When companies need to raise money to continue or expand their operations, they generally have the option to choose between long-term loans and bonds. Long-term loans and bonds work in a similar fashion. With each financing option, a company borrows money that it agrees to repay at a certain time and at a predetermined interest rate.
When a company takes out a loan, it is typically borrowing money from a bank. Though repayment terms can vary, typically, a company that borrows money will make periodic principal plus interest payments to its lender over the life of the loan.
Bonds are similar to loans, only instead of borrowing money from a bank or single lending source, a company instead borrows money from the public. With bonds, the issuing company makes periodic interest payments to its bondholders, usually twice a year, and repays the principal amount at the end of the bond's term, or maturity date. There are benefits and drawbacks to each of these financing options.
Advantages of bonds
When a company issues bonds, it is generally able to lock in a long-term interest rate that is lower than the rate a bank would charge. The lower the interest rate for the borrowing company, the less the loan ends up costing.
Additionally, when a company issues bonds instead of pursuing a long-term loan, it generally has more flexibility to operate as it sees fit. Bank loans tend to come with certain operating restrictions that could limit a company's ability to grow physically and financially. For example, some banks prohibit their borrowers from making further acquisitions until their loans are repaid in full. Bonds, by contrast, do not come with operating limitations.
Finally, some long-term loans are structured to include variable interest rates, which means a company's rate could go up significantly over time. When a company issues bonds, it is able to lock in a fixed interest rate for the life of the bonds, which could be 10 years, 20 years, or more.
Advantages of long-term loans
Unlike bonds, the terms of a long-term loan can often be modified and restructured to benefit the borrowing party. When a company issues bonds, it is committing to a fixed payment schedule and interest rate, whereas some bank loans offer more flexible refinancing options.
Furthermore, obtaining a bank loan is generally less of an administrative hassle than going through the process of issuing bonds. To sell bonds to the public, the issuing company must spend time and money on advertising while taking steps to ensure that it adheres to SEC requirements. The costs of obtaining a bank loan can therefore be significantly lower than the costs involved in borrowing money through bonds.
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