What Does It Mean to Issue Debt?

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In the business world, to issue debt means selling bonds. The list of companies that issue bonds includes A-list established firms but also fly-by-night operators selling "junk" bonds. Debt issuance can grow your company, but in a tight economy, you could wind up defaulting on the debt.

TL;DR (Too Long; Didn't Read)

Issuing debt is another name for selling bonds. Corporations sell bonds to investors, make interest payments and eventually return the principal when the bond matures. Unlike stocks, highly rated bonds are a predictable, stable investment and are attractive to investors who want to minimize their risks.

Why Issue Debt?

When corporations need cash, there are two ways they can raise it: sell equity or take on debt. Stocks are the textbook example of selling equity to raise money. To issue debt, companies typically either take out a loan or issue bonds. Bonds offer several advantages:

  • They don't affect shareholder equity. Owners in a small, privately held company, for instance, may not want to dilute their control of the business.

  • By issuing bonds, you go directly to investors instead of applying to banks for money. Usually, the interest rate you'll pay on bonds is better than the loan rate you might get.

  • Bonds allow you to borrow money at a fixed rate for a longer term than a bank would accept.

  • Bonds appeal to investors because they pay interest predictably. Good-quality bonds are a stable investment, so investors use them to balance out the constantly fluctuating stock market.

  • It's cheaper than issuing shares. As stock purchases carry more risk, investors who buy shares expect them to better pay off.

  • Interest on bonds is treated as a business expense, which lowers your pretax income and your taxes with it.

The potential drawback to issuing bonds is that despite their advantages, they do cost you money, and you do have to pay them back. Suppose you issue bonds to finance a massive expansion of your business. If your expansion doesn't generate enough income to pay off the bonds, you may have to default on the debt or enter bankruptcy.

The Debt Issuance Process

Another advantage to issuing bonds is that you don't have to negotiate with each buyer. One of the steps in the bond issuance process flow is to draw up a master loan agreement, or bond indenture, spelling out the terms of the bond. Whether investors are interested in buying one bond or 1,000, they all get the same terms:

  • The price of the bond

  • The interest rate

  • The timing of the interest payments

  • When the bonds mature — at that point, the investors recover their principal

  • Whether the investors or the company can shorten the maturity time so the bonds pay off sooner

  • Whether there's any collateral backing your debt issuance

  • Any special features — some corporations allow bondholders to convert their bonds into stock, for instance

Corporations usually hire a trustee such as a bank or trust company to sell bonds to investors. The trustee handles some of the work for you and also keeps track of whether you're honoring the terms of the bond agreement. That makes it easier for investors than having to read through the legalese and figure it out for themselves.

Investment-Grade Bonds

If you do decide to issue debt, the ratings your bonds get will have a big impact on the amount you're able to sell. Bond ratings from Moody's or Standard & Poor's give investors a sense of whether buying your bonds will pay off for them or be too big of a gamble. They're an essential part of the bond issuance process flow.

Ratings are the credit agencies' estimate of whether you'll be financially able to pay off the bonds. Treasury bonds from the U.S. government are considered a sure thing because the government isn't going to default. Next come AAA bonds, which are almost as secure — if your bonds are AAA, the raters are convinced that you can service the debt even in a catastrophe.

AA, A and BBB, as they're classed by Standard and Poor's, are less reliable, but they're still considered investment-grade bonds. Banks can't buy anything rated lower. These bonds are considered a safe place for investors to place their money, but the lower you get, the riskier the investment.

Speculative Investments and Junk

Below the investment-grade bonds are BB, CCC, CC and C, all of which are considered risky investments. The bonds at the bottom are the infamous "junk bonds," so called because there's a very good chance that the issuer will default. If your bonds are branded as junk, the rating agencies don't think much of your company.

Issuing junk bonds isn't necessarily a waste of time. Like many types of investments, the greater risks are balanced by greater rewards for investors. If your bonds are C class, you can still raise money by offering a higher interest rate.

That trade-off is why junk bonds are also known as high-yield bonds. The higher the interest they pay, however, the more money debt issuance will cost you down the road.

Collateral and Bonds

Unlike a loan, you're not required to offer collateral when you issue debt, but it can't hurt. A debenture bond is debt issuance without collateral. Corporations with a strong credit rating can issue debenture bonds and receive an investment-grade score, but for other companies, it helps to have collateral backing the bonds.

  • Mortgage bonds, as the name suggests, use mortgaged real estate as collateral.

  • Collateral trust bonds use any stocks, bonds or other investments your company owns.

  • Convertible debentures aren't secured, but the bondholder's ability to convert them for stock makes them more attractive to investors than regular debentures.

  • You can issue guaranteed bonds if you have a third party commit to making good on the bonds should you default.

How Agencies Rate Your Bonds

When you announce your plan to issue debt, agencies use a combination of professional analysis and mathematical models to set a rating. One measure they use is financial: how strong your balance sheet looks and how stable your revenue, earnings and cash flow. They also look at the quality of your company and its management.

  • Is your financial structure flexible enough that you can keep paying interest even if a recession hits?

  • Do you have the kind of management team that can manage the company to ensure the debt gets paid?

  • What's the competitive landscape? How do your competitive advantages and disadvantages affect your ability to pay?

  • How's your cash flow?

  • Do you have liquid assets available, or is most of your money tied up and illiquid?

  • What are the typical profit margins in your industry?

  • Are there risks of new regulations or political or economic changes affecting your company?

When Good Bonds Go Bad

Bond ratings aren't forever. Even if you've made a couple of A and BBB bond issues, if the economy shifts, the ratings agencies might downgrade your next issue. Even the ratings on bonds you've already sold can be downgraded, which affects whether buyers hold on to them or try to resell them.

What happens to bonds after you first sell them doesn't affect you directly. However, in a market disrupted by events such as a recession or a pandemic, downgrades can become a problem. Investors may decide to sell off the bonds before the company defaults, unloading them cheaply. That puts pressure on the junk bond market, which in turn could push those issuers closer to default.

References

About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com