Who issues bonds and why?
Bonds are securities, the issue and subsequent trading of which is governed by regulation, and as such there are many conditions that must be satisfied before a bond may be issued. Bond issuance is so frequent that this process is routine in the major financial centres, such as London and New York. Satisfying regulatory conditions is costly and will deter those who wish to borrow relatively small sums or who do not intend to be a regular issuer of bonds. In practice the smallest amount borrowed in the bond market is about USD 100m, but a typical industrial issuer will have approximately six bonds each of which is of the order of USD 800m.
The principal issuers of bonds are governments and related institutions; financial institutions; and large industrial and commercial corporations. The number of bonds in issue and the amount borrowed in the bond market varies with the type of issuer. Those issuers that borrow most and have the greatest number of bonds in issue are governments and related institutions, such as the World Bank, the European Investment Bank and the US Agencies Fannie Mae and Freddie Mac. Government issuers not only borrow more than a typical company, but the size of each bond issued is larger. For example, the UK government has approximately forty bonds outstanding, of a type usually referred to as conventional gilts, with an average size of GBP 20bn, whereas a financial institution might have twenty bonds outstanding and a typical industrial issuer would have six.
Bonds are issued to raise money to fund budget deficits, capital expenditure and acquisitions; replace bonds that will mature imminently; and for particular financial strategies.
Governments will issue bonds to fund budget deficits and the deficit provides the immediate motivation for issuing a bond. However, the deficit could be financed by raising taxes, or cutting expenditure, or by selling assets. Similarly, when companies decide on their revenue and capital budgets, they have to find a balance between their ambitions on the one hand and their operational and financial constraints on the other. Thus any company considering a bond issue will also have examined budgetary measures – raising revenues, reducing costs and the scope to make asset disposals – as well as their capacity to borrow more from banks and to issue further equity.
Therefore the policy choice for the issuer is to strike a balance between their strategic objectives and the cost and availability of the various funding options. So rather than ask why bonds are issued a better question might be: why do issuers chose to issue a bond rather than taking any of the other options open to them. Part of the answer to this question is that issuers use all the alternatives open to them, and bond issuance is just one of those alternatives.
One alternative is to take out a loan from a bank. This will generally have a lower interest rate than a comparable bond, but the bank will place much more restrictive conditions on the borrower than would a bond prospectus. A second alternative is to issue equity. The undertakings the company must make when issuing equity are less strict than those expected by bondholders, but the returns expected by an equity investor are higher. The protections for an equity investor rest in the right to vote at shareholder meetings to approve such things as share issues, dividend payments, acquisitions and disposals and board appointments. In the normal course of events banks and bond investors have no such rights and their protections are contractual in nature.
The different restrictions, costs and obligations of each form of funding influence the choice of financing, or more accurately, how the financing is spread over the three choices. In the following paragraphs, we look at some factors that influence the choices made by each of our issuer types.
In summary bonds are issued by governments and related institutions; financial institutions; and large industrial and commercial corporations. The bond market allows issuers to diversify their sources of funding and provides a means for financial institutions to manage their risks.