to make dividend payments, i.e. the company can forfeit dividend payments when the company experiences losses, and the company can also alter the amount of dividend paid per share depending upon their level of profitability and future cash flow requirements.
However, the downside of issuing new stocks can be the change the shareholding composition and dilution of ownership of the existing shareholders.
Corporates can issue bonds without diluting its existing shareholding composition, as a result of this, the promoters of the business can retain their control. Also, issuing new stocks can affect the EPS or earnings per share of the company as the net profits of the company needs to be divided among a larger pool of investors or shareholders, as a result of this means less money for every shareholder.
Further, EPS is a vital metric used by investors while evaluating the financial health of a firm, and a declining EPS is often viewed as an unfavourable investment, as a result of this discouraging investors from investing in the company.
Issuing bonds can help corporates to maintain their existing shareholding, safeguard their EPS and does not dilute the control of the promoters.
Advantages of issuing Corporate Bonds
- Enhance Returns to Shareholders
Issuing bonds can help in enhancing the returns to shareholders as interest paid on bonds are lower than the interest rates paid on bank loans. Lower interest payments translate into higher net profits, as a result of this, shareholders enjoy higher earnings per share.
Further, the issuance of bonds does not increase the number of shares. Hence net profits are distributed between existing shareholders only and not among additional shareholders, therefore bonds aid in enhancing earnings per share and returns for shareholders.
- Lowers Tax Liability
Interest paid on Corporate Bonds is tax deductible, as a result of this it aids in reducing the taxable income of the corporation, which in turn lowers the tax liability of the corporation. This is not possible in the case of issuing equity and dividends are paid from post-tax net profits of the firm.
- Lowers Cost of Capital
Issuing bonds can also aid in reducing the overall cost of capital of the firm, especially if the corporation issues these bonds at a low rate of interest.
- Known Payback Terms
The terms and conditions of the repayment of the bonds are known and transparent as the maturity date, face value of the bond are locked in the bond agreement before issuance of the bonds.
As there is no uncertainty about how much needs to be paid back to the bondholders and when the bondholders need to be paid back, the CFO of the firm can easily plan for bond repayment.
Whereas, this is not the case when it comes to issuing equity shares, as the company needs to offer the shareholders a substantial premium to convince them to sell back their equity.
- Ownership Protection
Issuing Corporate Bonds result in alteration of existing shareholding patterns and promoters who do not wish to dilute their controlling interest, should opt for issuing bonds instead of equity. As a result of this, by issuing bonds, the company can raise capital while maintaining the controlling interest of the promoters and existing shareholders.
- No Bank Restrictions
A corporate issues bonds directly to the investors, which do not come in any form of restrictions which can accompany a bank loan. Banks loans can often come with restrictions and conditions such as restrictions in raising additional debt, restricting making any new acquisitions etc. These restrictions can hamper the operations of a corporation and as a result of this forcing the company to miss out on attractive investment and expansion opportunities.
- Trade in for attractive interest rates
Companies can use the call feature of the bond when the rate of interest falls in the market to buy back the bonds and reissue bonds at a lower rate of interest. This will help the corporation to reduce their interest obligations, reduce their overall cost of capital, which improves the over the profitability of the firm and in turn enhance the earnings per share and dividends for the shareholders.
And there is a intricate relationship between Bond yields and economic growth.
Disadvantages of Issuing Corporate Bonds
- Limitations
One of the major limitations of issuing bonds is that it limits the ability of the issuer about the utilisation of the borrowed funds. The issuer needs to specify the usage of these borrowed funds and cannot divert them for any other project. The issuer of the bond requires to adhere to all regulations issued by SEBI and its fund utilisation, the performance of the bond etc. are also monitored by the SEBI.
- Repayment Obligation and Liability
The issuer is required to repay interest at regular intervals irrespective of its profitability and cash flow position. Also, at the time of maturity, the issuer needs to make a lump sum payment of the principal amount, which can be a substantial cash outflow for the company. The dividend payment is not mandatory in case of issuing shares, and the amount of dividend per share can be determined and altered as per the financial performance and cash flow position of the company.
The Bottom Line
The Bond market is an effective way for corporations to borrow money and raise capital. Issuing bonds have its pros and cons, both for the issuer and the investor. Issuers have a wide array of options towards selecting the type of bond to be an issue, the rate of interest, maturity period of the bond and other features of the bond, depending upon the long-term strategy of the corporation. While bonds are an economical alternative to raise capital for the corporates, it also offers a stable interest income for the investor.