Chapter 17: Problem 2

From a firm's point of view, how is a bond similar to a bank loan? How are they different?

Short Answer

Expert verified

From a firm's perspective, bonds and bank loans are similar in that they both serve the primary purpose of raising funds for operations, capital investments, or other financial needs and require regular interest payments. However, they differ in terms of maturity, with bonds typically having longer maturities, and transferability, as bonds are easily transferable and more liquid than bank loans. Additionally, bank loans often require collateral and have more restrictive covenants, while bonds could be either secured or unsecured and tend to have fewer covenants. Finally, credit risk and issuance costs may vary between the two financial instruments, with bonds being more exposed to market-driven credit risk and potentially having higher or lower issuance costs depending on the specific parameters of the bond or loan.

Step by step solution

1. Definition and Purpose

A bond is a debt security issued by a firm (or government) to raise capital, while a bank loan is a debt arrangement between a firm and a financial institution. Both instruments serve the primary purpose of raising funds for the firm's operations, capital investments, or other financial needs.

2. Interest Payments

Both bonds and bank loans require firms to make regular interest payments to the bondholders or the lender. The interest rate on bonds is called the coupon rate, while the interest rate on bank loans is the loan rate. However, fixed-rate bonds have a constant interest payment, while the interest rate on bank loans can be fixed or variable.

3. Maturity

The maturity of a bond is the date when the principal amount (the face value) is repaid to the bondholder. Bank loans also have a maturity date, after which the loan amount should be fully repaid. Bonds typically have longer maturities, ranging from a few years to as long as 30 years or more, while bank loans tend to have shorter maturities, generally less than 10 years.

4. Transferability

Bonds are easily transferable and can be bought and sold in the secondary market, whereas bank loans are not as easily transferable and usually require the permission of the lender to transfer to another party. This makes bonds more liquid than bank loans.

5. Collateral and Covenants

Bank loans are often secured by collateral, such as assets of the borrowing firm, which provides a lender with a recourse in case of the borrower's default. In contrast, bonds could be either secured or unsecured. Bank loans may also have covenants (restrictions and requirements on the borrower) to protect the lender's interests, whereas bonds tend to have fewer and less restrictive covenants.

6. Credit Risk

Issuing bonds exposes firms to credit risk, as it affects the bond's price, credit rating, and yield. In case of a credit rating downgrade, the bond's price may decline, and the firm might face higher borrowing costs in the future. Bank loans' credit risk is directly related to the risk of default and the impact it may have on the relationship with the lending institution.

7. Issuance Costs

Issuing bonds involves underwriting fees, registration fees, and other associated costs. Bank loans may have arrangement fees, legal fees, and other covenants which can increase the overall cost of borrowing. However, depending on the size of the loan, its terms, and the borrower, the issuance costs for bonds may be higher or lower than bank loans. In conclusion, both bonds and bank loans are debt instruments that firms use to raise capital. However, there are several differences between them related to interest rates, maturity, transferability, collateral, covenants, credit risk, and issuance costs.

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