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Background

I'm trying to solidify my understanding of bonds, and I have a question regarding something that's probably very basic.

Question

Say I have a company and I want to issue some bonds in order to fund some of my plans. Let's say I need $1 billion at a coupon rate of 5%.

From a creditor's point of view, why would they ever even consider investing in my company? The fact that I need to borrow all this money would be a telltale sign that I would have a hard time paying the annual coupons, right?

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No, having to borrow money does not necessarily mean a company will have a hard time paying the interest on it. Similarly, having to take out a mortgage on a house does not mean a person will not be able to make their mortgage payments.

Borrowing money can be a way to spend future money instead of present money (at a cost, of course). A company might not have all that money at the moment, but that in no way implies they won't have it in the future. And as you allude to in your question where you talk about "funding some … plans", a company might be able to grow itself—possibly increasing future profits—by borrowing money.

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Apple is currently the most valuable company in the world by market capitalisation and it has issued bonds for instance. Amazon have also issued bonds in the past as have Google.

One of many reasons companies may issue bonds is to reduce their tax bill. If a company is a multinational it may have foreign earnings that would incur a tax bill if they were transferred to the holding company's jurisdiction. The company can however issue bonds backed by the foreign cash pile. It can then use the bond cash to pay dividends to shareholders.

Ratings Agencies such as Moody's, Fitch and Standard & Poor's exist to rate companies ability to make repayments on debt they issue. Investors can read their reports to help make a determination as to whether to invest in bond issues. Of course investors also need to determine whether they believe the Ratings Agencies assesments.

  • Because the ratings agencies are also privately owned, and susceptible to payoffs, right? – Alec Feb 13 '16 at 11:21
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    Not really, more that the Ratings Agencies economic models may not be sufficiently accurate or that the Ratings Agencies may not be given the complete picture. S&P claimed that Parmalat misled it for instance. – Robert Longson Feb 13 '16 at 11:24
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One more scenario is when the company already has maturing debt. e.g Company took out a debt of 2 billion in 2010 and is maturing 2016. It has paid back say 500 million but has to pay back the debtors the remaining 1.5 billion. It will again go to the debt markets to fund this 1.5 billion maybe at better terms than the 2010 issue based on market conditions and its business.

The debt is to keep the business running or grow it. The people issuing debt will do complete research before issuing the debt.

It can always sell stock but that results in dilution and affects shareholders. Debt also affects shareholders but when interest rates are lower, companies tend to go to debt markets. Although sometimes they can just do a secondary and be done with it if the float is low.

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People borrow money all the time to buy a house. Banks will lend money on one (up to 80%, sometimes more), because they consider it an "investment."

If you own a large company and want to expand, a bank or bond issuer will first look at what you plan to do with the money, like build new factories, or whatever. Based on their experience, they may judge that you will earn enough money to pay them back. If you don't, they may "repossess" your factories and sell them to someone who can pay.

As protection, you may be asked to "mortgage" your existing company to protect the lenders of the new money. If you don't pay back the money, the lenders get not only your new "factories" but also your existing company.

  • Yeah, in the case of mortgages, it makes sense, because it's backed by security (e.g. house). But if a company issues bonds, do the investors have any guarantee beyond the company's bond credit rating? – Alec Feb 15 '16 at 19:33
  • @Alec: The offering documents will tell investors what the bonds will be used for (new factories, debt refinancing, whatever). Investors can then judge the value of the proposed investments. – Tom Au Feb 15 '16 at 19:51
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It (usually) is better to use Other Peoples Money (OPM) than your own. This is something that Donald Trump has mastered. If you use OPM and something goes wrong you can declare bankruptcy and wipe out that debt. The Donald has done this more than once.

At the fantastic low Intrest rates a company would be wasting resources if they only used their own money.

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