Financial Markets and Assets
This article covers how companies raise money. As we discussed, this can be done by issuing stocks and bonds. Of course, those are not the only ways for a business to raise capital. Another option is borrowing from banks. There is an ongoing debate as to whether traded loans should be considered debt securities or not. For loans to be considered tradable debt instruments, the following criteria need to be considered:
- "Loans which have become negotiable de facto should also be classified under securities other than shares" [1993 SNA (para. 11.75)]
- "Loans that have become marketable in secondary markets should be reclassified under securities other than shares and should be valued on the basis of market prices or fair values in the same manner as other types of securities other than shares" [GFSM 2001 (para. 7.111)].
How do bonds differ from bank loans?
Borrowing: Banks and Bonds
Businesses need money to operate and to grow. When a firm has a record of earning revenues, or better yet, of earning profits, it becomes possible for the firm to borrow money. Firms have two main borrowing methods: banks and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can take the firm to court and require it to sell its buildings or equipment to pay its debt.
Another source of financial capital is a bond. A bond is a financial contract like a loan, but with two additional properties: Typically, bond interest rates are lower than loan interest rates, and there are organized secondary markets for bonds, making them more liquid to bondholders than loans. Bonds are issued by major corporations and also by various levels of government. For example, cities borrow money by issuing municipal bonds, states borrow money by issuing state bonds, and the federal government borrows money when the U.S. Department of the Treasury issues Treasury bonds.
A large company, for example, might issue bonds for $10 million. The firm promises to make interest payments at an annual rate of 8%, or $800,000 per year and then, after 10 years, will repay the $10 million it originally borrowed.
Treasury Bills, Notes and Bonds
When the U.S. federal government runs a deficit, it borrows the money from financial markets. The U.S. Treasury sells three types of debt: Treasury Bills, Treasury Notes and Treasury Bonds. Each of these debt instruments represents an IOU from the federal government. The difference between bills, notes and bonds is in their maturities: Bills are the shortest term debt with maturities less than one year. Notes have maturities between one and ten years. Bonds have maturities longer than ten years.