Bonds 3: Who issues bonds and why?
In other words, why do bond issuers borrow, and what do they do with the money?
Understanding what kinds of things your money will fund, and why governments and companies turn to lenders, helps you have a better informed opinion when it comes to picking a bond!
Of course, you might not be able to know for what exact purpose that particular loan will be used. But before you invest in a bond, you would gather information about its issuer: what have they done in the past? What projects do they have in the pipeline? If it’s a country, how are their public finances managed? If it’s a company, how do the leaders take decisions?
After all, the bond yield doesn’t give you the answers to these questions…
So, why do institutions issue bonds?
Corporations: capital, tax benefits and maintaining shareholder equity
Corporations might want the money to invest in new material or build new plants, to expand and improve their operations, or because they want to grow big and grow now in order to keep ahead of competitors.
As a result, they can’t wait, or don’t want to wait, for the money to collect before they can invest. Taking on debt might be a strategic decision that a company takes without ever actually needing the money: it’s simply a route to develop faster.
To meet its financial needs, a company could ask a bank for a loan, could issue more stock, or could issue bonds. Each strategy has different advantages (there is also the strategy of operating at a higher level of sales, profit and efficiency, but of course this doesn’t directly have to do with financial markets).
Borrowing from a bank
If you want to borrow all the money you need from one bank, the big question is – if you want to borrow a lot, will the bank agree, and will it have the capital for that? An additional concern is that, in this context, the bank would be the only buyer: as a result it would hold a lot of power over the company.
Instead, with lots of “little bondholders”, as long as they don’t group together into one powerful voice, a company can power ahead with whatever it wants to do – whereas a bank is much more likely to put a company under more stringent scrutiny.
That is why a huge multinational like Nestlé might prefer to issue bonds instead, raising all the money it needs from thousands of people in very little time.
Selling more shares
If you want to issue more stock (that is, sell more shares), the problem is that is “dilutes shareholder equity“. In other words, it makes the share of each shareholder less valuable. If the company doesn’t increase its capital, but only issues more shares, it means each share is worth less: if the size of the “prize” doesn’t change, but the number of people partaking in it is higher, everybody will get a smaller slice of the pie.
This reduces the worth of each share: shareholders wouldn’t be too happy with that, of course, and they are the ones who get to make the decisions, since shareholders vote in decisions that affect the company they own. So they are unlikely, save in some very special circumstances, to vote against their own interests – all the more so since, according to the law of supply and demand, more of the same product might cause its price to decline if demand remains the same.
Also, the company might not be interested in entering a relationship with people who will in effect become decision makers, for an indefinite length of time: shareholders become de facto owners of the company, and they enter a relationship with the company that could last as long as they don’t sell their share.
Bondholders on the other hand are creditors: once the company has paid back its debt, their relationship to the company comes to an end. The company might prefer to just benefit from lenders’ money, for a definite amount of time, and would be ready to yield other advantages in return for the loan. What’s more, interest payments that the company would have to pay out regularly to its bondholders are tax-deductible.
This is interesting for potential bond buyers, for several reasons:
– paying out interest on bonds is an obligation; whereas paying out dividends to shareholders is optional.
You might remember a few months back that Apple finally paying out dividends to its shareholders was huge news, as it would have been the first time in seventeen years.
– if the company files for bankruptcy, bondholders, as creditors, are first in the “pecking order”. They are paid back first (if there is any money left), whereas shareholders might never be paid back at all.
And you – should you buy stocks or bonds?
But a shrewd investor might say “Wait a minute – this company needs more money because it is going for growth. Instead of buying this company’s bonds, why don’t I buy its shares? If this company grows, its shares will become more valuable, so I might be able to sell them in a few months’ or years’ time at a nice profit…”
Indeed you could buy stocks, but you shouldn’t disregard bonds, and this for several reasons: the stock price could fall and there is no guarantee that it would rise, whereas bonds still provide fixed income. So you might have a stock strategy on top of your bond strategy, but don’t think stocks and bonds are competing financial products: they are complementary. They serve different objectives. The question is not “Should I buy bonds, or should I buy stocks?”, but “What proportion of bonds and stocks do I want in my portfolio?”
Countries and local authorities: fund deficits, fund projects, smooth out cashflow
The first thing you might have thought of when I mentioned countries, would be the national debt that is used to fund the deficit. Indeed, this might be the most pressing financial need of several governments at the moment, and the one we hear about in the news all the time.
The recession has become synonymous with national deficit, as the expenses of governments have risen with the costs of the live register, while revenue dwindled since governments were taking in less tax.
And then there are less tragic reasons to borrow money and issue bonds – a country or a local authority might have a particular project to fund.
It might be a project that will bring in revenue, and so will pay for itself: an airport that will charge airlines, shops and passengers to use it, a motorway with a toll system, etc.
Or it might be a project that is needed now, but will be funded by tax over time: you might want to provide users with better infrastructure now and there simply isn’t the time to wait for tax revenue to fill the gap.
Perhaps you remember the example of Laois’s growing population and the need to invest in roads. The government could issue general obligaton bonds to bring in money today and the money would be repaid with taxes collected over time, as the people living in Laois will continue to pay taxes in the form of Pay & Display parking, etc. In this case, bonds serve to smooth out cashflow.
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