Companies issue bonds to finance operations. Most companies can borrow from banks, but view direct borrowing from a bank as more restrictive and expensive than selling debt on the open market through a bond issue.

The costs involved in borrowing money directly from a bank are prohibitive to a number of companies. In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans. Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed when it gives a large loan to a company. In other words, restrictive covenants protect the bank’s interests; they’re written by securities lawyers and are based on what analysts have determined to be risks to that company’s performance.

Here are a few examples of the restrictive covenants faced by companies:

• They can’t issue any more debt until the bank loan is completely paid off
• They can’t participate in any share offerings until the bank loan is paid off
• They can’t acquire any companies until the bank loan is paid off

Relatively speaking, these are straightforward, unrestrictive covenants that may be placed on corporate borrowing. However, debt covenants are often much more convoluted and carefully tailored to fit the borrower’s business risks. Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the chief executive officer (CEO) quit, or should earnings per share drop in a given time period. Covenants are a way for banks to mitigate the risk of holding debt, but for borrowing companies they are seen as an increased risk.

Simply put, banks place greater restrictions on what a company can do with a loan and are more concerned about debt repayment than bondholders. Bond markets tend to be more forgiving than banks and are often seen as being easier to deal with. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.

For more further reading, see Debt Reckoning and Corporate Bonds: An Introduction To Credit Risk. For more about bonds, see Bond Basics Tutorial and Advanced Bond Concepts.

Although it is rare, companies and governments do issue bonds that exceed an average person’s life expectancy. For example, multi-billion dollar companies such as the Walt Disney Company (DIS) and Coca-Cola (KO) have issued 100-year bonds in the past.

Many of these bonds and debentures contain an option that lets the debt issuer partially or fully repay the debt long before the scheduled maturity. For example, the 100-year bond that Disney issued in 1993 was suppose to mature in 2093, but the company can start repaying the bonds any time after 30 years (2023).

Countries such as Argentina, Austria and Mexico have recently issued 100-year bonds, and there has been talk of them being considered in the United States in the future as well.

Why Long-Term Bonds Are Attractive for Some Investors 

Companies issue bonds with long maturities because the goal of any business is to profit from the market’s demand. When it comes to 100-year bonds, there is a group of investors that have shown a strong demand for these bonds. Specifically, certain institutional investors use 100-year bonds to lengthen the duration of their bond portfolios to fulfill certain duration-based goals.

Some analysts see the demand for this type of long-term bond as an indicator of consumer sentiment for a specific company. After all, who would buy a 100-year bond from a company they didn’t believe would last? For example, if there was especially high demand for Disney’s 100-year bond, this could mean that many people believe that the company will still be around to pay out the bond a century later.

Believe it not, 1,000-year bonds also exist. A few issuers (such as the Canadian Pacific Corporation) have issued such bonds in the past. There have also been instances of bonds issued with no maturity date, meaning that they continue paying coupon payments forever.

In the past, the British government has issued bonds called consols, which make coupon payments indefinitely. These types of financial instruments are commonly referred to as perpetuities.

(To learn more about bonds and duration, see the Bond Basics Tutorial and Advanced Bond Concepts.)

Banks are the usual issuers of CDs. Individuals, companies and organizations are commonly the depositors that put their money into these financial instruments. The interest payable on a CD is the cost (to the recipient bank) for using the money. The interest receivable on the CD is the return (to the depositor) for providing the money. CDs are issued for periods ranging anywhere from 90 days to five years, and, generally speaking, the longer the term of the CD, the better the interest rate paid to the depositor.

The takeover of Manchester United by the Glazer family beginning in 2005 saddled the historic club with substantial amounts of debt, which is a source of continuing controversy for many long-time supporters of the club. The Glazers paid around £790 million for the team. The family initially took the club private, which created a great deal of debt, but then had an initial public offering (IPO) in 2012. At one point in 2010, the club’s debt exceeded £716.5 million, or over $1 billion, prompting outcry from the club’s supporters. That debt amount was paid down over the next few years. As of February 2015, the club had around £380.5 million of debt, which had increased over the prior quarter. The lack of participation in the Champion’s League in the 2014-2015 season hurt the club’s revenues.

Malcolm Glazer built his wealth through real estate investing, including mobile home parks and shopping centers. The Glazers also own the Tampa Bay Buccaneers of the National Football League (NFL). The Glazer takeover of Manchester United has been fraught with controversy due to the amount of debt used for the transaction.

