When budget time rolls around in your city or town, you many have heard your elected officials agreeing to “float a bond” to construct a new park or to funnel money into an affordable housing program. But, what does that really mean? In a nutshell, bond financing is a way for businesses to get the money they need to pay operational costs or fund other projects.
Understanding Bond Financing
Bond financing is a type of long-term borrowing in which companies and governments issue bonds to raise money to cover the costs of daily operations, infrastructure improvements, and long-term capital projects. Basically, when an investor buys a bond from a business or government, it is loaning the money for a specified period of time to an issuer. The borrower (the company or government that issued the bond) promises to make payments with interest according a set repayment schedule to the investor until the bond matures. This type of funding is popular with state governments because the interest the agency has to pay investors on the bonds it issues for public infrastructure is exempt from its federal and state income taxes. This means the state pays less interest than it would with a more traditional type of funding.
Types of Bonds
Most often issued in denominations of $1,000 with terms from one to 20 years, corporate bonds pay taxable interest. This type of bond can mature, or the time when a loan is due, after weeks or after years. These bonds are riskier because the value of the bond depends on the creditworthiness of the business issuing it. On the upside, higher risks equate higher yields, or profits.
Municipal Bonds, which are the ones issued by state and local governments and agencies, are one of the most popular types. They are issued in amounts of at least $5,000 and mature in one to 30 or one to 40 years. The interest made is exempt on federal taxes.
Benefits of Bond Financing
Like any other type of loan or funding, bond financing is more expensive than paying for it upfront directly out of a business savings account or capital fund. Bond financing makes most sense when having a particular project completed sooner outweighs the extra expense. Also, depending on the project, delaying it also can make it more costly. For instance, if you were expanding an existing building, as well as renovations, repairs can worsen and construction material and labor cost could rise.
In addition to being safer investment than stocks, there are many more legal protections for bondholders and issuers. For instance, if a company goes bankrupt, its bondholders often receive some money back while stocks become valueless. Also, bonds come with formal debt agreements, including clauses, that establishes the term of a bond issue. It outlines the bondholder’s rights and the duties of the issuers, including what action an issuer must take and what it prohibited from doing, in the agreement.
The Risks of Bonds
There are several risks that come with issuing and borrowing against bonds.
For instance, inflation can erode the value of a bond because its interest payments are fixed. The longer the life of the bond, the greater the inflation risk. However, deflation increase the value of the dollars that bond investors receive.
In addition to finding out the interest payment and return of a bond, it is vital to know whether or not it is callable. When a bond is callable, it means that even if a business has agreed to make payments plus interest, it can choose to pay off the bond early. Referred to as reinvestment risk, this means an investor must a new place for the money. Since this often at time when interest rates are low, an investor may have a hard time finding a good deal.
As previously mentioned, when interest rates rise, bond prices fall. This occurs because new bonds are issued that pay higher interest payments, which, in turn, makes older, lower-paying bonds less attractive. The opposite occurs when interest rates fall. The greater the term of a bond, the greater the chance of price fluctuations.
Finally, bonds carry what’s called a credit risk. This is when a bond issuer can’t make payments on time or defaults. Also, if the credit rating of an issuer gets downgraded, it will negatively impact the market price of a bond. Corporate bonds carry much more credit risk than government-issued bonds.
Bond financing is a way for businesses to tackle larger long-term projects and pay for day-to-day operations without taking out a traditional loan. Funding a project through a bond allows a business to get a project completed sooner, improving its bottom line and taking the venture to its next level.
If you are interested in bond financing, turn to First American Merchant (FAM). Its application process is simple and easy, and it is known for offering solutions that help businesses get where they want to be.