The issue of bonds vs. loans is a confusing one for a lot of people, and understandably so. There are a lot of similarities between the two but in the end, they are both very different.
Companies usually have to choose between bonds and loans when they are looking for ways to raise money to finance different business activities. The choice is not easy to make unless you have a clear idea of the differences between bonds and loans, and the implications of each to your business.
Both are methods used by firms or the government as a debt instrument to borrow money, and when it comes to repayments, an interest rate will apply in both cases.
Before we delve deeper into the key differences between these debt instruments, let us look at the definitions of each to help you differentiate between bonds and loans in real-world scenarios.
By the end of this article, not only will you be able to tell the difference between a bond and a loan, but you will also be able to choose the better option for borrowing money for your business.
A bond works in much the same way as stock offerings in that it is a debt instrument issued by the government or a private company as a means to borrow money from investors. In such cases, the companies that issue bonds are referred to as borrowers while the individuals or entities buying the bonds are called investors.
The amount the investor gives to the borrower is called the principal amount and they will get it back when the bond reaches maturity. In the meantime, they will receive interest payments on the bond twice a year. Bonds have a fixed interest rate and a fixed maturity period.
Unlike when you buy stock in a company, when you buy bonds, you are not a stockholder because no matter what happens to the company you will still receive your money back.
Corporate Bonds and Government Bonds
When the government needs to raise money, it can issue bonds to ordinary citizens and private entities, for example, the UK government bonds. This can be done at a national level in the form of “risk-free bonds” in which the country will redirect taxes or print more currency to pay off debts.
At a local level government bonds are called municipal bonds, and are used to cover everyday tasks and to keep the city from going bankrupt. Municipal bonds build interest on a tax-free basis but offer far fewer returns than corporate bonds.
When a private entity issues bonds they are called corporate bonds and have a flexibility that other debt instruments do not. This is because matters such as the maturity of the bond, use of funds, and terms of the bond are decided by the company that issues it.
Corporate bonds are riskier than government bonds. As a result, companies with poor credit ratings will find it difficult to sell bonds unless they offer an appealing interest rate and use other forms of collateral to improve debt security.
What Is a Loan?
When one party gives money to another on the agreement that the borrower will make periodic payments on the interest and the principal amount, it is called a loan. The fixed repayment period can range from short-term loans of a few months to long-term loans of as many as 10 years or more.
Agreements have to be made regarding the interest rate and the installments which will be expected from the borrowers. Private loans tend to be the easiest debt instrument for individuals or companies to obtain capital from banks or other financial institutions.
Bank Loans and Forgivable Loans
The most commonly known types of loans tend to be bank loans, where an individual or organization gets a lump sum from a financial institution on the promise of making annual interest payments and installments to pay back the money.
In some rare cases, the borrower may not be required to make any interest payments or installments to cover the principal amount as long as they agree to certain conditions of the loan as dictated by the lender.
Such a loan with no repayment period is called a forgivable loan and may include a wide range of conditions, for example, using cash credit for specific things. Failure to adhere to the agreements of the loan may result in loan interest rates being applied and repayment being required.
The Key Differences Between Bonds vs. Loans
Now that you have a better idea of what bonds and loans are, we will look at the specific areas where these two debt instrument options differ.
The Parties Involved
A loan usually involves two parties, the lender and the borrower. While the lender is usually a financial institution, the borrower can be an ordinary person or an organization. This means they are private loans, which is beneficial to borrowers who want to maintain their confidentiality.
On the other hand, bond investors tend to have pension and hedge funds, or be professional investors and financial advisors. This is because of the added complexity that comes from bonds, which makes them unsuitable for individuals without a lot of financial knowledge.
Privacy is also not an option when securing bonds, such as UK government bonds, because they are public offerings.
A loan is repaid in installments over a long period on which either a fixed or variable interest rate is added. The advantage is since the loan is not repaid in full all at once, you can easily manage to cover the installment as long as your business is generating adequate cash flow.
The downside is that if you are struggling to raise money for the installments, then the burden of repayment will only get worse as time goes by. There is not always enough time on the payment schedule given for your business to generate cash before the first installment is due.
Bonds only require payment at maturity, which gives the borrowing company or government some time before they have to worry about paying back the money or keeping an eye on the interest rates.
However, if the borrowing company does not plan well, the repayment of a matured bond may exhaust its funds. Some companies sell new bonds to investors to help them pay back the money on existing ones.
Loans tend to have either a fixed or variable interest rate, with the amount calculated based on the current market conditions and the amount of risk the lender is exposed to. If, for example, you apply for an unsecured loan, you should expect to be burdened with very high loan interest rates.
Whether it is a secured or unsecured debt, loans usually have higher interest payments than bonds. However, it can be easier to meet your installments if the interest payments are calculated on a reducing balance basis, in which the amount decreases monthly.
Bonds come with either zero interest, variable interest rate, or fixed interest. The most appealing type for most companies is a fixed interest as this is the easiest to predict.
When applying for a loan from a bank, your credit rating will play a huge part in whether you are approved, how much you can be given, the agreed repayment period, and the attached interest rates. This is because financial institutions are all about minimizing risk as much as possible.
Even after you get approval for the loan, the bank may still have a say in how you are going to spend that money. Although it is not unheard of for someone to receive a loan even if they have no collateral, such an unsecured debt will come with high loan interest rates.
Bonds, on the other hand, do not usually come with so many conditions. All that is required is that the company be reputable or have some form of collateral to attract investors.
Amount That Can Be Raised
If a loan is used as a debt instrument, there is a cap on the amount of cash credit a bank is willing to extend to you based on your credit rating. With a poor credit history, loans are not the best option to raise a huge amount of money.
When companies issue bonds, many investors can be relied upon to contribute, which means a company can quickly raise a huge amount of money. Issuing bonds that are affordable will allow a company to attract a wider pool of potential buyers.
Loan agreements constitute a binding contract between the financial institutions and the borrowers. This means you cannot at any time transfer the loan to another individual. However, bonds can be sold to someone else through the bond market without affecting the terms of the bond.
Cost of Issuance
The processing of both bonds and loans will have various administrative costs not associated with the principal amount or the interest rates. With loans, these costs are deducted from the loan amount you actually receive, and the higher the loan, the more it will cost.
Bonds will require a lot more paperwork than loans, and companies or governments may need to hire the services of underwriters to handle the complicated process. This makes the cost of issuance a lot higher for bonds than taking out a loan.
Loans are subject to a renegotiation of the terms at any time as long as both parties are in agreement. This means you can agree to extend the loan, pay off the balance immediately, or change the interest rates. Bonds on the other hand are difficult to restructure once they have been issued.
Is It Better To Sell Bonds or Get a Loan?
The choice between a loan and a bond is not an easy one and has the potential to affect your business in a lot of ways. Therefore, you need to approach financial advisors for the right investment banking advice before you make your final decision.
Things such as interest rates, repayment period, and amount of money required should be carefully considered. In the end, the right choice for one company may be the total opposite for another.