Bonds versus Banks

Bond financing differs significantly from traditional bank financing. The first major difference is that the corporate entity seeking finance does not make an application to a “bank” that can ultimately accept or reject the application. Instead, the borrowing corporation establishes a set of terms and conditions that it is willing to comply with in exchange for the required finance.

In the case of a Debenture Bond, the bond itself is secured solely by the credit rating, or promise to pay, of the issuer. Such issues are usually undertaken by large corporations with a well established track record and a good credit rating. However, smaller corporations can successfully issue bonds/promissory notes via a Regulation D Offering (see separate information sheet)

An alternative to a debenture bond is a secured bond, sometimes known as a mortgaged backed bond. This is essentially a pledge of security for the required finance which is usually in the form of real property or highly liquid securities.

The creation of a bond is a legal function instigated by the borrowing corporation. It involves the creation of security agreements (in the case of a secured bond) and a bond indenture (full disclosure of the terms and conditions of the bond along with its several provisions for repayment etc.).

Having created a bond, it is then placed either on a best endeavours or fully underwritten basis in the capital markets. These markets comprise of high-net-worth individuals, corporate investors, insurance and investment companies and, of course, banks. Placement is simply another word for selling the bond. In reality what happens is that the bond is formally offered either on a private placement basis or through a public offering. For the latter, the bond must be listed for trading on a formal exchange.

The advantage of a bond over traditional bank borrowing is that the issuer has a greater degree of control over the terms and method of repayment. For example, a company may elect to issue a bond that pays interest significantly above market interest rates in order to secure a higher uptake. A placement of this type can often result in a premium being paid for the bond (i.e. a higher price can be achieved than the face value of the bond). Alternatively, if the borrower wishes to pay a lower interest rate, the bond may be sold at a discount. The choice of which way to move depends upon market conditions at the time of placement, and is best agreed with professional advisors during the creation process.

Another advantage is the method of repayment itself. Ordinarily bonds pay a fixed annual interest rate for each year of issue followed by redemption of 100% of face value. Under this type of arrangement the borrower will have to make some contingent plan for the repayment of capital. This is normally achieved by the establishment of a sinking fund into which regular contributions are made by the borrower. At the end of term, those contributions, plus applied interest on the sinking fund, usually results in a fund large enough to redeem the bonds. However, this is not the only option. In a property development project, for example, sales of the development may produce the required redemption figure. Therefore, there will be a provision in the bond indenture to ensure that sales revenues will be charged to the bondholders as an additional security for repayment of capital. Likewise, if the project involved long term leases, those leases would also become a security for bondholders.

In addition to the usual repayment terms and conditions, a borrower also has flexibility in when to repay and how to extend the term of a bond. For example, if a borrower issues a bond paying, say, 7% per annum for a term of five years, it is usually because that is the acceptable rate at the time of issue. Should interest rates fall, however, in say year two to 3.5%, the borrower will be paying more than he has to for the money he has borrowed. This problem can be overcome by making a bond “callable”. In other words, the borrower can redeem the bond early and pay bondholders their capital in year two. This would normally coincide with a new issue of bonds at a rate of say 4% (to reflect current market conditions). The proceeds of the new issue will be used to redeem the first bondholders, thus securing a lower interest rate for the borrower.

Why doesn’t everyone raise money this way?

In order to attract investors to a bond placement, the amount involved must be significant. There are a number of reasons for this. The primary reason is that few potential bondholders wants to be majority bondholders. In fact, the regulations of the investing institutions may even prevent them from investing more than a pre-defined

percentage of a total placement. This coupled with the fact that many investors have a minimum investment value means that they simply cannot participate in small issues. Assume for a moment that an institutional investor has a minimum investment value of $600,000 and it cannot purchase more than 4% of any one issue. This automatically means that for a placement to be acceptable to such an institution it must have a total placement value of $15,000,000 (fifteen million USD). Therefore, the value of a placement is instrumental in its acceptability to the markets.

Secondly, to prepare a placement costs money. This is no “begging-bowl” scenario. Bond issuers want to be assured they are going to get the money they need so they employ the services of professionals to give them the credibility to get the money in a first hit. Preparing a bond involves valuations of a business, appointment of accountants, trustees, attorneys and placement agents. If there is to be an element of underwriting, there will also have to be an investment bank. These people are not charities, neither do they accept contingency payments. The view of most industry professionals is that if you can’t afford to retain professional services then you shouldn’t even be looking to raise significant funds from the capital markets.

What are the costs?

With the exception of Regulation D Offerings, your initial legal and fiscal costs can be circa $150,000 to $250,000. In addition, upon placement you will be responsible for paying negotiated commissions to anyone who introduces investors. In order for a placement to justify this type of cost automatically means you must be looking for a serious amount of money. In the example of our $15 million placement, such costs would account for a circa 4.67% before any interest payments. Of course, it is possible for such costs to be built into the actual bond pricing structure, but there is no getting away from the fact that a significant sum has to be paid in advance for the professional services you will need.

An Important Note

Although raising finance through bonds is a viable proposition, you have to be professional in your approach and confident of the ability of your business to raise the volume of money in question. You cannot be undercapitalised; there is no way you can enlist the services of those who can “make it happen” on the basis that you will pay them later. They will not want to know. In fact, by even attempting to offer professional advisors a contingency payment may well result in a total rejection of your proposal by anyone. As a rule of thumb, if you do not have at least 5% of your required financing available in liquid cash, forget going to the bond markets. However, if you do have this level of initial input, the bond market may prove to be the cheapest money available.


is usually engaged under aformalc onsulting services agreement that encompasses the

provision of professional advice, assistance in the selection of professional service providers, the preparation of mandatory documents, including the Placement Memorandum (prospectus) and the provision of placement services (selling the bond).

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