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However, many companies consider this financing method problematic, including in the context of finding investors to buy bonds.
This method is often compared with long-term loans. There are many reasons why issuing bonds can be beneficial to the issuer.
Bonds are an alternative to a bank loan, but their buyers (capital providers) are usually financial market entities.
These capital providers include mutual funds, investment fund companies, asset management companies, insurance companies, banks, and individual investors, allowing issuers greater flexibility in this instrument, as well as lowering the cost of funding.
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Some advantages of bond financing
One of the most important advantages of bonds is that bond financing can be used flexibly and efficiently.Holding companies are one of the main issuers, since this instrument allows them to flexibly use financial resources within their entire group, depending on their current needs. In contrast, loans are often only allowed to be used as part of a specific project. Throughout the life of the bonds (usually 3-5 years), the issuer can transfer funds between its projects or companies, depending on the needs, without having to take out several loans or get bank approval each time.
The flexibility of bond financing can also be seen in the variety of purposes that are funded through this instrument. Bondholders tend to adopt a much broader range of objectives and tend not to specify the specific source of the funds raised.
For example, banks are very reluctant to finance the purchase of land by developers, which in turn is a widespread activity among bondholders.
Bondholders are willing to be more flexible with regard to hedging. The ability to issue unsecured bonds reduces costs, including the absence of collateral and monitoring costs. At the same time, the issuer releases free assets that can be used as collateral for obtaining other financing.
Diversification of capital sources is considered a major advantage for bond issuers.
On the one hand, this makes the issuer more independent of the credit policy of banks.
On the other hand, this strengthens the negotiating position of a potential borrower in negotiations with banks, which in such cases are forced to offer more competitive terms of the loan agreement.
The above advantages of bonds have a significant impact on the perception of the cost of financing by project participants. Most often, the interest rate on bonds is higher than the interest rate on loans. However, in the case of an investment loan, it is worth remembering that any company operating on a large scale must actively work to obtain numerous loans. The latter is associated with additional costs and the involvement of a large number of company employees.
The above are several factors for using bond issuance to finance large projects. Management should not compare only the standard interest rate on bonds, but should also take into account the associated costs and non-financial aspects that affect business performance.
Often the best solution is to use bonds as additional financing to long-term loans.
Income bonds as a tool for financing investment projects
The basis for the implementation of any investment projects is to ensure smooth and uninterrupted financing throughout the entire life cycle.The source of financing can be internal resources of the company or financial resources attracted from outside (the so-called debt financing). A common form of debt financing of investment projects is the issuance of bonds.
Essentially, a bond is a security in which the issuer declares that it is indebted to the bondholder and assumes a specific financial obligation. Over the past decades, a large number of different forms of bonds have emerged in financial practice, each of which has certain features and applications.
In particular, income bonds are additionally distinguished by two important features:
• The holder of an income bond has an advantage over other creditors. Satisfaction of their requirements can be carried out at the expense of the assets of the company or the project, which is fully or partially financed through the issuance of bonds.
• The issuer of income bonds may limit its liability for obligations arising from the bonds to a certain amount of income or the value of project assets.
Unfortunately, this method of financing investments has a significant limitation.
The issue of income bonds can only be carried out by entities acting in the public interest (especially of an infrastructural nature), such as municipalities and other local governments. It is advisable to fully use this tool in commercial projects, of course, with an appropriate balance of benefits and risks arising from this and ensuring the interests of creditors.
Bond financing of local government projects
Why are local governments in many countries reluctant to use bonds but very willing to use loans?From the point of view of leading financial experts, it is critically important for local governments to use combined financing, which may include bond issuance and long-term loans, to ensure the reliability and sustainability of capital-intensive municipal projects.
When a local government signs a loan agreement with a bank, it knows that it will definitely receive the money on the required terms and within the required time frame. Issuing bonds, if not guaranteed, may seem more risky from a local government perspective because the project may not find investors. In addition, banks are actively interested in lending to local governments, as they are an excellent customer in terms of risk and solvency.
Local governments are the ideal client because they cannot actually go bankrupt.
Their balance sheet and their level of debt is usually controlled by the requirements of public finance legislation, and this is actually considered by banks as a reliable "financial shield".
It should be noted that local governments vary greatly in terms of their powers, financial situation and investment opportunities, depending on the legislative framework of a particular country. Some local governments, mostly in large wealthy municipalities, invest heavily in construction, energy, infrastructure and far outperform many commercial borrowers in terms of economic performance.
Thanks to a clear legal framework, it is very easy for banks and potential investors to assess the financial situation of local governments. This can be much easier than for private companies. With regard to bankruptcy, legislation usually provides a mechanism for distributing the debts of an insolvent local government to other bodies. This is also a significant benefit for capital providers.
Bond financing of large investment projects is largely based on financial market factors.
The liquidity of specific bonds in the market, along with the level of confidence in specific local governments, opens up ample opportunities for financing investments beyond loans and alternative financial instruments.
Public information about the level of risk of a particular project is also important. Investors know how much an issuer's debt is worth in a particular risk class assessed by a rating agency.
In the absence of such a benchmark, valuations are sometimes quite random and sometimes not very favorable from the point of view of the issuer.
