External sources of finance come from outside the business. Bonds (debentures) belong to external sources of finance. When businesses need to use the money in the long term (more than five years), this creates the need for long-term finance.
The amount of long-term finance needed for buying Fixed Assets, or Non-Current Assets, with a relatively low value such as vehicles will be small. While the amount of long-term finance needed for buying Fixed Assets, or Non-Current Assets, with a relatively high value such as new machinery for the assembly line will be large.
3. Bonds (debentures)
Bonds, or debentures, are financial instruments, essentially long-term loans issued by a business to investors. The business in this case is a borrower. Investors include private individuals, other businesses or even governments. By borrowing money from others, the company can raise significant amount of finance in the long-term.
How bonds work?
When a company wants to raise long-term finance, it will sell a bond. Bonds are fixed-income instruments meaning that the buyer of the bond receives regular payments of the stipulated fixed interest rate per year. Bonds typically come with annual or semi-annual interest payments.
Those regular payments of fixed interest are called ‘coupons’. The coupons are paid at a predetermined frequency between the bond’s issue date to the bond’s maturity date. The life of the bond can be up to 20 to 30 years.
At the end of the bond term, the full purchase price of the bond must be repaid to the bond holder. Because the bonds do not have an owner’s name printed on them, they can be transferred or sold to another party.
Types of bonds
Importantly, bonds are used by a vast range of organizations ranging from limited companies to cities or even countries.
- Corporate Bonds are issued by companies.
- Municipal Bonds are issued by cities.
- Governmental Bonds issued by countries.
Do bonds have collateral attached to them?
Many bonds come with some sort of collateral. This is called secured bonds. It is security against the value of the bond to the lender in case the business is unable to repay the bond at the maturity date. For example, a land lot, a building, a vehicle, or any other valuable property.
However, some other bonds come without collateral. They are not backed up by any asset class. This is called unsecured bonds.
What happens if the business fails to repay the bond?
In the US, when a corporation goes bankrupt, is not able to repay its bond obligations, according to Section 507 of The Bankruptcy Code bondholders get first priority to get repayments from the business’s assets that are distributed to creditors. Next in line are the company’s suppliers, employees and banks. Shareholders are last in line to be paid only if there is any money left over after all the other creditors have been paid in full.
Benefits of bonds
- Can raise large amounts of finance. Bonds are sold by many companies mainly with the purpose of raising huge amounts of money for funding large-scale business projects. For example, pay for organic business growth, business expansion, acquisitions and takeovers, purchasing new premises and developing Product Portfolio.Â
- No loss of ownership. Bondholders do not purchase any ownership in the business at the time when bonds are issued. Investors in bonds do not acquire any voting rights either. Neither they are entitled to attend the Annual General Meetings (AGMs). Therefore, by issuing bonds, the business can raise substantial amounts of money without losing any control whatsoever.
- Some come without collateral. While some of the bonds are secured on particular business assets, some other bonds are unsecured. It means that the company does not have to give any rights to investors to sell those particular assets to gain repayments in case the company ceases trading.
Drawbacks of bonds
- Coupons must be paid. The business must pay regular interest payments to bondholders from Net Profits Before TAX. This means that bondholders are entitled to the company’s profit before shareholders get their dividends. Also, the interest payments must continue for the whole duration of the bond life even though original investors decide to resell their bonds to other investors. It does not matter who owns the bond, the coupons must be paid.
- Increase gearing. Issuing debentures increases firm’s gearing. This means the firm has more borrowing as a percentage of its capital employed.
TIP! Gearing refers to the ratio of a company's debt-to-equity. Gearing shows how much of the firm’s capital comes from long-term borrowed funds versus how much comes from the equity.
In conclusions, bonds, or debentures, can be a very important source of long-term finance for any well-established business. Simply, a bond is an I.O.U agreement (‘I owe you’) between the lender and the borrower acknowledging debt.
