MARIE RODLENE G.

MALLEN MABA, 2 nd SEMESTER

2021
Seminar on Current Economics Problem Position Paper No. 1

CORPORATE BONDS OR BANK LOANS?

For a firm, the choice of issuing bonds versus borrowing from a bank is essential
from a macroeconomic perspective due to the variances of debt which may be more or
less resilient, or anticyclical, during recessions or times of financial distress. The
corporate choice of funding sources depends on the accessibility and cost of financing,
required collateral, risk, leverage and tax shield. Bank loans and corporate bonds are
used by businesses not only to finance investments (in tangible assets, real estate or
financial investments in shares or stocks) but also to maintain liquidity or rollover of
debt.

What Is the Difference Between A Bank Loan and A Bond?

The primary difference between Bonds and Loan is that bonds are the debt
instruments issued by the company for raising the funds which are highly tradable in the
market i.e., a person holding the bond can sell it in the market without waiting for its
maturity, whereas, loan is an agreement between the two parties where one person
borrows the money from another person which are not tradable generally in the market.
The terms bond and loan are related to each other; however, they are not the
same and have specific core differences. Both are debts. A bond is a kind of loan that
will be used by large entities or the corporations or the governments to raise capital,
which they require for operating their business, and it’s done by selling IOUs to the
public. Many government and corporate bonds are publicly traded; others are traded
only over-the-counter (i.e., OTC) or privately between the lender and the borrower. A
loan is a debt in which a lender will lend the money, and a borrower will borrow the
money. A specific time limit will be set for the repayment of the debt-money, which
includes both the interest amount and the principal amount which has been borrowed by
the borrower from that lender. This principal amount is mostly paid in installments
regularly. When every installment is a similar amount of money, it will be called an
annuity.

The main difference is that a bond is highly tradeable. If you purchase a bond,
there is usually a market place where you can trade it. It means you can even sell the
bond, rather than waiting for the end of the thirty years. In practice, people purchase
bonds when they wish to increase their portfolio in that way. Loans tend to be the
agreements between borrowers and the banks. Loans are generally non-tradeable, and
the bank will be obliged to see out the entire term of the loan.

Bonds that are traded in the market do possess credit rating, which is issued by
the credit rating agencies, which starts from investment grade to speculative grade,
where investment-grade bonds are considered to be of low risk and usually have low
yields. In contrast, speculative bonds are considered of higher risk, and hence they are
traded at higher yields to compensate the investors for the risk premium. On the
contrary, Loan doesn’t have any such concept; instead, the creditworthiness is checked
by the creditor.

But Why Do Some Firms Borrow from Banks as Oppose to Issuing Bonds?

Like people, companies can borrow from banks, but issuing bonds is usually
recognized as the more attractive proposition. The interest rate that companies pay
bond investors is usually less than the interest rate available from banks. Companies
are in business to generate corporate profits, so minimizing the interest is an important
consideration. That is one of the reasons why healthy companies that don’t seem to
need the money often issue bonds. The ability to borrow large sums at low interest rates
gives corporations the ability to invest in growth and other projects. Issuing bonds also
gives companies significantly greater freedom to operate as they see fit.

But some firms prefer borrowing from banks instead of issuing bonds especially
for a small business or a start-up company. According to the 2019 List of
Establishments of the Philippine Statistics Authority (PSA), they recorded a total of
1,000,506 business enterprises operating in the country. Of these, 995,745 (99.5%) are
MSMEs and 4,761 (0.5%) are large enterprises.

Businesses take out commercial bank loans with the hope of using borrowed
capital to become more profitable. Depending on where and how the loan originates,
borrowing money can be dangerously expensive, as interest and fees are associated
with virtually every loan. Businesses can and should calculate the amount of total
interest that will be paid over the course of a loan before accepting one. The following
are some of the reasons why firms prefer borrowing from a bank as opposed to issuing
bonds:

1. To Purchase Real Estate and Expand Operations

Banks are likely to loan money to existing firms that want to purchase real estate
to expand their operations. Expansion generally happens if a firm is turning a profit, has
a rising cash flow, and has positive forecasting numbers for the future. This is a
scenario that makes a bank likely to approve a small business loan. Bank loans for real
estate are usually in the form of a mortgage. Long-term bank loans will use company
assets as collateral, and will require monthly or quarterly payments from profits or cash
flow. The loan term can run anywhere from 3-25 years and will have an interest rate
associated with its repayment.

For example, Jollibee signed the deal for a three-year syndicated loan agreement
in 2008 with the Metropolitan Bank & Trust Co MBT.PS, Banco de Oro-Unibank, Inc,
BDO .PS, Rizal Commercial Banking Corp RCB.PS and the local branch of the Bank of
Tokyo-Mitsubishi UFJ, Ltd 8306.T to fund its expansion in China.

2. To Purchase Equipment

Businesses have two choices with regard to the acquisition of equipment: they
can buy it, or they can lease it. If a business owner borrows money to buy equipment,
they can take a tax write-off of $25,000 the first year, and depreciate the rest of the
equipment over its economic life. The equipment can also be sold for salvage value
when it's outdated or no longer functional. A cost-benefit analysis is necessary to
determine whether it's better to buy or lease equipment for a given company. When a
bank makes a loan for equipment, it's usually an intermediate term loan which runs less
than three years and is repaid in monthly installments. Repayment will often be tied
directly to the useful life of the equipment being financed.

