Companies need capital to fund their operations. Bonds and loans are two financing options available to them that work similarly. Both avenues let corporations borrow money that they will eventually have to repay. But certain differences come into play with either choice, such as where the money comes from. Each one has its benefits and disadvantages, though. So, if you want to know how bonds and loans stack up against each other, here are the main points to learn.
Investing in debt can be a smart move, and it can be an especially smart move if you work with a financial advisor to chose the debt security that best fits your risk profile, timeline and goals.
What Are Bonds?
Bonds are a source of funding that companies obtain through the public. The corporation creates the bonds, which are then available for purchase. In turn, the organization has to pay back the bond-purchasers plus a coupon, which is an annual interest payment.
Companies of all sizes may issue bonds. However, creditworthiness is an important factor when doing so. If you have a weak credit rating, then issuing bonds will be harder and probably more costly. For this reason, bonds come with a rating that represents their credit quality. Private services like Standard & Poor’s and Moody’s Investors assign these grades, typically as a letter, to indicate an issuer’s ability to repay the bond and its interest.
Governments have the ability to issue bonds. That can happen on a national level down to a state or local level.
For a national government, they can create “risk-free bonds.” The nation can print more currency or redirect tax dollars from citizens to pay off government debt. These bonds come with considerable risk if a country is experiencing instability or is still developing though.
On a state or local level, bonds are considered municipal bonds when issued. You may see them referred to as “munis.” With munis, the goal is to fund everyday tasks, like repairing infrastructure. They are important to these lower-level governments because they keep the city from bankruptcy. Munis are also appealing to investors since they build interest on a tax-free basis. However, compared to corporate bonds, they typically yield fewer returns.
Corporate bonds come with a flexibility that other financing options may not. That is because the issuer can decide how to use those bonds and the terms that come with them. So, matters like the maturity of the bond and more are up to the company that creates it.
For example, the Federal Reserve initiated corporate bond purchasing initiatives in 2020 as part of the Coronavirus Aid, Relief and Economic Security Act (CARES). Under the bond-buying program, the Fed purchased individual corporate bonds. The active approach allowed companies to add to their liquidity during the COVID-19 lockdown, which slowed the economy.
Some companies have weaker credit scores which can make it harder to sell bonds. If they want to improve the appeal of their bonds, they can back them up with collateral. As a result, the bonds become more secure for investors to purchase.
What Are Loans?
More often than not, if a company is looking for funding, then it will turn to a loan. In fact, according to the Small Business Credit Survey conducted by the Federal Reserve, 89% of applicants sought a line of credit or loan for financing. Broken down, 45% of applicants sought a business loan, and 42% wanted an SBA loan. But organizations of all sizes and financial needs pursue loans. Many are available through banks, credit unions and local redevelopment authorities.
Government Grant Plans
Governments on a federal, state or local level can award grants out to organizations or companies. These come with a strong advantage over other funding options since you don’t need to repay them.
While they are very helpful, they are also difficult to earn. A government grant usually involves strict requirements, and many groups want them, which means you face stiff competition. Often, eligibility is relegated to nonprofits and businesses that are beneficial economically or to the public.
In some cases, the borrower doesn’t have to pay the loan back. However, this requires them to meet certain requirements. For example, there are government agencies, nonprofits and businesses, that offer loans with specific terms. If the corporation adheres to said terms, then they don’t have to repay the loan.
Let’s say an organization offers your company a $10,000 “loan.” The group wants you to put that money towards specified areas, like improving safety procedures. After five months, the loans are forgivable as long as you have proof that you put the money where the organization requested.
In that regard, the loan acts somewhat like a grant. But if you fail to meet the criteria, you will likely have to pay back the money and possibly with interest.
Bonds vs. Loans: Key Differences
While both bonds and loans give corporations the funding they need, they have their differences. Again, they both receive their money through divergent sources. A loan obtains funding from a lender, like a bank or specific organizations. In contrast, bonds obtain money from the public when companies sell them. In either case, the corporation typically has to repay the borrowed money at a prearranged interest rate.
To start, bonds usually have a lower interest rate than loans. However, loans are a reliable and secure choice for financing since the monthly payments don’t fluctuate with interest rate changes. In addition, a loan doesn’t come with a huge payment at the end of the repayment term.
Still, companies can lock in their bonds, just as home buyers do with a mortgage, at a fixed rate, which means they will not fluctuate over time. In contrast, loans may involve variable rates, which can go up over time.
Each choice comes with certain flexibilities as well. For example, a company has flexibility in how it issues a bond, the terms and where the finances go. In comparison, loans can include restrictions that require the company to use the funding in specific ways. On the other hand, bank loans may offer more varied or flexible refinancing options. That is because a company relying on bonds has to refer to a fixed interest rate and payment schedule.
Both financing options may involve collateral if the business has a weaker credit rating. A lender may require a business to use collateral to get a lower interest rate with their loan. Likewise, a corporation may have to use collateral to back up its bond to make it more appealing to potential buyers.
Financing is not a one-size-fits-all path for most businesses. The right option depends on your goals, financial circumstances and more. It’s important to review all the available ways to obtain funding so that you can find the avenue best suited for your group. Both bonds and loans provide vital financing for future projects like expansion. So, picking the right one comes down to factors such as the terms you want to work with and the repayment schedule.
Tips for Smart Investing
- When you create a diversified portfolio, you lower your overall risk while investing. But choosing the right places to allocate your money may take some investigating. With a financial advisor on your side, you can simplify that process. As a professional in the area, they can help you build a balanced portfolio that includes the assets best suited for your goals. Finding the right financial advisor is an easy step with SmartAsset’s free matching tool. It shows you local financial advisors that meet your situation in only minutes. If you’re ready to begin working on your portfolio, get started now.
- As an investor, finding the right risk tolerance for your portfolio is vital. Bonds can help you find the perfect balance you are looking for in your investments. But navigating how much to put where comes with its challenges. SmartAsset offers an asset allocation calculator that can help you determine the right distribution for your desired risk tolerance.
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