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Bond Villains: How the Bond Markets Fan the Flames of the Fossil Fuel Industry [1]
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Date: 2023-12
01
What Is a Corporate Bond?
When companies need to raise funds, they have two choices: equity financing or debt financing. Equity financing means giving up a percentage of ownership in the company to investors by selling shares. Debt financing means choosing to borrow money over an agreed period of time, with interest. There are two main options for debt financing: obtaining a loan from a bank or issuing a bond.
Think of a bond as an IOU (I owe you): investors (bondholders) lend money to a company (bond issuer) for a set period of time (maturity period) in exchange for regular interest payments (coupon rate). After the maturity period, the principal (also known as face value or par value) is repaid to the bondholder. For companies to access money via the bond market, they rely upon a chain of financial institutions: investment banks (underwriters), investors (bondholders) and credit rating agencies.
Issuers: companies issue bonds to borrow money for general operations, capital intensive projects and refinancing other debt. Issuing bonds is attractive to companies because: they offer less scrutiny than loans (direct project financing); they can borrow large sums of money at potentially cheaper rates than loans; and companies don’t have to hand over any control (equity) of the company to investors.
Banks (underwriters): acting as an underwriter, investment banks manage all aspects of the bond issuance process. Banks advise companies issuing bonds and help market bonds to investors. Issuers rely on banks’ credibility to gain access to potential investors. Underwriting bonds allow banks to profit without carrying any risk on their books in the way that making a private loan would. Instead, risk is passed on to investors.
Investors (bondholders): When an investor buys a bond from a company, they are lending to fund its activities. Investors or bondholders are typically asset managers, pension funds, insurers and private equity companies.
Credit Rating Agencies (CRAs): For a bond to be issued, the credit worthiness of the issuer needs to be rated. Three credit rating agencies (CRAs) dominate 95% of the credit rating business — S&P, Moody’s and Fitch. They tell potential investors how risky a bond is. The lower they deem the risk, the cheaper and easier it becomes for companies to secure debt. Though these ratings are ostensibly independent, CRAs are paid by the same companies they rate.
Though both bonds and loans are forms of debt financing, bonds are different from bank loans in several important respects. While a loan is a direct relationship with agreed terms between a bank and the borrower, corporations issuing bonds sell them on what’s known as the “primary” market to any interested investors.
Once purchased, bonds are often subsequently traded between investors on the “secondary market”, like shares and other financial assets. Bonds are also substantially more “liquid” — easy to exchange for cash or other assets — than loans. Crucially, bond markets are subject to less stringent regulation and oversight than bank loans or equity shares.
When a company issues a bond, money is transferred from the initial buyers of the bond to the issuing company. These transactions constitute the “primary market”. The primary market is the point of maximum leverage for increasing the cost of capital for companies or disrupting bond issuance entirely. When bonds are later traded between investors on the “secondary market”, money exchanges hands between investors rather than from the investor to the issuer.
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[1] Url:
https://www.common-wealth.org/interactive/bond-villains-how-the-bond-markets-fan-the-flames-of-the-fossil-fuel-industry/
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