Why Do Companies Issue Debts And Bonds? Can’t They Just Borrow From The Bank?
Companies issue bonds to finance operations. Most companies can borrow from banks, but see borrowing directly from a bank as more restrictive and more expensive than selling debts on the open market through a bond issue.
The costs involved in borrowing money directly from a bank are prohibitive for a number of companies. In the world of corporate finance, many chief financial officers (CFOs) see banks as a last resort because of the restrictive debt covenants that banks place on direct business loans. Covenants are rules placed on debt that are designed to stabilize business performance and reduce the risk that a bank is exposed to when providing a large loan to a company. In other words, restrictive covenants protect the interests of the bank; they are written by securities lawyers and are based on what analysts have identified as risks to the performance of that company.
Here are a few examples of the restrictive covenants companies face: they can only spend more debts when the bank loan is fully paid off; they cannot participate in a stock offering until the bank loan has been paid off; they cannot acquire businesses until the bank loan is paid off, and so on. Relatively speaking, these are simple, UN- restrictive covenants that can be placed on corporate loans. However, debt covenants are often much more complex and carefully tailored to the borrower’s business risks. Some of the more limited covenants may state that the interest on the debt would increase substantially if the chief executive officer (CEO) were to stop, or earnings per share should fall in a certain period. Covenants are a way for banks to reduce the risk of holding debt, but for borrowing companies they are seen as an increased risk.
Simply put, banks set greater limits on what a company can do with a loan and are more worried about debt repayment than bondholders. Bond markets are generally more forgiving than banks and are often seen as easier to handle. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.
For more information, see Debt Reckoning and Corporate Bonds: an iMarch Rewire to Credit Risk . For more information about bonds, see Bond Basics Tutorial and Advanced Bond Concepts .