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Tuesday, May 10, 2011

So why do borrowers generally pay lower on bonds than on loans?

This was a question which I had for quite some time. My initial reasoning was validated(mostly) but also supplemented and disproved(in parts) during a Debt Capital Markets introductory session held for us interns. Unlike the boilerplate handouts/training material, this one was interposed with live examples, experiences and thumb rules as well, making it an interesting session. And the closed door nature of the session allowed no holds barred questions, which enlivened the whole feel. But lest this sound like a press report of that session, let me push to the topic at hand!

I have pored through several bond prospectuses of USA, UK, Indian & Singapore based companies. While comparing the interest rates/LIBOR spreads for existing debt, the bond coupon has invariably been lower. At first, I attributed this to the difference in sophistication of the lenders-banks when lending on their own account will be as savvy as possible, but bond investors may be too scattered to command such a position. But there are other factors as well:
  1. Why bonds should pay LOWER coupon:- Unlike the relatively oligopoly for bank supplied capital, the market for bonds has more supply from buy side investors, shadow banks  etc. So only because SUPPLY of capital is more, the rate should be lesser. 
  2. Why bonds should pay HIGHER coupons: Covenants are generally incurrence based(hinge on certain events happening/not happening) as opposed to a maintenance covenant like in loan agreements. Also, bonds are generally unsecured. Investors often cannot conduct a due diligence on the scale banks can(for bank loans). Also, it is usually a bullet payment on maturity, with both put/call options-more often issuer's call options. All these should push up the cost of the bond. 
 In an environment with over supply of funds(as in USA post Quantitative Easing II), the factors for lower coupons will outweigh the factors for higher coupons, while the reverse will happen in a recession. So like most other things in management, one cannot take a firm decision on this.

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