The Market for Borrowing Corporate Bonds - Essay Example

?Introduction The corporate bond market contains those debt securities which are issued by corporations and sold to investors to raise operating capital. Corporate Bond markets acts as facilitators in issuing and trading debt securities. The corporate bond market can help in improving the financial stability of an economy and provide competition in the private sector as well. The corporate bond market can also help in enhancing the financial sector stability by reducing or mitigating the interest risk and rollover risk for the borrowers. An efficient corporate bond market will lead to the efficient allocation of investment funds. An efficient market will also lead to investments in riskier assets. The types of securities which can be issued in the corporate bond market are debentures, unsecured notes and subordinated debt. One of the major reasons for developing a corporate bond markets is that the bond market provide an alternative solution or source for operational funds for the private sector other than borrowing from the equity markets and banks. This helps in improving the financial stability and allocation of credit. Companies running successfully can decide to expand their activities and commence new projects. To raise capital the company can decide on raising the funds from the corporate bond market as it can be beneficial for the company in the long run. The following sections give a detail understanding of corporate bonds. These sections describe the types of securities that can be issued in the corporate bond market, the types of companies that can issue it, the benefits of issuing bonds over other sources of finance, the providers of debt and their requirements. This information will certainly help the Board of Directors to reach a decision regarding the use of corporate bonds for raising capital to finance the new project. Types of securities that can be issued in the corporate bond market A company can issue three types of securities in the corporate bond market. These three types are explained below. 1. Debentures A debenture is secured by a fixed or floating charge over the issuing company’s unpledged assets. There are two types of debentures: fixed charge and floating charge. Both the types are explained below. a. Fixed Charge debenture: A fixed charge is placed over the permanent assets of the company such as fixed assets. These assets cannot be sold until the bondholder has been repaid in the event of default. These bondholders have the first claim on the assets of the company. b. Floating charge debenture: A floating charge is issued over those assets which the company will sell in the normal course of the business to generate income such as finished good. These assets can be sold so the company issues a floating charge over these assets. Once the company defaults the floating charge becomes fixed charge. The bondholders will then take possession of the assets. Once the claims of the fixed charge bondholders have been satisfied, these bondholders can claim on the remaining assets. For example, if all the fixed assets have been used to pay off the fixed charge debenture holders, then the assets that the company sells to generate income will be used to pay off the floating charge debenture holders. 2. Unsecured Notes It is a corporate bond with no form of underlying security attached. These bondholders have no claim over the assets until the claims of the fixed-and floating charge bondholders have been satisfied. For example if a company defaults, the fixed charge debenture holders will be paid first, then the floating charge will be paid and finally the unsecured notes holders will be paid. 3. Subordinated Debt Subordinated debt is a long-term debt issue that ranks behind all other creditors. The subordinated debt also pays a specific interest stream. In the event of a default, the holders of subordinated debt receive nothing until the claims of all other creditors are satisfied. The debt issue may also include an agreement which states that the debt will not be presented for redemption before the elapse of a particular period. Subordinated debt is more like equity than debt. On the balance sheet it is shown as shareholders’ funds rather than as debt. As a result of this, issuing subordinated debt improves the credit rating of the company. Hence, the creditworthiness of the company improves and the ability of the company to borrow strengthens. Types of companies that qualify for raising direct debt A public company can raise direct debt. A public company can issue securities to the general public and have more than 50 non-employed shareholders. There are four different types of public companies: limited by shares, limited by guarantee, unlimited with shares and no liability company. Public company limited by shares Public company limited by shares A public company limited by shares is one that has shareholders and whose debt is usually limited to the nominal value of the shares in addition to any amount unpaid on shares. In this case, shareholders are protected from any lawsuits and or legal action limited to the amount they have paid for. For example, if a person purchases $100 worth of shares of a particular company, then their liability is limited to only the $100 paid, thereby limiting their liability only to the value of shares bought. Public company limited by guarantee Public companies limited by guarantee usually include small businesses and charities. Members of the company can place a guarantee on the company and do not have share capital. Instead, this guarantee is only enforced in the event that the company is wound up and is not an asset of the company which can be charged on the books during the course of the company’s life. Unlimited liability companies Unlimited companies are those companies whose members do not have any limit placed on their individual liability to contribute towards the company. Partnerships are a common form of such unlimited liability companies and these companies usually raise debt through the personal investment of its members. No liability company No liability companies are those public companies that have no contractual or statutory right to recover unpaid calls. These companies have ‘no liability’ or ‘NL’ in their name and are usually mining or resource extraction companies. Reasons why corporate bond market debt raising may be beneficial When raising funds through the use of corporate