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The issue of corporate bonds is one of the promising mechanisms that can be used to finance both operating and investment activities.
The development of the global corporate bond market and the accumulation of experience in using them to attract financial resources expand business opportunities and create favorable conditions for future economic growth.
Bonds are one of the attractive instruments for obtaining borrowed funds by entrepreneurs, SMEs, large companies and even local governments. Bond issuance is considered to be a very flexible form of project financing, since the issuer determines the parameters of the offer (interest rate, maturity, collateral).
Funds received from the placement of bonds are used for current or investment business activities. It is a real alternative to bank lending for companies seeking debt financing.
Corporate bonds, which are issued by large enterprises, are classified as fixed income securities and are a form of debt obligation to pay a specified amount with interest within a certain period of time.
Buyers of bonds can be private / institutional investors who expect higher returns than government bonds and other securities, but do not want to take the high risk of investing in shares.
If you are looking for financing for new projects or refinancing loans on adequate terms, contact ESFC Investment Group.
We provide long-term loans for up to 20 years and offer large businesses a comprehensive range of financial services, including bank guarantees, organization of project finance (PF), financial modeling, project management, etc.
Definition and general principles
A corporate bond is a security that establishes a loan relationship between the owner of the bond and the issuer, confirming the obligation of the issuer to return to the owner of the bond its face value within the terms stipulated by the prospectus and pay interest on the bond, unless otherwise provided.In practice, corporate bonds should be understood as debt securities issued by companies to achieve various goals (for example, business expansion).
The issue of corporate bonds can be used to solve the following tasks:
• Raising financial resources to cover the short-term shortage of funds needed to replenish working capital; covering the medium-term or long-term shortage of funds necessary for the implementation of investments in fixed assets.
• Restructuring an enterprise to change the ownership structure or improve financial performance (eg acquisitions and mergers, closing of unprofitable branches and subsidiaries, decommissioning of inefficient assets).
• Financial restructuring of the company, including the formation of liquid collateral in the form of securities, securitization of assets, debt restructuring, raising funds for the financial recovery of the enterprise.
• Achieving other marketing goals (eg brand awareness, advertising, public company valuation by independent experts).
• Formation of a positive exchange and credit history of the business to obtain more favorable financing conditions in the world markets and within the country.
• Financial engineering activities to solve current or long-term financial problems using complex financial mechanisms.
Specific conditions for the placement of corporate bonds depend on the method of placement and the specific market the issuer is oriented to. Raising financial resources through the placement of corporate bonds corresponds to the five listed principles.
Principles of using corporate bonds for business financing:
1. Competitive nature of funding. From the point of view of the volume of placement and the cost of attracted financial resources, the success of the issue of corporate bonds is determined by the ratio of supply and demand in the financial market.
2. Single placement. When placing corporate bonds, the issuing company attracts all financial resources in a short period of time, and not in separate consecutive tranches.
3. Use of professional intermediaries. The complexity of the issue is determined by the significant amount of attracted financial resources and the issuer's interest in maximizing the range of bond holders.
4. Using the infrastructure of stock exchanges. This principle involves the placement, circulation and redemption of corporate bonds using the stock exchange, which allows minimizing the costs of market participants.
5. Fixed debt service. Coupon payments and redemption of the nominal value of corporate bonds are carried out with fixed and predetermined parameters, which ensures the predictability of the issuer's debt service costs and the predictability of investor returns.
The ratio between public and private placement of corporate bonds varies and depends on the form of financing chosen by entities in a particular economy, on the specifics of the legislative framework and other factors.
Advantages and disadvantages of corporate bonds
The issuance of corporate bonds plays an important role in raising capital by companies around the world.Typical features of corporate bonds in different conditions can become both advantages and disadvantages for issuers (as shown in the table below).
Table: Advantages and disadvantages of issuing corporate bonds to finance large business projects.
| Advantages | Diadvantages |
| Attracting significant financial resources for a long period (more than a year) | High costs associated with the organization of the issue and disclosure of financial information |
| There are no strict requirements for the intended use of attracted capital | Restriction on the use of attracted funds to form the authorized capital, as well as to cover the company's losses |
| Minimal project dependence on a single lender and reduced risk concentration | High costs of organizing the first placement of corporate bonds |
| Attracting cheap financial resources from a variety of private and institutional investors in the public market | Regular expenses of the issuer related to the payment for the services of the depositary, underwriters, rating agencies, auditors, etc. |
| Minimization of debt service costs due to flexible issuance terms | Risk of irretrievable loss of funds in case of unsuccessful placement of bonds |
| Expanding business opportunities for financial, tax and production planning | Increase in the cost of capital raised in the event of a decrease in the interest rate on the market |
| Formation of a positive credit history and exchange reputation of the issuer | Risk of decrease in key indicators of the issuer's financial stability |
| Extensive opportunities for financial engineering using the most advanced tools | Complicated and lengthy formal procedure for attracting financial resources |
| Increasing the investment attractiveness of the issuer and a specific project thanks to the disclosure of financial information and continuous monitoring | Decreased financial mobility and profitability of the issuing company due to the need to reserve funds for payments to bondholders |
Given these advantages and disadvantages, we can outline the potential range of issuers who can really benefit from corporate bonds in solving current and future problems.
