It happens in the business world that the author, disappointed about not receiving bank funding for his project, kills a very good idea. There is no collateral, no cash flow, just a good business project and faith in it – but the bank needs more. In such cases, the gap can be filled in by several alternative financing methods. One of them is bonds. A classical tool that allows growing the businesses up to a stage when it becomes interesting to the banks.
I will be honest: The bond market in Lithuania is still in vague. There are a number of reasons, but some of the infamous stories when companies did not return the bonds they borrowed have had the greatest impact. This has seriously violated this part of the financial market at the very beginning of its formation. However, in other parts of the world, bonds are successfully issued and a larger part of debt in capital markets exists in the form of bonds.
In fact, a bond is yet another form of borrowing alongside the usual types like credit or leasing. We are talking about the same debt, but the terms and conditions for borrowing – deposit, repayment terms, easier or more difficult borrowing – are different. One of the most important goals of the bond issue is to help grow and at the same time minimize the restrictions of the actions of a business entity. It seems that the freedom is paid; therefore, the interest on bonds is usually higher than on bank loans. Recently, there has been a significant increase in the demand for financial instruments of such a return and risk profile in Lithuania. Conditions for developing them are favourable: there are many individuals on the market who would be willing to lend, and many individual businesses that need to borrow. Bonds are an instrument capable of implementing such needs.
One of the major advantages of a bond is that it’s issuer has a clearly defined deadline for the completion of the project made from the borrowed funds. This means that during the project, the promoter does not feel the pressure otherwise felt when borrowing from the bank, when it comes to paying monthly credit and interest payments. In the case of bonds, the debt can be paid at maturity, and the interest payment can be adjusted flexibly. By borrowing in bonds, the company does not restricted with any control that it feels when extracting share capital.
Borrowing in bonds allows to focus on and achieve the final result, although the company does not have a secured cash flow or collateral required by the bank. Thus, it becomes possible for niche participants to engage business, implement promising or highly innovative projects, remaining a business owner and not restricting with monthly paid credit contributions to the bank or the control of new shareholders.
Bonds are effective as bridge financing: business is raised so that it becomes possible to contact the bank. It is important that bonds provide the opportunity to borrow for Lithuanian small and medium-sized enterprises with a turnover of 50 to 250 million euro. It is an opportunity to borrow for companies without history, capital, and collateral but with a good business plan. The bond owner is concerned about the end result, and hoping for it, he gives time to implement the plan and leaves the promoter in peace for the entire period of the issue of the bonds.
The major and most notable shortage of bonds is that it is a relatively expensive borrowing. However, looking more closely, mathematics doesn’t look so bad. Let us say, a real estate company is implementing a project. The bank will probably require worried to have its own land with construction permits, detailed plans and other attributes – it accounts for about 25-30% of total costs in such business. All assets are mortgaged to the bank, and it actually finances the construction. During the development of the project, it is necessary to repay the loan monthly and to pay interest. What does this mean for real estate developer? This means that, until he sells a certain number of real estate units (for example, apartments), there will be no revenue, only costs. In addition, interest is paid on the total loan amount, although only a small part of the funds might be used.
The bond model offers an alternative: the amount required for the project is borrowed for a certain period. The amount received can be used by the project implementer at own discretion, he knows how much he will pay to the bondholders at the end of the term, and interest may not be required charge when implementing the project. Interest rates on bonds will not change until the maturity, while bank interest rates are unpredictable. The project is completed, a certain number of apartments are sold, and the debt is repaid.
It must be acknowledged that interest rates on bank loans and bonds varies greatly: In Lithuania, classified as higher risk country, with relatively young business, the interest on bonds is on average 12%. The bank could offer 4-5%. Yet: it is possible to borrow cheaper, but you will have to return them halfway – and where to take the money? “Cheap” in this case is not an appropriate concept; the whole financing logic should be taken into account, and it is as follows: arithmetically, it’s cheaper to borrow the same amount at the bank, but after evaluating cash flows during a project, the bond’s advantage is often better.
If the promoter really believes in his business idea, then the bonds may eventually bring the business to the traditional capital markets. Moreover, bond buyers, especially from other countries, have their own relations, interconnections with the markets of other countries, and the issuer is expanding its product sales opportunities.
With regard to global examples, the show that the bond issue can become an important tool to check market assessments and response to major shocks or crises. For example, a global automotive giant Volkswagen AG in 2015 got involved into one of the biggest scandals in the automotive industry – the so-called “dieselgate”.
The scandal’s damage to the reputation of the concern is enormous, trust in the company’s message has dropped, and the yield on previously issued bonds has risen sharply. However, Volkswagen has taken action and began to radically change its priorities, planning a big electric vehicle program. Did the market believe in them? Volkswagen recently released issued 500 million bonds with 3-year maturity and successfully distributed them at just 0.35% annual interest. This is the answer.
The credit market is not just a bank or just bonds, – it is a general process. The bond market works well in Germany, Scandinavia, and in the Baltic States the growth of this market is slowed down by the way of thinking – if the bank did not borrow, then the project is doomed, any alternatives are forgotten. Even if they are remembered, only bare figures of interest rates are visible, and the logic underlying them remains invisible. Time to tame the bonds.
Commented by the author – Ruslanas Andrejevas, Director of Lewben Investment Management