When a company faces the need to take out financing, it can choose from several options in securing it. Among the two most popular are long-term loans from one or more investors and issuing bonds to investors. Both of these methods of securing operating capital have advantages and disadvantages linked to risk and the amount of money the company will spend servicing the loans.
Advantages of Long-Term Loans
Perhaps the main advantage of a long-term loan is that the company that is taking out the loan will have the choice of approaching a large number of lenders when seeking the loan. Each of these lenders may be willing to accept different terms for the loan. This can lead to a lower interest rate or a flexible payment structure. This is in contrast to the relative rigidity of the bond market.
Advantages of Bonds
One of the chief advantages of bonds, however, is that the borrower has great certainty that the payment rate of the bond will not deviate over time. In the case of a long-term loan, if the loan is structured so that the borrower pays an adjustable interest rate, then the cost of servicing the loan may rise suddenly. In addition, the baseline interest rate for bonds is often lower than for loans.
Disadvantages of Long-Term Loans
One of the chief disadvantages of long-term loans is that many banks are unwilling to issue loans to businesses at a fixed rate of interest for a long period of time. This means that the borrower will end up having to a pay a variable rate of interest, one that will fluctuate with changes in the market rate. If interest rates skyrocket, the cost of the loan can become very high.
Disadvantages of Bonds
However, while bonds may be more stable, they are also less flexible. When issuing a bond, a company must issue it according to the strict rules of the bond market. And, unlike a long-term loan, which can be modified and refinanced, a company cannot generally modify the terms of a bond. In addition, the origination costs of a bond are often higher than those of a long-term loan, as the bond must be pitched to investors.
- "Business Management: Fresh Perspectives"; S. Goodman; 2007