Advantages & Disadvantages of Bonds in Comparison to Bank Loans

Both bonds and bank loans are debt instruments that allow corporations to borrow money. Bondholders are creditors, while the issuers are borrowers. With bank loans, banks are creditors, but investors who invest in bank loan funds in effect become creditors. Borrowers and creditors (investors) see different advantages and disadvantages of bonds in comparison to bank loans.

A borrower can usually get better terms by issuing bonds than from a bank loan. The interest rate and other terms of bank loans are set by the bank whereas when a company issues a bond, it sets the interest rate and other terms, albeit based on the current market conditions, otherwise investors won’t be interested.

Most bank loans come with multiple conditions, or covenants, that the borrower must follow for the life of the loan. Bank loan covenants protect the bank (and in effect bank loan fund investors) but impose restrictions on the borrower. For example, if a bank finds a borrower in violation of a loan covenant, it has the right to call the loan – that is, demand its immediate repayment. No such restrictions exist for bonds; once a bond is sold to investors, the issuer’s only obligation is to pay the interest and return the principal at maturity. The bondholders have no say in the affairs of the corporation as long as they receive their interest.

A borrower can establish a revolving credit facility with a bank where it only borrows what it needs when it needs it and can repay at any time, provided it makes the required minimum payments on time. A bond issuer raises the money upfront and must continue to pay interest on it until maturity. It cannot repay a bond early even if it has the money and considers the interest a burden or an unnecessary expense. Many bonds come with a call provision -- the ability of the issuer to call, or redeem, them after a certain number of years -- but until then he must continue to pay interest.

Investors can buy a variety of U.S. government, municipal (tax-free), corporate and foreign bonds. They can choose the maturities, annual yield and amount of risk they are willing to take. In addition, there are multiple bond funds that invest in different types of bonds. The only way investors can invest in bank loans is through a bank loan fund. Interest rates on bonds and bank loans are usually comparable, and both bond funds and bank loan funds are liquid (can be sold at any time). Many bank loans have floating interest rates which rise when interest rates rise, providing bank loan investors some protection against inflation that fixed rate bonds lack.