To understand the difference between the bond and the loan markets, it is important to appreciate the distinction between bonds and loans themselves. Looking at their various features helps us comprehend the benefits of a diversified and optimized financial structure, and the ways in which the two seemingly competing markets might be softly complementing each other.
A loan is the act of giving money or other material goods to another party with planned future repayment of the principal amount along with an added interest rate or other finance charges. In general, a loan contains only two parties; a borrower and a lender, where the latter usually decides its conditions. Loans are typically issued by banks and financial institutions and are available to small and big businesses alike. Borrowers, thus, vary from the regular consumer to companies and corporations. Loans can be regarded as unique debts, unlikely to be traded, offering custom payment schedules and flexible refinancing options.
A bond is a type of loan; it represents funds which are being given to an entity (e.g. corporation, government, public authority) by an investor (often the public) for a defined period of time. However, it includes more than two parties—an issuer (borrower), a middleman (promoter/guarantor/market maker) and all the purchasers of the bond. It is also more often standardized and tradeable. In practice, this means two main things:
- Bonds usually have lower interest rates than loans. This is because they are a more securitized asset, and as such can be traded more easily. The bond issuer can, therefore, get a better rate as the bond market is more liquid and there is more competition relative to the loan market.
- Bonds do not come with operating limitations. For instance, borrowers can issue more debt or make further acquisitions—an allowance that might not often be granted when opting for a bank loan. Low-rated companies and treasurers, who have a difficulty predicting their own financial performance, would, therefore, prefer bond funding as it does not require them to maintain a certain level of risk default. Bond’s lenders could easily liquefy their bonds if they felt the company is at risk e.g. going bankrupt.
Why do most companies choose loans if the bond market promises ‘security’, ‘freedom’, and ‘investment’? It is partly a question of flexibility. Loans are tailored according to the company’s interests and can change as it evolves. They can be modified and restructured for the benefit of the borrowing party; that is, a borrower can go to the lender or lending syndicate to reach a new deal and pay back their debt faster. Bonds, for the most part, cannot be paid off earlier than the fixed schedule. In order to do so, the bond issuer would need to buy back the bonds it had sold, create a new bond with a new payback schedule, and sell it again. Their refinancing conditions are more complex and restrictive.
Moreover, obtaining a loan involves less of an administrative hassle compared to issuing a bond. While negotiations and transactions are inevitable, almost everyone can get a loan from a bank. The bond market, on the contrary, is primarily used by governments and corporations to finance municipal development and business expansions. When issuing a bond, the company must meet a set of rules and regulations, as specified by the country where the bond is created. In the UK, for instance, regulated covered bonds need to comply with the RCB regulations and be registered by the FCA; in the US, the issuing company must ensure its bonds adhere to the Security and Exchange Commission’s requirements. Advertising the company’s bonds additionally consumes time and money, potentially leading to a higher total cost than that of a bank loan.
Still, bonds have been increasingly supplementing bank lending as a source of finance for the private sector. The credit crisis triggered such a shift in favor of the bond market that it overshadowed the domineering loan market in 2009. Bonds were preferred for their low-interest rates and rising inflows and are seen as a reliable alternative to loans. P2P loans offer another option as they allow a private individual to have a lending structure similar to bonds.
All in all, from a borrower’s perspective, the main question comes down to whether they prefer a structure that can be more easily set up and changed (loans) or a structure that is more likely to get them a better rate with the drawback being that it is less flexible (bonds). To get the best access, however, the borrower might not have to decide between the two. Combining both funding sources could optimize the financial structure of their company by providing them with the benefit of better rates and the flexibility. Not despite—but rather because of—their differences, bonds and loans should not be seen in mutually exclusive terms. Their diverse characteristics make them complementary financing instruments, from which the borrower can only benefit. In the end, the decision comes down to the borrower—as much as their financial situation might determine. It is a purely pragmatic choice.