Businesses with excess cash have many choices for making use of their money. Some companies pay off debt, hire new employees, give bonuses or open new plants. Other companies keep cash invested for future needs and unexpected contingencies. Some invest cash in insured money market or savings accounts for easy access with low risk. Bonds usually carry more risk and offer less access to savings than bank accounts; on the flip side, bonds often yield higher returns than savings accounts, giving companies a compelling incentive.
Types of Businesses
Companies that provide money-related services and firms desiring a stable cash flow typically invest in bonds. The largest purchasers of bonds include banks, insurance companies and pension funds. Mutual funds, central banks and large corporations with substantial pensions to service also invest substantial amounts in bonds.
Companies that invest in bonds usually rely on the regular interest income to pay ongoing expenses. A bond investor lends money to the issuer until a certain date, called the “maturity date.” In return, the issuer or borrower pays interest at regular intervals, such as quarterly. Banks use the income from bonds to pay their depositors, and insurance companies use it to pay claims from policyholders. Corporations and pension funds similarly use the interest to cover monthly outflows to pensioners.
Businesses invest in bonds rather than savings accounts to put their money to work at higher rates. The interest on bonds is often higher than banks pay on savings and money market accounts as well as higher than the inflation rate. The rate of return varies with economic conditions at the time of purchase, the type of bond and the time to maturity. Types of bonds include municipal, corporate, Treasury and other federal agency bonds. Corporate bonds, for example, typically pay more than Treasuries. The highest-interest bonds, sometimes called “junk bonds,” are not as safe as higher-rated bonds. Bonds with a longer term usually carry a higher interest rate than comparable short-term bonds from the same issuer.
Preservation of Capital
A company may utilize bonds to preserve capital for future use. Although a company can resell bonds to a new buyer before maturity, they bring less than face value if interest rates have fallen. Hence, a company must hold its bonds to maturity to guarantee preservation of capital. Bonds may also help a company hedge against a declining stock market – bonds historically do well when equity stocks are in a downturn. Bonds give a business the ability to customize its financial planning by choosing the desired time to maturity, whether one year, 10 years or longer. For example, an enterprise buys bonds maturing in five years to build a new factory at that time.
If interest rates go up, a business misses out on higher potential income on money tied up in bonds. A business can minimize this risk by buying bonds with different maturity dates, which frees up money to reinvest at staggered intervals. Some bonds are "callable," meaning the issuer has the right to pay them off early. In this case, the business loses the expected interest rate. The most serious risk inherent in bonds is that of default. If a corporation or other bond issuer cannot repay, the investor loses part or all of the principal. High-interest or junk bonds pose the highest risk of default. Treasury bonds, on the other hand, carry the full guarantee of the U.S. government.
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