3. To Purchase Inventory

Banks sometimes make short-term loans (repaid within a year) to small

businesses that have developed a trustworthy relationship with the bank. Making
payments on time and holding a positive balance in a checking or savings account are
both ways to build trust with a bank. Some small businesses are seasonal in nature,
such as retail, hospitality, and agricultural businesses. If a company makes most of its
sales during the holiday season, they can take out a short-term loan to purchase most
of their inventory in advance. Bank loans to purchase inventory are generally short-term
in nature; companies strategize around repaying them once the season is over, using
proceeds from their seasonal revenue. They also wanted to take advantage of supplier
discounts. Having access to working capital can put your business in a better position to
take advantage of incentives like early settlement discounts. This can save company
money which can be better spent elsewhere.

4. To Increase Working Capital

Working capital is the money used to manage day-to-day business operations.

Small businesses may take out a loan to satisfy operational costs until their earnings
reach a certain volume. If the debtor has good credit and a solid business plan, a bank
loan can offer short-term money for a business to get off the ground and grow. Working
capital loans generally have a higher interest rate than real estate loans because banks
consider them riskier; if the business is mismanaged at a crucial time during its infancy,
or if the earning assets of the business never generate a profit, the company will face
bankruptcy.
Why Do Banks Resulted to A Bank Run?
A bank run occurs when a large number of customers of a bank or other financial

institution withdraw their deposits simultaneously over concerns of the bank's solvency.

This situation takes place in fractional reserve banking systems where banks only
maintain a small portion of their assets as cash. As more customers withdraw their
money, there is a likelihood of default, and this will trigger more withdrawals to a point
where the bank runs out of cash. An uncontrolled bank run can lead to bankruptcy, and
when multiple banks are involved, it creates an industry-wide panic that can lead to an
economic recession.

How Does Bangko Sentral Ng Pilipinas Solve This Problem?

In a systemic banking crisis, bank runs (actual or potential) and failures can
cause banks to stop honoring their liabilities or require government intervention to
prevent this by extending liquidity and capital assistance on a massive scale. It,
therefore, falls upon the central bank to assure the public by sustaining the stability and
building the resilience of the financial system. Resilience does not only mean adequate
capital and sufficient liquidity. It also entails operational flexibility or the ability of
financial institutions, financial market infrastructure and the financial system as a whole
“to prevent, adapt and respond to, recover and learn from, operational disruption” (BoE,
2018). Bangko Sentral ng Pilipinas (BSP) has developed crisis management
frameworks and business continuity management plans which included the
identification, mitigation, reporting and monitoring of both financial and non-financial
risks.

According to Sec. X272 of the BSP Circular No. 517, Series of 2006 (Emergency
Loans and Advances to Banking Institutions), the emergency loan or advance to
banking institutions is provided to assist a bank experiencing serious liquidity problems
arising from causes not attributable to, or beyond the control of, the bank management
(bank runs).  The grant of such facility is discretionary upon the Monetary Board and is
intended only as a temporary remedial measure to help a solvent bank overcome
serious liquidity problems.  As provided under Sections 84 to 88, no emergency loan or
advance may be granted except on a fully secured basis and the Monetary Board may
prescribe additional conditions, which the borrowing banks must satisfy in order to have
access to the credit facility of the Bangko Sentral. 

In the year 2001, The Bangko Sentral ng Pilipinas (BSP) has also put in place an
early warning system for possible bank failures to avoid bank runs and closures. Then
BSP Governor Rafael Buenaventura said the move is part of a number of risk
management measures the central bank wants implemented to strengthen local banks
and better prepare them for competition. The BSP also assist banks to better match
their foreign currency assets and liabilities, while carrying out reviews to identify
regulatory loopholes in the transactions of bank-affiliated foreign exchange
corporations. At the same time the BSP, which introduced risk-based capital
requirements, tighter loan classification and provisioning rules and consolidating
reporting, had also introduced stiffer penalties for violations of banking regulations.

CONCLUSION

When companies need to borrow money, they can borrow from the bank or issue
bonds. If the bank lends them money, the bank can then sell some of its exposure to the
market to create bank loans. Bonds are also a form of debt – they are loans in which the
investor acts as the bank. Investors lend the company money, which it promises to
repay in full, with interest. But while bank loans and bonds can serve similar purposes,
they have several differences. Usually, the bank loans rank ahead of the bonds if
something goes wrong. In short, if the company goes bankrupt, then usually the bank
loans get paid out before the bonds get paid out. In addition to that, due to the number
of SMEs and start-up companies in the Philippines, most firms prefer borrowing from a
bank to expand its operations, to purchase equipment and inventory and to increase
working capital. In response to banking crisis i.e., bank runs, the BSP promised to grant
emergency loans and advised banking institutions to implement a business continuity
management plan and to provide a crisis management framework.

Sources:

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