Turn to the bond market for funding when a bank isn't enough

If you're expanding your firm or starting a new one, finding money to operate the business is a priority. But as banks get tougher on their lending policies, you might find the bond market to be a solid alternative.

Growing a business isn’t easy—especially when it’s an IT consulting or professional services firm competing for funding resources in a crowded market.

Businesses have been relying on bank financing for years, as they should have been. But as they grow, they need to start looking to the bond market for a portion of their funding. I’ll talk about how bonds differ from traditional bank loans, why the changes in bank funding have made bonds more attractive, and just what types of companies can qualify for bond funding.

Going beyond the bank
In the past, banks competed directly with the bond market for borrowers. These days, banks are cutting back on funding large, long-term loans for major investments (like the purchase of a competitor) because they’re under pressure to expand short-term credit obligations, including offering lines of credit.

Recent years have seen several inversions of the yield curve—a situation where borrowing short-term money actually costs more than long-term, at least for a brief period of time—and a massive, long-term expansion in the economy. This unusual circumstance has shaken bankers, a highly conservative group, which explains why banks are reluctant to make long-term loans at a fixed rate.

Only a very desperate business would incur millions of dollars of long-term debt at a variable rate, so CFOs and founders of new consulting ventures need to consider more stable funding sources, which means either floating an IPO or issuing a debt instrument of some sort. The road to a successful IPO, however, can be long and slippery. A vast number of Web-related companies have gone public because they burn cash at an incredible rate and needed a quick cash pop.
Like a term loan, a bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holder of the bond. Although bonds are similar to term loans, a bond issue is generally advertised, offered to the public, and sold to many different investors. Unlike term loans, a bond’s interest rate is generally fixed, although in recent years there has been an increase in the use of various types of floating-rate bonds.Courtesy of Financial Management: Theory and Practice, by Eugene F. Brigham
Cashing in on bonds
If your business has a positive cash flow, it should qualify to issue bonds—usually the preferred long-term funding method because it’s generally cheaper than a bank loan. Even if the difference in rates is only a quarter of a point, it can make a big difference: A quarter point (0.00125) on a $100 million loan is another $125,000 per year—which can buy a lot of copier paper.

But it takes a lot longer to float a bond than to arrange a loan from a bank that already knows you. In many cases, speed is of the essence when completing a deal, so the best option is often to get a short-term bank loan, or even a variable-rate loan, rather than take the time to float a bond issue that can be used to pay off the loan. This is the business equivalent of a homebuyer who takes a variable-rate mortgage because they know they’ll be relocating and selling the property before rates can get too high.

Since there are certain fixed costs associated with borrowing money in the bond market (such as establishing and maintaining a credit rating), this is only an option for relatively large companies. However, with the economy running full steam ahead as it has for the past several years, there are a growing number of companies expanding rapidly and making plans to grow even more. They’ll be wise to consider bonds to secure part of their financing.
Wondering how to finance your firm’s expansion? Looking for tax advice? Send us your questions and John may consider them for an upcoming column.

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