Why Do Companies Issue Bonds?

Bond issuance is a common strategy for companies seeking to finance their operations or projects. It is a means of raising capital without diluting ownership or equity, providing a predictable cost of capital. However, the process of issuing bonds involves several key considerations and requirements.

Debt vs Equity Financing

One of the primary reasons companies issue bonds is to balance debt vs equity financing. Bond issuance is often preferred by companies due to its predictability and the tax benefits associated with it. Unlike equity financing, bond interest is tax deductible, which can lower a company's overall tax burden.

Key Differences:

Bonds: Debt Finance; Fixed Interest Payments, Predictable Cost of Capital, Tax Deductible Equity: Equity Finance; Potential for Dilution, Variable Cost of Capital, Double Taxation on Dividends or Capital Gains

Bond Securitization

Bonds can also be issued as a means of collateralizing and selling owned debt. Securitization is a financial process where assets are pooled and sold to investors in the form of securities. For instance, if a company owns existing debt from customer loans, it can use these loans as collateral to issue a bond. This process converts future cash flows into more current and liquid cash.

Process of Securitization:

Purchase an asset, like a portfolio of loans, from an originator. Aggregate multiple similar loans into a pool. Create securities from this pool and sell them to investors. Continuously manage the payment of the remaining loans and assure timely payments to bond holders.

Main Requirements for Issuing Bonds

The decision to issue bonds is not straightforward. Companies must meet several requirements to successfully issue bonds to the market. These requirements include:

Faithful Performance: Compliance with bond agreements, timely payment of principal and interest. Appropriate Registration: Ensuring that the bonds are registered with relevant authorities such as the Securities and Exchange Commission (SEC) in the United States. Underlying Assets: The bonds must be secured by underlying assets that generate sufficient cash flow. Financial Strength: Companies must demonstrate financial stability and predictability, as indicated by their credit ratings. Interest Rate: The bond's interest rate is based on the calculated risk associated with the collateral or the borrowing company. A higher credit rating results in lower interest rates, while weaker ratings require higher interest rates. Bond Insurance: Companies can seek bond insurance to raise the bond’s credit rating and make it more attractive to investors.

The 2008 Financial Crisis and Bond Securitization

The subprime mortgage crisis of 2008 highlighted the risks associated with the securitization of bonds. As securitized bonds changed hands, the underlying collateral and its true value became increasingly unclear. Further, bond insurance companies, which were supposed to mitigate risk, underestimated the risks and insured too many bonds, leading to financial instability.

The impact of this crisis was devastating. Many bond insurers went bankrupt, leading to a market monopoly by the remaining insurers. This resulted in higher prices, limited competition, and a prolonged period of recovery in the bond market.

Conclusion

Issuing bonds is a strategic tool for companies aiming to secure capital without diluting ownership, and it offers tax benefits and a predictable cost of capital. However, it comes with significant regulatory requirements and risks. Understanding these requirements and the risks involved can help companies make informed decisions and better navigate the complexities of the bond market.

Keywords: bonds, debt financing, equity financing, bond securitization, financial crisis