When a company needs money to continue or expand its operations, it usually has the option of taking out long-term loans or issuing bonds. Long-term loans and bonds function similarly. A corporation borrows money and agrees to repay it at a defined time and interest rate with each financing option.
Usually, a corporation will take out a loan and use the funds to buy new equipment, renovate its facilities or expand operations. Each of these things makes the company more productive, which results in increased sales and more profits. Bonds, on the other hand, are typically used by corporations to finance projects that have already been completed. For example, a corporation may use a bond to raise money to purchase a new building that it already owns.
But there are important differences to consider when deciding which option to use.
What Is a Term Loan?
A term loan gives borrowers a big sum of money upfront in exchange for certain lending terms. Term loans are often reserved for well-established small firms with solid financial records. The borrower agrees to a specific repayment schedule with a fixed or fluctuating interest rate in exchange for a specific amount of money. To lower payment amounts and the total cost of the loan, term loans may require large down deposits.
Term loans are applied for in the same way that any other credit facility is applied for: by approaching a lender. They must produce financial statements and other proof of their creditworthiness. Borrowers who are approved receive a lump sum of money and are obliged to make payments over a set length of time, usually monthly or quarterly.
What Is a Bond?
A bond is a fixed-income security that represents an investor’s debt to a borrower (typically corporate or governmental). A bond can be thought of as a promissory note between the lender and the borrower that outlines the loan’s terms and installments. Companies, municipalities, states, and sovereign governments all use bonds to fund projects and operations. Bondholders are the issuer’s debtors or creditors.
Bonds are extensively used by governments (at all levels) and enterprises to borrow money. Roads, schools, dams, and other infrastructure must be funded by governments. The unexpected cost of war may necessitate the need to raise finances.
Similarly, businesses frequently borrow to expand their operations, purchase land and equipment, embark on profitable ventures, conduct research and development, or hire new personnel. The issue that huge organizations have is that they frequently require significantly more funds than the normal bank can supply.
The end date when the principal of the loan is scheduled to be paid to the bond owner is normally included in the bond specifics, as are the terms for the borrower’s variable or fixed interest payments.
Bonds offer a solution by allowing a large number of individual investors to act as lenders. Thousands of investors can each contribute a share of the required funds through public debt markets. Furthermore, markets enable lenders to sell or acquire bonds from other individuals long after the initial issuing institution has raised funds.
What Are the Differences Between Term Loans and Bonds?
The major difference between the two is that bonds are generally more risky investments. This fact makes sense when you consider that bonds have a limited lifespan. As investors buy them, they are removed from the market and can only be purchased by the investor who buys the bond. If interest rates go down, more investors will seek out higher-paying investments.
Loans are a type of debt in which a lender lends money and a borrower takes out a loan. A deadline is established for the return of debt money, which includes interest and the principal amount borrowed from the lender by a corporation or an individual; on the other hand, a bond is a sort of loan also known as debt security. The public is the creditor or lender in the case of bonds, and huge corporations or the government are usually the borrowers.
An extremely simple way to think about a bond is to look at it as a loan with a maturity date. At maturity, the borrower, who is essentially the bond issuer, repays the principal to the bondholders by paying them the maturity value of the bond, which is the stated par value or face value of the bond, once known as the coupon.
Advantages of Term Loans
Unlike bonds, long-term loans can frequently be amended and restructured to benefit the borrower. When a corporation issues bonds, it commits to a set payment schedule and interest rate, although some bank loans allow more flexibility in terms of refinancing.
Furthermore, securing a bank loan is less of an administrative headache than issuing bonds. To sell bonds to the general public, the issuing business must invest time and money in advertising while also following SEC regulations. As a result, the expenses of obtaining a bank loan might be much cheaper than the price of borrowing money via bonds.
Advantages of Bonds
When a corporation issues bonds, it is usually able to lock in a lower long-term interest rate than a bank would charge. The lower the borrowing company’s interest rate, the less the loan will cost.
Furthermore, when a corporation issues bonds rather than taking out a long-term loan, it has more freedom to operate as it sees proper. Bank loans often come with operational constraints that hinder a company’s capacity to expand physically and financially. Some banks, for example, bar borrowers from making additional purchases until their loans are fully returned. Bonds, on the other hand, have no operating restrictions.
Finally, certain long-term loans include variable interest rates, which indicates that a company’s rate could increase dramatically over time. When a firm issues bonds, it can lock in a fixed interest rate for the duration of the bonds, which could be ten years, twenty years, or longer.
A company that has the capacity to borrow money through a term loan or bond issuance may need to think about the use, purpose, and necessity of the money. In terms of utilization, the amortizing nature of term debt puts some pressure on management to spend funds right away or wait until plans are highly precise before borrowing.
Bond proceeds may not be associated with that stigma. If the funded activity or project is multi-staged or collateral is unavailable, the objective of the intended spending may favor using bonds. Finally, if the borrower needs to act quickly, such as for opportune pricing on essential equipment or available assets, the perceived urgency of need may favor a term loan.