I was just looking at investment opportunities, and I found a number of places offering bonds paying up to 12% interest over two years. My first thought was, I can get a loan from my bank for 5% interest - so if I get a loan to use to buy the bond, it's free money!

Except, if I can do it, so can they - and paying 5% on the loan is a better deal for them than offering 12% on the bonds, so why are they doing it? Why sell bonds rather than get a loan?

Bonds offered by the government seem to be paying less than 3%. So are these other bonds all just a scam?

Edit: For clarification, in response to comments.

  1. 12% interest means that, if I invest $100, then at the end of the year, I will receive back $112.
  2. My local bank is willing to loan, both secured and unsecured, at a rate of approximately 5%. If they are willing to offer this to me, an individual, I see no reason why they would offer significantly worse terms to a corporation.
  3. The company offering the bonds is offering them at significantly worse (for them) terms - i.e. 12% is bigger than 5%. The bonds they are offering are usually secured by some sort of tangible asset, e.g. property, which a quick google says can be mortgaged for only 4% interest.

Leading to my question: Why are they offering the bonds at such good rate, rather than going directly to a bank or other lender and arranging a mortgage? Dealing with large numbers of small investments from individuals is much more work than doing a single deal with a large institution, so there must be some reason why they are not able to do so. What is that?

I had included an example link, but someone removed it so I guess I'm not supposed to do that. So if you want to see an example, just google "bond investment", and at the top are a bunch of ads saying things like "Fully Asset Backed and Secured Bond Investment Up to 14% Per Annum Returns‎", which is so good that has to be a catch somewhere.

This is not a duplicate question, because I'm not asking whether it's possible for me to borrow money to invest with them, I'm asking why they don't.

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    "...offering bonds paying up to 12% interest over two years." Paying a total of 12% or paying 12% a year? If 6% per year and the bonds are trading over par then the actual yield may be lower. Old market axiom: If it looks too good to be true, it usually is. – Bob Baerker Aug 14 at 13:19
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    Can you get an unsecured loan at 5%? Seems cheap. My bank is currently offering a minimum of 9.99% for unsecured loans. – Peter K. Aug 14 at 13:29
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    But a bond is a loan. – RonJohn Aug 14 at 13:55
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    By now, I'm thoroughly confused by the wording of the question and some of the answers. And I think others are as well. The web address for the bonds that was in the original question indicates that they are offering bonds that pay 8-12% a year. A 12% bond is a significant yield improvement over a 5% loan. A bond paying 12% in two years (6% per year) is not. – Bob Baerker Aug 14 at 14:30
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    Are you sure that your bank will loan you £9M at 5%? If you ask them I'm sure the rate will go up very quickly. That's one thing you're missing. – MD-Tech Aug 14 at 15:08

10 Answers 10

They are not necessarily a scam, or even likely to be. There is a reason they didn't just borrow the money at 5% though and this is virtually certain to be because they are higher risk.

There was a recent question along these lines which I unfortunately cannot find. A number of points were raised.

  1. The investment is higher risk
  2. Your bank may not be willing to loan you money to invest like this
  3. The repayment schedules may not line up, meaning you will have to make payments on the bank loan before you get any returns from the bond and this affects the profitability.
  4. A good rule of thumb is that if something looks like unlimited free money you are probably missing something.
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    Yes, I'm pretty sure I am missing something - that's why I posted the question! Is it just that the investment is higher risk? Is there anything else I might be missing with it? – Benubird Aug 14 at 13:25
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    '... if something looks like unlimited free money you are p̶r̶o̶b̶a̶b̶l̶y̶ missing something." ftfy. – J... Aug 14 at 13:25
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    There're three ways of getting something like "unlimited free money": 1. Be smarter than everybody else! 2. Be faster than everybody else! 3. Cheat! – Thomas Aug 14 at 14:51
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    Arbitrage is a good way of making money.... But it only works if you get it right. – Valorum Aug 14 at 20:37
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    @Valorum: Arbitrage usually either means you're smarter than everybody else (lower transaction costs, finding opportunities nobody else does) or faster than everybody else (finding and using opportunities before anyone else does). – Thomas Aug 15 at 6:02

It doesn't necessarily have to be a scam. The most likely scenario is that the issuer of the 12% bonds is higher risk, so you have to take that into consideration in your calculations.

If you borrow money from a bank at a 5% rate, lend it to someone else at a 12% rate, what happens if they default and don't pay you back?

The same concept applies to credit cards. Why do some people decide to carry a balance at a 20% interest rate on a credit card, when they could get a conventional loan from a bank at a much lower rate? Well, because they have a bad credit history, so it is too risky for a bank to lend them money at the lower rate. A credit card is willing to take on the risk, but it's going to cost the borrower 20%.