This circle covers:
• Medium and large companies that are looking for affordable financial resources to implement investment projects in addition to or instead of lending.
• Companies that can use bond issuance as a powerful tool to attract financial resources on an ongoing basis.
• Economic entities with excellent financial health, high liquidity, solvency and financial stability and a positive credit rating.
• Business entities that operate in rapidly growing markets and require additional funding for dynamic development.
Obviously, this flexible financial instrument can be successfully used to finance many industries, including energy, industry, infrastructure, transport, mining, trade, ecology and others. We would like to tell you more about the benefits of bonds for large businesses.
Corporate bonds for large businesses
Leading financial experts have repeatedly argued that the most likely potential issuers of corporate bonds are large business entities that have established themselves as market leaders.It can be both producers of goods and services, and trading companies.
It is not easy for such business entities to attract significant bank loans due to the presence of internal lending limits and difficulties in finding partners to create a loan consortium. In addition, conservative banks often refuse to support large-scale investment projects that would provide a breakthrough for the borrowing enterprise in the target market. This situation is especially true for the weak banking sector of developing countries, including the post-Soviet republics, countries of Africa and Central Asia.
Financial practice shows that large companies use bonds to finance the takeover of other businesses, thereby increasing market share and entering new markets.
The issue of corporate bonds (including those pegged to foreign currencies) may also be appropriate for export-oriented business entities.
Large and financially strong companies have a significant advantage in entering the international capital market, since they have a chance to receive a credit rating higher than that of their country of origin. This indicates the possibility of attracting financial resources at a lower price.
The issue of corporate bonds seems appropriate for construction companies acting as developers.
A large developer builds objects for sale, so he needs financial resources for a limited period from the beginning of the construction of the building to its sale to the final buyer.
Since the developer does not remain the owner of the property in the future, he usually faces the problem of the lack of collateral for each subsequent bank loan.
Another problem for such issuers is the high cost of financial resources, because it is growing as a result of a decrease in profitability in the commercial and residential real estate construction market.
Raising capital for the construction of large projects with the help of corporate bonds allows developers to minimize dependence on bank loans and sell off unfinished properties at an early stage.
The use of this tool allows entities to obtain funds for the purchase of equipment by mobilizing funds from private investors without involving expensive instruments.
Below we will discuss such an important point for market participants as potential restrictions on the use of bonds, risks and ways to minimize them.
Risks for the issuer of corporate bonds
The most important risk for the issuer of corporate bonds is related to the failure of the issue, as a result of which he does not raise the necessary funds to implement the investment project on adequate terms.The reasons for the failure of the issue may be, for example, the wrong structure of the bonds, the wrong time for the issue, or the wrong market in which the issue should be placed.
In the case of an incorrect structure of bonds, we are talking about its key financial parameters, such as face value, interest payment terms, interest rate formula, bond maturity and debt collateral. The source of the risk associated with the nominal value is its inconsistency with the specifics of the particular financial market where the securities are placed.
Interest risk, in turn, consists in incorrect mechanisms for determining financial terms and the structure of bonds.
In the case of long-term corporate bonds issued for a period of several years, the interest rate is usually floating and is tied to certain interbank market interest rates. To offset the investment risk that investors take on, issuers must increase the percentage accordingly.
On the one hand, interest on corporate bonds should encourage the purchase of bonds. On the other hand, a high interest rate may cause financial difficulties for the issuer, having a negative impact on debt servicing. This contradiction is often a potential source of risk for both parties.
Potential investors' appetite for buying corporate bonds is largely determined by the quality of debt collateral.
Therefore, there is an obvious disproportion in the level of demand for corporate bonds in the primary market today, depending on the availability of collateral.
In the absence of adequate collateral, investors may refuse to buy bonds even when it comes to financing promising investment projects and high interest rates.
Typically, institutional investors avoid unsecured bonds.
Obviously, the success of the issue is also determined by the correct choice of the time of issue and the target market in which the bonds will be placed. The inability of the participants to choose the moment when the issuer announces its borrowing needs, with the best offer of capital in a particular market, may mean the failure of the campaign and the delay in financing the project.
Another type of risk faced by issuers of corporate bonds is the loss of control over the company (project).
This applies to cases of project financing through the issuance of convertible bonds.
On the one hand, such bonds may be more attractive to investors. On the other hand, the result of their issuance may be a complete or partial loss of control over the business by the current owners due to the transfer of bonds into shares.
