So Many Shoes, So Little Money – Blog

More Corporate Bonds

August 7th, 2009

Why do companies issue bonds?  If they need money, why don’t they just go to a bank and borrow it?  There are a few reasons, but the main reasons are that borrowing from a bank can be very restrictive and very expensive—more expensive than selling a bond to the general public. In other words, banks are usually more conservative when it comes to investing than people are. (Unfortunately, this is not always true—I wish they had been more conservative before making all those home loans that could never be repaid.)

So it costs a company more to borrow from a bank than it costs them to borrow from you. Plus, when a company borrows money from a bank, the bank often tells them what they can and can’t do with their money. The banks give the company lots of rules, which are called covenants. For example, a bank might tell a company that the money can only be spent on one thing, like operations and not on expansion. Or the bank might say that if the present head of the company leaves the company, all of the money is due back to the bank immediately. Or the bank might tell a company how much cash it must keep on hand at all times. Sometimes the bank requires the company pay back the loan too quickly for the purposes the company is raising money for, like building a new plant.

Companies can find these rules stifling. So, instead of going to a bank for a loan, a company will issue a bond through the bond market. (Think of a bond market as a huge shoe store—where you can buy all different kinds of shoes. In the bond market, you can buy all different kinds of bonds.)

Company bonds are typically issued in 1,000 or 5,000 dollar increments. These increments are called the face value. Face Value really refers to your principal—the amount of money you paid for the bond. The face value has to be paid back to you within a set time frame, called a maturity. The time period in which the face value must be paid can vary from as little as 30 days to as long as 30 years and anywhere in between—there are bonds with even longer maturity dates than 30 years, but they are rare. But typically a bond’s maturity is seven to ten to fifteen years in the future.

Generally in exchange for borrowing your money and issuing you a bond (which is the piece of paper or contract that describes the terms of the loan), a company will periodically pay you interest. Interest is the fee the company pays you for borrowing your money and is no different from the interest the bank pays you. When interest is paid from a bond rather than from a bank, it is called a coupon. To reiterate, a coupon payment is conceptually no different from the interest the bank pays you for leaving your money in a savings account. And, just like with a treasury, the longer the company borrows your money, the higher the interest rate because the longer you are agreeing to tie up your money.

So, when a bond is issued, the bond issuer (the company borrowing the money) determines how much money they need to borrow, the total value of each individual bond (principal), how long they need to borrow the money for (maturity), and the fee they are willing to pay to borrow the money (interest rate or coupon).

Filed under: Money Management

Tags: Bonds, Investing