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    I think the key point OP is missing is that a bond at 12% has a very high chance of defaulting. So, good job mentioning this in your answer. – ChrisInEdmonton Aug 14 at 13:54

Plenty of other people have mentioned that the bond issuer might be a bigger risk. That's a possibility, but there are other factors -- probably more important factors -- in play as well.

First, consider the size of the loans involved. Your bank is probably offering to loan you...maybe ten grand, unsecured, at 5%? Probably not more than 100k at the most. The company, on the other hand, is probably trying to raise tens or hundreds of millions of dollars. Not every bank has the assets to make this loan even if they want to. So immediately supply and demand kick into play: with fewer suppliers able to loan out that kind of money, the "price" of the loan (i.e., the interest rate) goes up.

But it's worse than that. Even if a bank could afford to make a giant loan, they might not want to. There's a couple of factors at play:

  1. Opportunity cost. If the bank loans out a huge portion of its reserves to this customer, what happens if interest rates go up next year? Now the bank doesn't have the resources to make even more money, because they foolishly tied up their resources into one giant loan.

  2. Risk. Let's say that both you and the company are 3% to default. If you default, the bank is out a few grand, shrugs its metaphorical shoulders, and continues to make tons of money. If the company defaults on a $100,000,000 loan, though? That's a pretty big chunk of change and could easily cripple or bankrupt the entire bank. A 3% chance to be mildly inconvenienced is one thing, a 3% chance to go bankrupt is something entirely different.

There are some other factors at play as well (for instance, if a single loan makes up a large portion of a company's business, that has to be reported in their financial statements, which might spook investors), but the above represents the gist of it.

  • The size of the loan is probably the bigger factor of why bonds. The opposite is also true, you won't see a bond issue for a $100K. There are really two questions: here why the rate and why bonds. – JimmyJames Aug 14 at 18:22
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    There is also the point that bonds are tradeable - you can sell of part of the loan if better business comes around. – TomTom Aug 16 at 7:31

You can get a loan at 5%, can they get a loan at 5%? Probably not or they would be getting a loan, or selling a bond at 5%. Borrowing cost reflect credit worthiness, so they probably have some financial issues that make their borrowing cost higher. Government debt is usually considered the safest kind of debt in a given country, so it usually has the lowest rate.

A bond's interest rate also has to do with how much demand there is for a bond. If there is high demand then the interest rate on the bond will go down. So if you took out a large loan to buy bonds the interest rate on those bonds would fall until you quit buying.

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    Of course, "high demand for a bond" means "lots of investors willing to extend a loan to the bond issuer". If there are lots of investors willing to extend a loan, that usually implies that the issuer is reasonably credit-worthy, and thus that for them to take on a loan is (relatively) safe for whoever is putting the cash on the table. Whether that is a bank, an institutional investment firm, or a private individual... – Michael Kjörling Aug 14 at 17:38

Make sure that you are comparing apples to apples. 12% over two years or 12% annually. 5% yearly over two years is (1.05)² -1 = 10.25% ~= 12%

The difference between 12% and 10.25% may be due to the risk of investing in the company bonds. Also double check any commisions, fares and risks on your side both in the loan and the bond.

Also. Is this bond in the same currency? I could get better interests in turkish liras but I will recieve the money in a currency that has a higher probability of going down.

Furthermore. Your bond earnings will probably have to pay taxes. Double check before doing it. The company have some fiscal benefits by having debt but this may be very complex.

  • Can you explain your calculation more? I don't understand where the 1.05 comes from, for example. – Caleb Jay Aug 14 at 19:31
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    The long way is start with $1,000. Earn 5% the first year so that's $1,050. 5% of $1,050 is $52.50 the second year. Total of $102.50 earned or 10.25% ($102.50 / $1,000). – Bob Baerker Aug 14 at 20:02
  • 1.05 is the return in one year of 5%. For more information see en.wikipedia.org/wiki/Compound_interest – borjab Aug 16 at 7:51

Since the bond interest rate is 12%, there's a good chance - say 1 in 10, just to make the numbers simple - that the borrower will default on it. So if I loan $1 million, there's a 1 in 10 chance that I'll lose the entire sum.

OTOH, if I buy $100K worth of 12% bonds from 10 different companies, and 1 defaults, I've still made $80K profit from the other 9. Looking at it from the other direction, it might difficult for the bond maker to find a single entity that would loan $1 million, but much easier to find 10,000 individuals who're willing to risk* $100 on a bond.

*Taken to an extreme, this is why people buy lottery tickets, even though the expected rate of "default" (that is, not winning) is much higher than 12%.

