How does a bond work?
Institutions like the Federal Government, private companies and local governments, issue bonds as a type of “IOU” to borrow money to fund projects. Investors purchase bonds and in return, are guaranteed by the issuer some type of return rate for their investment.
Once the bond is purchased, the issuing agents take the money to use as they see fit. The investor then holds onto their bond until the maturity date and redeems it when the time has come.
Why are bonds preferred over banks?
Although many companies are legally entitled to borrow from a bank, the process is costly and time consuming. Companies issue bonds rather than borrow from banks because the bond process is viewed as less prohibitive, and a cheaper option than going the conventional bank loan route. The reason being is that banks place “covenants” (rules) on the money being borrowed that may limit the flexibility a company has in operating its business. This is understandable as the bank is only trying to mitigate risks involved with the money they loaned to increase their odds of getting repaid.
On the other hand, when companies issue bonds rather than borrow from banks, bond holders do not put restrictions on the terms of the arrangement. The companies set up the rules for the bonds value and maturity, and the bond markets tend to be a bit less rigid than the banks. For these reasons, companies prefer to issue bonds versus borrowing from a bank as they get the funding and spending freedom they require.