We should also not forget about the traditional risks to which the issuer is exposed, namely interest rate risk, currency risk and early redemption of bonds (debt repayment). In the first case, the issuer suffers losses in the face of falling market interest rates by taking on debt at a fixed interest rate. This type of risk can be limited to a floating interest rate.
Currency risk arises when corporate bonds are issued in a currency other than the currency of the issuer. An appreciation of the foreign currency in which the capital was borrowed exposes the issuer to the risk of increased debt servicing costs.
This is especially important for issuers that sell their goods or services abroad or receive cash flows in local currency only.
The risk of early repayment of debt is associated with the issue of corporate bonds with an early redemption option, which is used in countries with an underdeveloped secondary market. This may lead to a loss of the issuer's liquidity and even to the suspension of the investment project.
Investor risks in the corporate bond market
Investors are most exposed to the risk associated with buying and holding corporate bonds.An important group of investors are banks and financial institutions, which include investment funds, pension funds and insurance companies. The uncertainty that accompanies this type of investment must be offset by higher interest rates compared to alternative financial instruments.
The key question is whether the proposed interest rate is sufficient to take the risk.
Financial institutions that decide to invest in the purchase of bonds, in practice, use two main strategies:
• Purchase of corporate bonds in the primary or secondary market for their redemption. The so-called "buy and hold" strategy, on the one hand, allows the investor to limit price risk to some extent. On the other hand, this strategy is associated with higher credit risk.
• Purchase of bonds in the primary or secondary market with the aim of their resale at a higher price. This strategy is speculative in nature, being based on the expectation of price growth.
Among the many types of risk that every corporate bondholder is exposed to, credit risk and liquidity risk should be the main focus.
Credit risk arises when the issuer of bonds is unable to service the debt incurred as a result of their issuance.
It is obvious that issuers get an advantage in information and covert actions, thereby increasing the risks of the investor. The favorable position of issuers of corporate bonds in relation to investors creates a moral hazard. This may be due to investor inexperience and poor project analysis.
The losses that investors may incur due to the types of risk described above can have a negative impact on the allocation of capital throughout the economy through a domino effect. It usually takes the form of a significant drop in confidence and tightening of criteria for the selection of projects by providers of capital, and in extreme cases, a massive refusal to finance projects of a certain type.
Credit risk can be caused by both external and internal factors.
It is believed that the credit risk borne by the bondholder is difficult to quantify, especially in the early stages of the project.
The general factors that determine credit risk are based on the insolvency of the issuer, which includes not only non-payment of the face value of bonds, but also late payment of interest. Ratings from reputable rating agencies can be helpful in assessing credit risk, especially as the number of issuers increases. Their negative ratings or lack of ratings at all could dampen investors' appetite for corporate bonds.
Another type of risk to which a bondholder is exposed is related to the low liquidity of the secondary market. It should be emphasized that not every issuer announces the introduction of bonds into secondary trading, which significantly complicates the resale of securities.
The liquid market, in turn, allows for a more active exchange of this instrument for financial resources.
Risks of an agent bank when issuing corporate bonds
The risk of failure of the issue can be neutralized by an agent bank that actively supports the issuer, focusing its activities not only on the primary, but also on the secondary market.By participating in the issue, a large agent is able to take on almost all types of risks to which the issuer is exposed.
Agents are usually financial institutions, including banks that provide investment banking services within corporate banking. Although the intermediation of banks increases the cost of capital raised, it guarantees the issuer the professional preparation of the issue and the successful placement of bonds on the market.
A bank providing services for organizing the issue of corporate bonds and other debt instruments may simultaneously act as a depositary and paying agent.
One of the services provided by agents is the provision of bank guarantees, which relate to underwriting, bond redemption and redemption.
Firm commitment underwriting or best effort underwriting services have become the most common models for assuming the risk of issuing corporate bonds. In the first case, the guarantor buys back from the issuer at his own expense all the securities that are the subject of the contract for the purpose of their subsequent sale.
In the case of best effort underwriting, the guarantor undertakes to make every effort to distribute the issue to investors, without incurring an obligation to buy them out on its own. This decision means that the risk of failure of the issue falls on the issuer, and the guarantor plays only the role of an active sales agent. In the event of a decrease in the inflow of funds from the issue of bonds, the guarantor can take over the organization of an investment loan for the issuer, looking for investors who are ready to take on the entire issue.
A buyback guarantee, on the other hand, obliges the financial institution to maintain liquidity in the secondary securities market.
It comes down to the role of a market maker, which is expressed in the constant receipt of applications and stimulation of demand.
Thus, the agent bank becomes an important party to the transaction. Taking care of maintaining an appropriate level of price and liquidity of bonds, he receives a significant margin for his professional services.
A buyback guarantee means the transfer of credit risk from investors to the bank providing the guarantee. It also protects the agent from the reputational risk of investors that may arise in the event of non-purchase of bonds in the primary market.
If you need long-term financing for large business projects or professional financial consulting services, please contact the representatives of the ESFC Investment Group.
