How to finance your business by issuing a bond?
Bonds are one of the most popular ways to finance a business (for liquidity, growth, or investment purposes), often as an alternative or supplement to bank loans. We can think about bonds just as a loan contract that is in a financial instrument form.
With interest rates on loans getting higher and higher, and banks today adding many additional conditions for insurance and collateral, bonds are becoming an even more attractive option.
Issuing a bond is similar to taking out a long-term loan, yet bonds offer some important advantages. Bonds are best suited when the issuer wants to borrow a larger amount of money for a longer period of time while already partially indebted to banks.
In this article we will look at the most important information as well as a practical example of how a company can finance its activities by issuing a bond.
The basics: What is a bond?
A bond is a security issued by the issuer or a debtor (a company or a government) that is sold to creditors (investors) to obtain fresh capital. The debtor agrees to repay the principal and interest to the creditor at a specified date. As mentioned above, a bond is very similar in content to a loan.
Bonds are considered debt instruments because the issuer is indebted to the creditor (at an agreed interest rate). Bonds are usually long-term securities where the principal and interest are repaid over a period of more than one year, most often three to five.
The main features of a bond are (that you usually determine first when considering issuing a bond):
- Issue size
- Number of bonds
- Nominal value (per bond)
- Minimum investment
- Maturity date (usually 3-5 years)
- Interest rate and method of interest repayment
- Main risks and financial obligations of the issuer
Bonds are often issued by governments, municipalities and other public entities, as well as by companies. They are one of the most popular ways of financing organizations, and one of the best options for investors who are looking for fixed-income and relatively safe investments.
When should a company decide to issue bonds?
Bonds are usually combined with bank loans, depending on the conditions on the market.
Corporate bonds are usually issued for the following purposes:
- Business expansion – opening new markets, launching new products, etc.
- Capacity expansion – expansion of production, acquisition of real estate, etc.
- Acquisition of companies
- Financing working capital
- Other reasonable scenarios involving meaningful investment
Description on the use of raised funds, and all other relevant information is described in the offering document (or bond prospectus), which we will consider later in this blog post.
Advantages of issuing bonds over bank loans
Like any financing instrument, bonds have their advantages and disadvantages. The main disadvantage is that the process is slightly more complicated than borrowing from banks (but not significantly so) and that it is necessary to systematically approach a wider range of target investors (institutional or private).
However, investor diversification also brings benefits.
The biggest advantage of issuing bonds over long-term bank loans is the high degree of flexibility, as the bond can be structured in a way that best suits the company. In other words: Only the company sets the terms, but the bond still must be interesting for investors (otherwise they will not invest).
Therefore, the bond can be structured in many ways, the only important thing is that the offering remains interesting for investors.
Specific examples of the advantages of a bond issue over a bank loan:
- Broadly defined purpose for raising capital (e.g., liquidity only)
- Known fixed interest rate over the long-term
- Greater flexibility in collateral and subordination of debt
- Diversification of investors through standardized communications and terms and conditions
- Preservation of greater liquidity through deferred payment of principal and interest
- Fewer covenants/restrictions than traditional bank financing
What are the usual conditions when issuing a bond?
As mentioned earlier, the issuer offers bonds to the market on the terms it wants. If the market accepts its terms, the fundraise (and issuance) is successful, meaning the issuer gets the desired amount of funds.
Financing through the issuance of bonds – long-term debt – is recorded on the company’s balance sheet in the same way as bank debt and other financial debt.
It’s also important to mention that the bond consists of:
- A principal – The amount of funds the issuer wants to raise, which is paid at the maturity.
- Coupons – Interest the issuer pays on the bond. The way the coupons are paid is specified in the bond terms and conditions or in the prospectus. They can be paid monthly, quarterly, annually, or in full at maturity.
Of course, the terms, which are the same for all investors, must be accepted by all of them. Financing through the issuance of bonds is somewhat more expensive than bank loans.
The interest rate depends on the assessment of the risk of default and the conditions imposed on the issuer by the investors. Under current economic conditions of rising interest rates (in 2023), corporate bonds are on average issued with annual yields ranging from 5% to 12%.
Who can issue a bond and what is the process?
A corporate bond can be issued by any type of entity (except sole proprietors and non-profit organizations). A brokerage firm licensed to approach suitable investors and experienced in the market will help you with the issuance process, especially with investor expectations for maturity, yield, and other bond terms and conditions.
Equito provides comprehensive bond issuance support. Please contact us for more information.
The most common process for issuing bonds is as follows:
- Formulation of bond terms and conditions
- Informal survey of investors (market research)
- Preparation of the offering document (prospectus)
- Systematic presentation of opportunities to investors (road show)
- Execution of investments (Equito provides a technological platform for this step)
- Listing of the bond on an exchange (optional)
So, once you have agreed with your brokerage partner on all the bond terms and conditions, a market test is usually carried out. This means that brokerage will target a specific group of investors with a short presentation document (“teaser”) about your company, your business, and the bond itself, and get feedback on the attractiveness of the investment.
If investor expectations (yield, collateral, maturity, etc.) differ from those proposed, the necessary adjustments will be made with the approval of the company/issuer, or the process will be terminated at the issuer’s request.
If there is investor interest in the bond, the process will continue. A complete bond offering document (prospectus) is prepared that discloses all legally required elements of the bond and the company’s operations and risks. There are several types of prospectuses that serve different issuance purposes.
There are differences in requirements of issuing a bond on the US, the EU, or other markets.
The entire process usually takes a few months and depends on the complexity of the issuance, the type of prospectus, and most importantly, the amount being raised, and the number of investors targeted.
Prospectus regulation in the EU
In the EU there are three options when it comes to preparing a prospectus:
EU Growth prospectus
An issuer that is an SME can raise funds from the public (professional and retail investors) using EU Growth prospectus document. It is a simplified prospectus usually about 50-70 pages long, which is not as extensive as the “full form”, and the process of raising capital is simpler and cheaper.
If the company is not an SME and is seeking larger amounts of funding, and wants to appeal to a combination of professional and retail investors, a full prospectus must be used (120+ pages), which requires more extensive disclosures and more formal procedures.
There are a few exemptions where issuers do not need to prepare a (growth) prospectus. One of them is if the minimum investment amount is at least 100.000 EUR, or if the targeted investors are only institutional investors, or the amount to be issued is less than 5 mio EUR (but this depends on the country where the bond is being offered).
For more information on the U.S. market, see the SEC Investor Bulletin on Corporate bonds.
Who buys the bonds?
As for the question of who buys bonds, we should first understand the financial market. Theoretically, the financial market is divided into:
- the money market, which includes short-term financial instruments with a maturity of up to one year (loans, commercial papers, etc.),
- and the capital market, which includes long-term financial instruments with a maturity of more than one year (bonds, etc.) or, in the case of capital (shares), without a maturity.
The role of financial markets is to enable an efficient flow of money and capital from savers/investors to companies that need additional funding. Since money, like all other goods, has its price, the borrowers promise to pay interest or dividends to investors that provide the money, where the interest rate is determined by the market.
Investors are usually split into two groups – institutional and private (retail) investors.
- Institutional investors include pension and mutual funds, investment banks and other private funds, and they are the most common (and largest) buyers of bonds.
- Private investors (non-professional investors or retain investors) also participate in the bond market, either through direct bond purchases (rare) or indirectly through investments in funds.
So, in practice, we are all part of the capital market and each of us can invest in bonds.