Understanding corporate finance: raising finance: longer-term borrowing
Longer term borrowing
For longer term borrowing needs, for example, to expand the business or purchase new plant or premises, a company may take out a term loan or a commercial mortgage from its bank. The lender will normally require the loan to be secured on some form of property held by the company.
Larger, creditworthy companies may be able to issue corporate bonds. These are financial instruments issued for a specific period of time and repayable on maturity. They can take a variety of forms, and may be secured (when they are known as debentures) or unsecured. Even when unsecured, the instrument would still be described as ‘a security of the company’.
Bonds may carry interest at a fixed rate or offer a floating rate return. A floating rate bond would be called an FRN - floating rate note. Or it may be issued at a discount. If it is issued at a discount and carries no right to interest, it is described as a zero coupon bond.
Bonds can be convertible or the return can be linked to an index or the performance of an asset.
Bonds can be in registered or bearer form. If a security is in registered form, the issuer keeps a record of the person holding it, and makes payments due on it to that person. If the security is in bearer form there is no register of who holds the bond. It is traded without any record of ownership, and the person holding or ‘bearing’ the bond can collect the interest payments, and can ultimately collect the repayment of the capital without further question. A bearer bond may also be known as a coupon bond, because it has coupons that must be separated from the security and presented in order to receive interest payments.
When a company issues a debt into a market where the debt can be bought for the first time, this is said to occur in the primary market. The market could be the domestic market or the international bond markets.
Once a bond is issued into a market by a borrower, it can be bought and sold between investors. This takes place in the secondary market, using that market’s clearance and settlement systems. The only effect on the borrower is to determine to whom they should pay interest, and who will collect the repayment. The London Stock Exchange is both a primary and secondary market.
Bonds are traded in round amounts reflecting their nominal value (£100, £1000, £100,000, etc.). The market price of a bond will depend on the yield expected from the bond, including the income it produces and the expected profit or loss on redemption. A bond paying interest at 9% will trade at less than its nominal value if interest rates have risen to 10%.
Corporate bonds (and bonds issued by governments) are given a ‘credit rating’ by agencies such as Standard & Poor’s, and Moody’s. The credit rating is based on an assessment of the company’s ability to make the interest payments and repay the principal. An ‘AAA’ rating is the most secure rating. Bonds with ratings between AAA and BBB are usually referred to as ‘investment grade’ bonds, those with a BB rating or lower are ‘speculative’. ‘D’ is a bond in default.