Bonds are an alternative to bank loans and are often preferred by larger corporations. 2 2
One can rightly ask, “But why is this the case? Why are companies eager to go through all the trouble of preparing a prospectus, 3 3
satisfying specific conditions, 4 4
hiring an investment bank, and dealing with investors? Isn’t it simpler to obtain a bank loan?” 5 5
Well, bonds are more complicated than bank loans, but they come with some very important advantages. 6 6
The first and most obvious reason is pricing. When all costs are considered, bonds are much cheaper than bank loans. 7 7
The interest rate paid to investors is lower than the one offered by bankers. 8 8
This is because banks lend their money at a higher interest rate (for consumer loans for example), 9 9
while investors don’t have similar options. 10 10
Another important reason is that issuing a bond is much less restrictive than borrowing from a bank. 11 11
Large corporate loans are often accompanied by a set of covenants, rules of conduct, that must be respected by the borrower. 12 12
These covenants come in financial ratios that must be maintained, or specific behavior that must be respected 13 13
(like buying insurance or maintaining sufficient levels of liquidity). 14 14
To be successful when issuing bonds, companies need scale. 15 15
You can’t issue bonds if your company needs $1 million or $2 million. 16 16
In these cases, a bank loan is preferable as some very high transaction costs will be sustained. 17 17
Hiring a bank, contacting investors, preparing a prospectus, involving sales agents, 18 18
being compliant to financial regulations can be very expensive. 19 19
Therefore, when issuing a bond, you need scale. You need to sell securities for tens of millions of dollars to cover these fixed costs 20 20
and benefit from the cheaper interest rate you will pay to investors. It is reasonable to conclude that all firms participating 21 21
in the bond markets want to obtain sizeable loans – as we said, tens of millions of dollars, 22 22
but much more frequently, hundreds and even billions of dollars. 23 23
A huge amount of money! 24 24
It is easy to understand why this can be problematic for most banks. Usually, they don’t have the size to offer such loans. 25 25
This will be a huge exposure in their portfolio, endangering the entire bank. 26 26
Banks look for ways to diversify their loan portfolio; they don’t want to take huge risk and gamble on a single firm. 27 27
Hence, issuing a bond seems like a better alternative for large amounts of money. 28 28
Debt capital markets are abundant in terms of investors looking to lend their money and earn a decent rate of return. 29 29
Are there any drawbacks when issuing a bond? Well, yes. 30 30
It is reasonable to expect that dealing with hundreds of investors is a difficult job, 31 31
especially if the issuer has difficulties and needs to renegotiate some of the loan terms. 32 32
It is very difficult to obtain consensus among bond holders, simply because they are so many and can have competing interests. 33 33
Another possible disadvantage is complexity. Only large firms have the expertise to prepare 34 34
and organize the legal and financial framework supporting a bond issuance. 35 35
These are some considerations that must be made when deciding whether to issue a bond or obtain a bank loan. 36 36
Is there a way between? There is! Loan syndication is the perfect example for that. 37 37
We’ll learn more about this in one of our next lessons. Thanks for watching!