Bonds are one of the ways businesses, governments and other organizations can raise capital for their operations. Alternatives include issuing stock and borrowing money from a bank. While each option has its own advantages, issuing bonds brings several potential drawbacks that issuers must be aware of before investing time and money in the process.
One of the key disadvantages that bonds present to their issuers is the need to repay them at a specific point in time. Once bonds reach maturity, investors receive their principal payments back. While a bond issuer expects to use this money to grow and gain value, the repayment still presents a cost, even if growth and income have been slower than expected. Stocks, on the other hand, can be used to raise capital without any future repayment obligation.
Bonds also cost issuers by requiring periodic interest payments. Most bonds feature fixed interest rates, which issuers are responsible for paying for the life of each bond they issue. Fixed interest rates hold steady even if the current interest rates drop, and the business can't earn enough of a return on its own investments to cover the interest it owes to bond holders. With fixed interest rates on bonds, issuers have no options to refinance, which isn't the case with other methods for raising capital, such as taking out a bank loan.
Strain on Cash Flow
Bond repayment and interest payments are fixed and ongoing obligations that require businesses to have enough cash on hand to cover upcoming bond expenses. This can place strain on a company's cash flow, preventing it from using available cash for other investments or purchases. One way to combat cash flow problems is issuing more bonds, however this perpetuates the problem by starting the process over again. When a company issues stock, it can cut its dividend payment to shareholders in the face of weakened cash flow, but this is not an option with bonds.
When an issuer offers bonds, it takes in cash but also takes on a financial liability. Each bond represents a liability, both in terms of repayment of principal, and interest payments. In particular, balance sheets list bonds as liabilities that decrease the value of owners' equity, and decrease net worth. While the money from issuing bonds offsets these liabilities, the liabilities remain on the books until the bonds are repaid.
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