General Question

2davidc8's avatar

Why would corporations offer bonds that pay 5 to 6% interest?

Asked by 2davidc8 (4952 points ) October 5th, 2012

Last time I checked, the prime rate was around 3.25%. As I understand it, this is the rate at which banks are lending to their most credit-worthy customers. So, if a corporation with good credit can borrow at 3.25% interest, why would it sell bonds and pay 5 to 6% interest?

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9 Answers

DrBill's avatar

some do because they need to borrow more than the banks are willing to loan.

Imadethisupwithnoforethought's avatar

Bonds are always variable based on the cost of investing in US treasuries. The yields vary based on those figures.

Assume, for example. that a US treasury bond will never, ever, default. Most of the world does. A bond other than a US treasury takes on more risk that it will the higher the payout.

You need to describe in more detail the bond offering you are looking at before we can help you, Do you know the credit rating for example?

2davidc8's avatar

@Imadethisupwithnoforethought This is just a general question. I’m not looking at a particular bond offering. But here’s what I’m wondering about. I know that it’s possible to invest in corporate bonds that pay 5 to 6%. My understanding is that these are corporate debts. In other words, a corporation is basically borrowing money from you and will pay you 6% interest. (Correct me if I’m wrong.) But why would they do that if they can borrow from the bank at prime rate (3.25%)?

Imadethisupwithnoforethought's avatar

When you borrow from a bank, the bank sets the terms and conditions of a loan.

When you sell a bond, you set the terms and conditions of the loan.

A bank may prevent you from taking on more debt until the loan is paid. You can keep selling bonds as often as you want.

dabbler's avatar

The basic reason behind higher interest paid on corporate bonds is : Risk of Default.

Only the most solid companies can borrow at the prime rate as their risk of default is low. Most companies are not as solid as that and they pay higher rates, all the way up to ‘junk’ bond rates that are relatively very high, but on which there is a real chance you won’t get paid back. Risk is high on ‘junk’ corporate paper.

Even banks lending among themselves have varying rates.
Recall the recent LIBOR-fixing scandal (London Inter Bank Offer Rate) in which Barclays is found to have reported lower rates than actual. Indicating that other banks would lend to Barclays at lower rates claims that other banks thought Barclays was more sound than they actually thought.

choreplay's avatar

There is always, I repeat always a direct correlation between risk and return/rate. That’s the simple answer.

The only time you have excess profit is if availability of information is not efficient.

dabbler's avatar

“availability of information” Astute observation @choreplay.

One of the things that went VERY wrong about the sub-prime mortgage catastrophe is the faulty ratings handed out by S&P and Moody’s and Fitch on mortgage-backed-securities (MBS). Many of them were given AAA, the highest rating available indicating nearly no risk, when in fact they contain some or a lot of…crap mortgages.

That is an example where “always a direct correlation between risk and return/rate” breaks down, because the risk on those securities was far higher than advertised. The returns on them were healthy, high enough to attract buyers – lots of buyers – but the returns really weren’t what they should have been given the probability of default.

20 years ago you would have to pay ratings companies for their research and the resulting ratings data. They prided themselves on providing accurate and thorough analyses of the securities they were covering.
As ‘securitization’ got popular the firms bundling loans into big blocks often found that the ratings firms would not spend the resources to rate every kind of stuff they could produce. Those securities could not get the same volume of business and prices that they could if they were rated.
At some (tragic) point the ratings firms noticed that they could make bigger fees “consulting” about securities they would not otherwise cover. The folks issuing those securities knew they could sell more and get better prices for the securities if they were rated and paid handsomely for the ‘consulting’ services. The ratings firms began to compete for that business and guess who gets the business…? Yes, it’s the ratings company that will give the most favorable rating.
These days you do not have to pay a penny for ratings information. Ratings firms will throw the data at you as fast as you can upload it. They make their cash from fees paid by the folks they are rating.
Can you say, “Conflict of Interest”? I think so.

CWOTUS's avatar

I thought you were going to be able to answer your own question. The one-word answer is “risk”. The prime rate is available, as you stated, “to the most credit-worthy borrowers”. That is, when there is little or no chance of default.

Corporate ventures (and the corporations themselves) are nearly always at some risk, to one degree or another, which prevents them from attaining the prime rate.

I could have saved myself some time by just reading @choreplay‘s answer. One thing that I would add to that is the word “perceived”, as in “perceived risk”. Few who lend, and in fact even few who borrow, fully know all of the risks that they face.

srmorgan's avatar

The primary difference between a bank loan at prime or prime + 1 and a corporate bond is the length of the maturity of the instrument. A bank loan is either a revolver, which is subject to call at any time subject to rules in the loan agreement or for a fixed period of time, generally short-term.

Bonds are considered long-term debt, that is the issuer expects to keep this money for whatever purpose for the length of the bond. The issuer does not have to pay back the principal, in general, until the bond matures say in 20 or 30 years. Corporations will issue bonds for shorter terms but the norm is the 20 or 30 year bond.

Because you are lending money to the corporation which does not have to pay you back for a long time (it pays the interest quarterly or semi-annually) you receive a higher interest rate because you are in effect tying up your money for a long time. If you wish to sell the bond prior to the maturity date, you do this on the open market, you don’t get a refund from the issuer.

The higher interest rate reflects both the risk based on the financial condition of the borrower and the length of the loan.

SRM

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