bonds, the cost of the financial intermediary is eliminated. If the company goes to a bank to get a loan, the bank will include a profit margin in the interest rates. This margin can be eliminated when raising money from the corporate bond market. One reason why corporate bonds are beneficial is that of the option of callable bonds. A callable bond can be redeemed by the issuer before its maturity. If the bond contains this embedded option then it can redeem the bonds when the interest rates decline so that it can raise capital at a lower cost. One of the main reasons for developing corporate bond markets is that these markets provide an alternative source of operational funds for the private sector other than borrowing from the equity markets and banks. This helps in improving the financial stability and allocation of credit. Another advantage is that diversity in the source of funds allows the companies to adjust their borrowing between the bond market and banks. An established Corporate Debt market means that it creates competition for the banks, which help in reducing the banking spread between the deposit and advances rates in the banking system. The corporate bond market helps in preventing the commercial banks from charging exploitative rates. An efficient bond market also leads to investments into more risky assets. The roles of corporate bond markets and banks are complementary. This means that any financial stress on one of the financial intermediary will not have a major impact upon the financial stability of the economy. The corporate bond market is also beneficial when companies are looking for long-term financing. If an organization is looking to invest in a project which may take a decade to complete, raising funds through issuing bonds can be beneficial for the firm. By issuing corporate bonds, the company can itself choose the terms and the date to maturity of the bonds. When a company issues bonds to the general public the corporation is better able to borrow on its own terms which it states in its prospectus and this creates an advantage for the company as if the company would have borrowed from the bank then the bank would have determined the repayment terms and the length of the loan. Another advantage of issuing bonds rather than raising funds through issuance of new stocks is the company avoid any changes in ownership. Raising funds through issuance of new stock devalues the current stock; the stock becomes less valuable than it was before the issuance of new shares. New issuance of stocks also means a change in the majority percentage of ownership. Hence raising funds through bonds is more beneficial for the company. Issuing corporate bonds also leads to tax advantage for the firms. The bondholders are the debt holders when a company issues new debt. The company now has to make interest payments to the holders of the bond throughout the year. The interest which the company is paying is tax-deductible; hence this can lead to large tax savings for the company. On the other hand, if stocks are used to raise funds the dividends are not tax-deductible. The corporate bond market can also be beneficial for the company as it can lead to access of more capital. Companies issue bonds to institutional investors but the small household investors can also purchase these bonds and these investors purchasing power can be substantial which means that it allows the issuer of the bond in this case the company can be able to generate more capital. Main providers of direct debt finance There are three main ways to issue corporate bonds. These three ways represent the three types of providers of direct debt. The three ways are explained below. 1. Public issues In this method the offer is made to the general public. The company invites interest from the general public to invest in the company. 2. Family issues In this method only those parties are invited who already hold the company’s security such as stockholders, bond holders and convertible notes holders. 3. Private placements In this method the offer is made to a small number of select investors. These investors are large institutions such as institutions that deal in securities, mutual funds, pension funds and insurance companies. Requirements of direct debt providers The requirements for companies to raise debt by issuing corporate bonds vary between countries. The requirements imposed by the legislation in these countries differ. However, in most countries it is required that the prospectus is registered with the regulator of that country. This prospectus is required to be accompanied by the invitation to the public. A prospectus basically states the terms and conditions by company on the issue of securities to the public. The prospectus is intended to protect the interests of the investors. The prospectus provides a detailed picture of the organisation and its business to the public. Using this information in the prospectus, the investor will be able to make an informed decision about investing in the company. The prospectus includes: ? financial statements ? directors and executive managers ? specialist accounting, taxation and legal reports ? any material information that may affect the company ? strategic business plans and the intended use of funds gained from the issue. Many companies prefer private placements more than issuing bonds using other methods. The reason is that they find it difficult and time-consuming to prepare and register the prospectus. So for private placements these companies do not require to prepare and register a prospectus but instead of this they must provide an information memorandum to the institutional investors. An information memorandum limited information to institutional investors. It is less detailed than a prospectus. Institutional investors are part of the market and therefore it is assumed that they have greater knowledge about a company than the general public and therefore it is not necessary to provide the full details that are required to be mentioned in the prospectus. The information memorandum includes up-to-date financial statements, changes that will or may affect the business and the reason of raising debt. References Asquith, Paul, Andrea S. Au, Thomas Covert, and Parag A. Pathak. "The Market for Borrowing Corporate Bonds." 2010. Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 8th. McGraw-Hill, 2006. Brigham, Eugene F., and Joel F. Houston. 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