The Glazers began purchasing their shares in Manchester United in 2003 through a holding company known as Red Football. They built their position over the next few years. In May 2005, the Glazers achieved over a 75% controlling interest in the club, and soon after had the shares delisted from the London Stock Exchange. As part of the takeover, the Glazers saddled the club with a large amount of debt. Around £265 million was secured by the club’s assets, with the total amount of debt around £660 million. This was the first time the club had debt since 1931. The loans were provided by large American hedge funds. The interest rates on the debt amounted to around £62 million a year. A substantial portion of the loans were payment in kind loans, which the club was paying 16.25% interest on at one point. The precarious nature of the club’s balance sheet led to protests by the club’s supporters.

The Glazers refinanced this debt in 2010 by issuing a series of bonds with two main tranches. The first tranche, worth about £250 million, paid interest around 8.75%. The second tranche, worth around $425 million, paid 8.375% in interest. The second tranche was issued as a result of high investor demand in the United States. The funds from the bond offerings were used to pay down outstanding debt.

In 2012, Manchester United had an IPO on the New York Stock Exchange (NYSE). Shares were offered at $14, offering around 16 million shares for sale. Class A shares were offered to the public, while Class B shares were controlled by the Glazers. The classes were structured so that the Glazers maintained voting control of the club, which some viewed as controversial. George Soros, the famed investor, was a major purchaser of Class A shares during the IPO. Money from the IPO was used to pay around £62 million in bonds, decreasing the club’s debt load.

All bonds are redeemed at face value when they reach maturity unless there is a default by the issuer. Many bonds pay interest to the bondholder at specific intervals between the date of purchase and the date of maturity. However, certain bonds do not provide the owner with periodic interest payments. Instead, these bonds are sold at a discount to their face values, and they become more and more valuable until they reach maturity.

Not all bondholders hold onto their bonds until maturity. In the secondary market, bond prices can fluctuate dramatically. Bonds compete with all other interest-bearing investments. The market price of a bond is influenced by investor demand, the timing of interest payments, the quality of the bond issuer, and any differences between the bond’s current yield and other returns in the market.

For instance, consider a $1,000 bond that has a 5% coupon. Its current yield is 5%, or $50 / $1000. If the market interest rate paid on other comparable investments is 6%, no one is going to purchase the bond at $1,000 and earn a lower return for his or her money. The price of the bond then drops on the open market. Given a 6% market interest rate, the bond ends up being priced at $833.33. The coupon is still $50, but the yield for the bond is 6% ($50 / $833.33).

A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion of its nominal value to either cash or a specified number of common shares of equal value. A corporation issues a convertible bond to take advantage of reduced interest rates, since the presence of the conversion option provides upside potential for the bondholders, and these bonds tend to demand lower interest rates compared to standard nominal bonds. Another advantage of issuing convertible bonds rather than equity is the tax deduction of interest, which lowers the cost of capital for a company. Also, as the bonds are converted to equity, a company has no more obligations. However, depending on the number of additional shares issued as a result of conversion, shareholders’ equity value declines as a result of stock dilution.

Convertible Bonds

Convertible bonds are typically issued by firms with substandard credit ratings and high expected growth. For example, in 2014, Tesla Motors issued $2 billion convertible bonds to finance the construction of the Tesla Gigafactory in Nevada. Because Tesla reported low or negative earnings over the previous few years, raising capital for this project using standard nominal bonds was prohibitively expensive as the interest rates demanded by investors were very steep. However, with the conversion option, the interest rates on Tesla’s convertible bonds ranged between 0.25% and 1.25%.

Stock Dilution

When convertible bonds are converted to equity by bondholders, a significant stock dilution could occur, which may result in substantial reduction in shareholders’ value per share. Thus, if a company wants to issue stock through a secondary offering in the future, it may not be able to raise as much capital due to stock dilution from convertible bonds.

The main difference between yields and interest rates is that each term refers to different financial instruments. Yield commonly refers to the dividend, interest or return the investor receives from a security like a stock or bond, and is usually reported as an annual figure.

Interest rate generally refers to the interest charged by a lender such as a bank on a loan, and is typically expressed as an annual percentage rate (APR).

A Yield Example

For example, if PepsiCo (NYSE: PEP) pays a quarterly dividend of 50 cents and the stock price is $50, then the annual dividend yield would be 4% [(50 cents x 4 quarters) / ($50)]. Therefore, the current yield is 4%.

If the stock price increases to $100 and the dividend remains the same, then the yield becomes 2%. (Bond yield is a bit more complex; if you want to learn about it, take a look at our tutorial: Bond Basics: Yield, Price And Other Confusion.)

An Interest Rate Example

As an example of interest rates, suppose you go into your bank to borrow $1,000 for a new bicycle, and the bank quotes you a 5% interest rate on your loan. If you borrow this amount for one year, the interest you would pay on top of paying back the $1,000 would be $50 (simple interest: $1000 x 0.05).