  • I'd add that the chance of all 10 companies defaulting drops to 1%. The chance that at least one of them fails is increased to around 65% but it's pretty unlikely that enough will fail to result in a loss, based on the scenario you've laid out. – JimmyJames Aug 14 at 18:38
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    @JimmyJames: 1%? Would it not be 1 in 10^10, assuming the failures are random & uncorrelated - which of course they aren't, in the real world. – jamesqf Aug 15 at 3:23
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    I think your profit when one of the ten lenders default should be 8k not 80k, – Eric Nolan Aug 15 at 9:09
  • @EricNolan Right, if the bond defaults right away and never pays anything. That would be pretty atypical though. The defaulting company will likely have some assets and have to pay some portion of the principal. – JimmyJames Aug 15 at 20:33
  • @jamesqf And yes this is based on the simple model you proposed. In the "real world" is relative since the bankers are going to build some model based on assumptions kind of like this. The difference is that the assumptions they make are going to be more complex. – JimmyJames Aug 15 at 21:23

It is because of the likelyhood of default, and the fact that the asset it is secured against might not be as easy to liquidate as a bond (or over-secured).

To play game, suppose I found a corporation. This costs 10s of dollars. I then transfer ownership of my beat up old car to it, then I lease it back to me. This corporation now has an income stream and an asset!

I then ask to borrow against the car. The car has a blue book value of 5000$, but I personally know it has a few problems beyond that. Still, I issue a bond for 10,000$ paying 12% interest under the corporation.

You invest in it. I then pay 2000$ in profits, 4000$ performance bonus, and 2000$ in salary to the owner and CEO of the corporation (me), and pay interest for a year (1200$).

I (the corporations sole customer) then cancel the lease to my corporation. The corporation is now the owner of a beat up old car and doesn't have the money to pay interest to the bond holder, let alone principle. It defaults, and liquidates.

You get the financial assets of the corporation (less than 800$) and a beat up old car, 1200$ and are out the price of your bond. I get rid of my old car in a year and clear 7500$+ in cash.

Even if you limited the loan size to the car value, you still end up getting a beat up old car which is going to be a pain to sell, and the corporation owner gets to keep the money.

LLC limit the liability of the investors to their investment. They are shells which can disappear, screwing over anyone who loaned them money. Meanwhile, a person can only do this by going bankrupt, which requires they run out of money. You cannot legally "move your assets to a new person" then become that new person, leaving the old one's debtors to be screwed over; you can do this much easier as an owner of a corporation.

Probably the exact scenario above is blocked by laws around solely owned corporations in some juridictions; but shell games like that, where you hollow out a corporations assets while realising gains and transferring them out, then letting the corporation die, is something that happens all the time.

Bonds have two different yields the running yield and the yield to maturity. It might have a running yield of 12% but a yield to maturity of only 5%. The running yield is the coupon divided by the market price of the security. The yield to maturity is the yield of an investor that bond today at the market price, assuming that the bond is held until maturity, and that all coupon and principal payments are made on schedule.

For example if a bond was issued in the past when interest rates were 5% and is redeemable in 1 year from now at a price of 100 if you pay 90 for it you'll get back a total of 105 for a yield to maturity of 16.67% (and a running of yield of 5.56%). But if you paid 105 for it you'd get back 105 (5 in interest and -5 capital) for a running yield of 4.76% but a yield to maturity of 0%.

The question is a good one. If the bond sells at 12% as an initial offering then this is the level that the underwriter has determined was necessary. If he (or she) could get the sought after funding level at a lower rate, they certainly would. If these are bonds from the secondary market, then a 12% yield is dictated by that market, a matter one should thoroughly investigate before investing. In a nutshell, they aren't borrowing at 5% because they cannot raise the funds needed with an offering at the lower level. To answer the question in specific terms, one would need to look into the details: what does the company do? What does it propose to do with the proceeds? And, of course, a good look at the financial statements would be in order as well.

Why don't bond makers just get loans?

Short answer: Because they cannot get loans offering better terms or because it's a scam.

..I found a number of places offering bonds paying up to 12% interest over two years.

Incidentally, they also offer the risk of not paying anything at all (if they go bankrupt in the mean time).

...if I can do it, so can they...

That is pure speculation and may be wrong. The banks may be more cautious with them than with you.

...Why sell bonds rather than get a loan?...

Bonds are for this purpose the same as a loan.

Bonds offered by the government seem to be paying less than 3%. So are these other bonds all just a scam?

Not necessarily. The higher interest rate might just reflect the higher risk of default. For example Greece is paying more for their government bonds than the US and it's not because Greek bonds are a scam.

If they are willing to offer this to me, an individual, I see no reason why they would offer significantly worse terms to a corporation.

That's not how it works. Corporations are not more or less credible than individuals per se. It always depends on the risk of failure to repay the loan.

Why are they offering the bonds at such good rate, rather than going directly to a bank or other lender and arranging a mortgage?

Two possibilities: It's a scam or they already went to the bank and didn't get better conditions.

... there must be some reason why they are not able to do so. What is that?

Other institutions just won't lend them money because the perceived risk is even higher (most probably).

By the way, this is not uncommon. Businesses regularly do not get loans from large investment entities.

protected by Ganesh Sittampalam Aug 15 at 21:48

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