- Bonds are a form of debt security that can be issued by companies, governments, and other organizations to raise funds from investors. In return for purchasing a bond, investors receive regular interest payments and a promise of repayment of the principal amount at maturity.
- Bonds can be an attractive source of finance for companies because they provide a predictable and fixed source of funding over a longer period than other forms of debt, such as bank loans.
Features of bonds as a source of finance:
- Fixed interest payments: Bonds provide a fixed interest rate that is paid to investors at regular intervals. This can provide a predictable cost of capital for companies.
- Long-term financing: Bonds can provide long-term financing for companies, with maturities typically ranging from 5 to 30 years.
- Customizable terms: Bonds can be customized to meet the specific needs of the issuer and the investors. This includes the interest rate, maturity, and other features.
- Diversification of funding sources: Bonds can be used to diversify a company’s sources of funding, reducing dependence on any one type of financing.
- Credit rating impact: The credit rating of the issuer can impact the cost of issuing bonds, with higher-rated issuers generally able to issue bonds at lower interest rates.
- Marketability: Bonds are a marketable security, which means that they can be bought and sold on secondary markets, providing liquidity for investors.
A Note on creditworthiness and credit ratings
- Some Zimbabwean students might struggle with the concept of credit ratings since they are not normally used in everyday life
- Credit rating is a measure of the creditworthiness of an individual, business, or government entity.
- It is an evaluation of the ability of an entity to repay its debts and obligations. Credit rating agencies, such as Standard & Poor’s, Moody’s, and Fitch, use a standardized rating system to assess the creditworthiness of entities based on various factors, including financial stability, past credit history, and economic outlook.
- The credit rating assigned to an entity reflects the agency’s assessment of the likelihood of default on its debts.
- Credit ratings are used by lenders and investors to determine the risk associated with lending or investing in an entity and to set interest rates accordingly.
- A higher credit rating typically results in lower borrowing costs, while a lower credit rating can lead to higher borrowing costs and a reduced ability to access credit.
Ideal situations for issuing bonds:
- Large capital expenditures: Bonds can be a suitable source of finance for large capital expenditures, such as building a new factory or acquiring another company.
- Growth opportunities: Companies that are experiencing rapid growth may need to raise funds to finance expansion, and bonds can provide a long-term source of finance to support this growth.
- Stable cash flows: Companies with stable cash flows may find that issuing bonds provides a predictable cost of capital that aligns with their cash flows.
Benefits of bonds as a source of finance:
- Predictable cost of capital: Bonds provide a fixed interest rate that can be used to calculate the cost of capital, providing predictability for companies.
- Longer-term financing: Bonds can provide longer-term financing than other forms of debt, such as bank loans.
- Diversification of funding sources: Issuing bonds can help companies diversify their sources of funding, reducing dependence on any one type of financing.
- Marketability: Bonds can be bought and sold on secondary markets, providing liquidity for investors.
- Flexibility: Bonds can be customized to meet the specific needs of the issuer and the investors.
- Credit rating impact: Successful bond issuances can improve the credit rating of the issuer, reducing the cost of future bond issuances.
- Tax benefits: In some cases, the interest payments on bonds may be tax-deductible for the issuer.
- Lower cost of capital: Bonds can provide a lower cost of capital than other sources of finance, such as equity.
Drawbacks of bonds as a source of finance:
- Interest payments are fixed: While a fixed interest rate can provide predictability, it can also be a disadvantage if interest rates decrease over time, as the issuer will still be required to make interest payments at the higher rate.
- Higher cost than bank loans: Bonds may have higher interest rates and associated costs than other forms of debt, such as bank loans.
- Credit rating impact: Poor performance or financial difficulties can negatively impact the credit rating of the issuer, leading to higher interest rates for future bond issuances.
- Limited flexibility: Once bonds have been issued, the terms and conditions cannot be changed without the agreement of bondholders.
- Default risk: If the issuer is unable to make interest payments or repay the principal at maturity, bondholders may take legal action against the business
