Bonds vs. Bank Financing. Why do companies choose Bonds?

As an investor, while considering investing in bonds, you may wonder: ‘OK, the business model of the company seems viable, the financial data looks solid, the project’s prospects are good, there aren’t too many risks… But why is the company raising funds through bonds instead of just going to the bank? Are there any hidden risks, and therefore the bank refuses to grant a loan?’

These are all good questions. Nevertheless, we have been observing some recent shifts in common practices for attracting financing through bonds vs. regular bank loans and the two have become more complementary to each other rather than different.

Terms of bonds and bank financing are becoming similar, especially for real estate development projects

For a long time, it was common for banks to be considered the main and the best option for businesses to borrow funds. This strategy was solid, reliable, and financially attractive. Alternative debt instruments, such as bonds, used to be more expensive and were chosen by companies only as a “plan B”, if the banks did not extend a loan.

Nevertheless, the problem with bank financing was that the loan terms were often not very flexible. On the one hand, banks could offer better conditions in terms of the cost of financing. Still, on the other hand, they were strict with the terms when it came to the amount, stages of release, and other conditions that the company had to fulfill, for example, equity/debt ratio, and use of customer advanced funds for construction.

Meanwhile, in the past couple of years, we have seen a shift in the roles of banks and other financial players in the market. Bank financing became more expensive both due to growing base interest rates worldwide, as well as the lack of competition in the local Lithuanian market. The more expensive it got, the more similar to the other options it became. Currently, we see that local businesses are choosing between bank and alternative financing by simply comparing the conditions for the two options and aligning them to their goals. The projects are usually structured in the following ways:

First bonds, then – bank financing. Financing projects in stages is popular among commercial real estate projects. At the initial stages of the project, when, so to speak, there is nothing to show, and nothing much to pledge as a security, only a land plot and a vision, the project owner chooses financing through bonds. Then, when the construction process is about to reach completion, and there are some lease contracts signed, the project owner applies for bank financing to refinance the bonds and finish the project. One of the recent examples could be the Artery business centre project in Vilnius, where 55 mln. EUR of bonds were redeemed at the end of last year and replaced by a banking counterparty. :

‘Sandwich’ financing. The second type of financing projects can be referred to as ‘sandwich’ because different financial instruments are layered together to compose the capital required for the project, for example, both bank loan(s) and bonds. Usually, in such a scenario there are different SPVs with different types of security to pledge. An example here could be the Sparta project, the construction of an office campus for the Tesonet group in Vilnius. As discussed in our previous newsletter, in such cases, you have to understand the whole capital structure of the project, whether the bonds are being used to complement the equity or bank financing part of the equation. Spoiler alert – it looks like our first investment project will be of this type – with the right equity ratio of course.

Either bank or bonds. There is always an option to choose either bank financing or raising capital through bonds. As discussed before, there are pros and cons to using both, hence the project owner may choose a better option depending on the circumstances of a particular project.

Additional financing options are always preferable

It should be noted that bonds may be added to the company’s financing options for only this reason precisely – to add another alternative to the list. The company might debut in the bonds market to ‘check out the temperature’ when there is no urgent capital need. This allows the company to see if the investors are willing to lend their money and for how much, in terms of coupon (interest rate). With such knowledge, sometimes it is easier for the company to negotiate with the existing banking counterparties, however, it is worth noting that this only applies to very reputable issuers, who can command similar terms. As a result, the company then has more flexibility and does not have to rely on the limited local banking market to fund business development opportunities.

Can it be about marketing?

Last but not least, for companies that are not listed on the market, bond issues can be a good marketing and customer-building tool. By offering to invest in bonds, the company creates an alternative product for the customers and enters the capital markets. Customers who already like the company’s brand and use the company’s products/services are more likely to want to invest in the company as well, and similarly, those, who invest in the company for financial reasons, will become more invested in the company’s brand and products/services. Public bond issues create more publicity and topics to communicate about, in addition to attracting capital to develop the business.

In the current business and economic environment, there are increasing reasons for companies to use bonds over bank financing due to preferred flexibility, however, naturally, we think we will see more and more combinations of both, especially with the expected gradual decline in the base interest rates. This also hopefully means more ‘bond deputantes’ in the market.