When a company is looking for debt capital, bonds and loans are usually at the top of the list. It might be challenging to decide which of the two is best for the company. You may have heard a bond described as a type of loan. However, this may create confusion between the two.
They have many similarities, but they are not the same. Therefore, it is essential to draw a clear line and show the differences between bonds and loans. Let us start by understanding the meaning of each, and then we will highlight the key differences between them.
What Is a Bond?
A bond is a debt instrument issued by a company or a government to investors. The issuing company is the borrower, while the person or entity being issued with the bond is the investor.
Bonds have a fixed maturity period and fixed interest rates per year. Investors are paid interest twice a year based on the principal amount. When the bond matures, investors are paid the principal.
Bonds provide an opportunity for individuals and organizations to invest in companies and governments. Unlike equity shareholders, bondholders have no shares in company ownership, and they bear minimal risk.
What Is a Loan?
A loan is an amount of money given by one party to another in exchange for periodical payments of the principal and the interest. Loans are issued with a fixed period of repayment. The period may be short-term such as 3 months, or long-term, such as ten years.
The borrower repays the loan to the lender in installments. Each installment comprises the interest and the principal.
Loans provide opportunities to individuals and organizations to obtain debt capital from financial institutions. As a result, they are the easiest and the most widely accessible forms of capital to the majority.
The Repayment Terms
Repayment of a loan is distributed over a long period. You pay a small part of the principal monthly. Therefore, you may not feel the repayment burden. This may be a good thing if your business generates cash regularly.
On the other hand, if your business has invested in a long-term project that will take time to generate cash, repayment of a loan may feel like a huge burden. Such is because you are required to repay the loan soon, regardless of whether your business is generating revenue or not.
Repayment of bonds is done at maturity. This means the company repaying the bonds will not experience a repayment burden at that moment. Instead, the company will have enough time to work on its projects - this will ensure that there will be enough cash to repay bondholders by the time the bond matures.
Without proper planning, the repayment of bonds may drain a company's cash reserves, creating a considerable liquidity problem. To avoid this problem, some companies decide to issue new bonds and use the cash to repay existing bonds.
The Parties Involved
A loan involves two parties, a borrower and a lender. The borrower can be a natural person like you and me or an artificial person like a company, an organization, or a government.
On the other hand, the lender is a financial institution such as a bank. Therefore, the lending contract between the two parties is usually private - this can be suitable for companies that want to maintain the confidentiality of their financial information.
Players in the bond market are mostly professional investors, pension and hedge funds, and financial advisors. However, this is because the bond market is complicated and requires much speculation, which a person without skills may not have.
Bonds are public debts since they are traded in the public bond market. Therefore, there is no privacy to the company's financial data.
The Amount You Can Raise
The amount of loan a bank can give you depends on your creditworthiness. Individuals and companies have limits on the amount of loan they can be issued. Banks are risk-averse and will do their best to minimize credit risk.
You cannot rely on loans to raise a huge amount of money.
When raising funds by use of bonds, a company does not rely on one investor. Instead, just like shares, bonds are issued to the public.
They are divided into smaller units, each being sold at a fixed price. Therefore, this makes it possible for you as an individual investor to invest in bonds since you pay for what you can afford.
Since the company is getting money from many investors, it can raise more money through bonds than through loans.
We have already seen that banks are risk-averse. They will only give you a loan if you are a credit-worthy borrower. On top of that, they will give you restrictions on the number of debts your business is supposed to borrow from other lenders.
As if that is not enough, banks will go ahead and restrict the way you use the borrowed money. The lending agreement is full of restrictions. As a business owner, you will not have complete control and flexibility in using your finances.
There are no such restrictions when it comes to bonds. However, the entity issuing bonds must have a good reputation. As a result, investors are more likely to invest in companies with less risk of default.
If you trust the company you are investing in, you will not need to give it many restrictions.
Loans are issued at either fixed interest or variable interest based on the base rate. The interest rate varies depending on the risk involved and the market conditions. For example, if the loan is unsecured, interest will be high to compensate for the high risk involved.
Generally, loans have higher interest rates than bonds. However, if the loan's interest is calculated on the reducing balance method, the actual interest paid reduces in each installment.
Bonds can be issued at fixed interest, variable interest, or zero interest. Most companies prefer to lock the interest rate so that it remains fixed throughout the bond period. Bonds issued at zero interest are issued at a discount.
For example, if the price of a bond is $1,000, it is issued at a discount price of $900. When you invest in this bond, you pay $900, but when the bond matures, you are paid $1,000. The difference of $100 will stand for the interest.
The payment of bond interest is always based on the principal amount. This means that the interest remains the same every year until the bond matures. Even though bonds have lower interest rates, the actual interest paid may be higher than a loan that pays interest in reducing balance.
Cost of Issuance
Any time you want to raise funds through bonds or loans, you must incur some cost. This cost is not the same as interest. Instead, it is the processing cost incurred to get the funds.
The borrower incurs the cost of issuance. Banks usually deduct it from the loan and give you the balance. The higher the amount of loan, the higher the processing cost.
Loans involve less paperwork than bonds and, thus, incur lower processing costs.
Bonds are issued to many investors, and they take longer to be processed. Companies may engage the services of underwriters, and in this case, they would have to pay underwriters commission.
For companies to issue bonds, they must meet minimum requirements set by the government. For example, in the US, a company must ensure its bonds meet the requirements of the Securities and Exchange Commission.
Once you have taken a loan from the bank, you cannot transfer it to another person. There is a private contract between you and the bank.
Bonds can be transferred from one person to another before maturity. You can buy bonds or sell them anytime through the bond market. Therefore, parties to the contract are bound to change.
There is a high risk in lending money to individuals who are not well known. One method banks use to minimize this risk is asking borrowers to repay the loan within a short time.
As a borrower, you may feel the pressure to repay the loan within the required time. As a result, you may end up having a regular refinancing problem. Every time you repay a loan, you are forced to take another one.
Bonds provide long-term capital to a company. For example, if a company issues a bond that goes for 30 years, it may not experience a refinancing problem in the short term.
Loans can be restructured to fit the borrower's needs. For example, you can agree with the bank to repay the loan before maturity. In doing so, you may end up paying less interest.
You can make a new deal with the bank that gives you an extended repayment period or take a new loan to replace the existing loan. In short, banks are flexible as they try to satisfy the needs of each customer.
Bonds can only be redeemed before maturity if there was such provision when the bond was being issued. Restructuring a bond is very difficult. The easier way to do it is to redeem the first bond and buy a new one with a new repayment schedule.
The main difference between bonds and loans is that bonds are tradable, long-term, and are used by large corporations and governments to raise funds. Financial institutions issue loans to individual borrowers and companies.
If you are looking to borrow a small amount of money, loans would be the best option. Loans and bonds are not precisely substitutes. The two can be combined where bonds are used to finance long-term projects and loans to finance short-term projects.