If the interest rate is compounded, the interest rate you will pay would be a little bit more. Lenders charge interest to compensate for the opportunity cost of not being able to invest it somewhere else. (To learn more about compound interest, see Accelerating Returns With Continuous Compounding.)

The main factors that impact the prices of fixed income securities include interest rate changes, default or credit risk, and secondary market liquidity risk. Fixed income securities are loans made by an investor to a government or corporate borrower. The issuer of the bond agrees to pay a fixed amount of interest on a regular schedule until the maturity date of the bond. At the maturity date, the borrower returns the principal amount to the investor. The fixed amount of interest is known as the coupon rate, whereas the principal amount of the bond is known as the par or face value. There are a number of different type of fixed income securities, including U.S. Treasurys, corporate bonds, high yield bonds and tax-free municipal bonds.

The main risk that can impact the price of bonds is a change in the prevailing interest rate. The price of a bond and interest rates are inversely related. As interest rates rise, the price of bonds falls, since investors can obtain bonds with a superior interest rate, which decreases the value of a bond that has already been issued. On the flip side, current bond holders are benefited by a drop in interest rates, which makes their bonds more valuable; other investors seek out higher yields of previously issued bonds. Bonds with longer maturities are subject to greater price movement upon interest rate changes, since an interest rate change has a larger impact on the future value of the coupon.

The second main factor is credit or default risk. There is a risk of default if the issuer will go out of business and be unable to pay its interest rate and principal obligations. Issuers of high-yield bonds have more credit risk, since there is likely a greater risk of default. To compensate investors for this higher risk, such bonds often pay higher interest rates. Credit rating agencies provide credit ratings for the issuers of bonds and can help investors gauge the risk associated with certain corporate bonds.

Except for government debt, most bonds are traded over the counter (OTC) and therefore carry a liquidity risk. Unlike the stock market, where investors can easily exit a position, bond investors rely on the secondary market to trade bonds. Investors who need to exit a bond position to access their invested principal may have a limited secondary market to sell the bond. Further, due to the thinner market for bonds, it can be difficult to get current pricing. Bonds vary so much in their maturities, yields and the credit rating of the issuer that centralized trading is difficult. However, FINRA introduced the Trade Reporting and Compliance Engine in 2002, which now reports a high percentage of OTC bond trades, thereby increasing transparency in the bond market.

Historically, investments in the stock market have experienced the greatest return. They have performed better than all other types of investments in the long run, but have a tendency to fluctuate from time to time. Analysts have found that stocks have held their position as giving the greatest return for a period of several decades. Between 1925 and 2007, stocks’ returns were positive for 53 of the 82 years and negative for 29 of the 82 years. Stocks have tended to do better than bonds by a margin of 2 to 1 since approximately the beginning of the same period. While bonds have traditionally been viewed as a more steady financial investment, they can still fluctuate in much the same manner as a stock.

Investors who purchase stocks acquire a portion of ownership in the corporation. Investors can buy either common or preferred stock. Common stockholders receive dividends and have voting rights at shareholders’ meetings. Preferred holders lack these voting rights but take priority over common holders in terms of assets and earnings.

Historical returns can be defined as the way in which a security or an index has performed in the past. Financial analysts examine the data to predict how a security is likely to perform in the future. The same data may also be used to predict how consumer behavior may affect the security. While the past performance of a security is sometimes useful in predicting future behavior, experts caution that it is never a guaranteed method. The general rule is that the older the data is, the less useful it is in predicting near-future behavior and as a guide for future investment decisions.

Trading Places

The bond market is where investors go to trade (buy and sell) debt securities, prominently bonds, which may be issued by corporations or municipalities. The stock market is a place where investors go to trade (buy and sell) equity securities such as common stocks and derivatives (options, futures, etc). Stocks are traded on stock exchanges.

In the U.S., the prominent stock exchanges include Nasdaq, New York Stock Exchange (NYSE) and American Stock Exchange (AMEX), which was acquired by the NYSE Euronext and became the NYSE Amex Equities in 2009. These markets are regulated by the Securities and Exchange Commission (SEC).

Key Differences between the Bond and Stock Markets

The differences between the bond and stock markets lie in the manner in which the different products are sold and the risk involved in dealing with each market. One major difference is that the stock market has central places or exchanges where stocks are bought and sold, while the bond market does not have a central trading place; bonds are sold mainly over the counter (OTC).

The other key difference between the stock and bond market is the risk involved in investing in each. Investing in certain sectors of the bond market, such as U.S. Treasury securities, is said to be less risky than investing in stock markets, which are prone to greater volatility.

Learn more about stocks and bonds in our Stock Basics and Bond Basics Tutorials.