A corporation has a choice of raising money by selling shares or by issuing bonds. There are specific reasons why the issuance of bonds is the better choice. These reasons are as follows:
- Boost returns. If the company can generate a positive return by using the funds garnered from the sale of bonds, its return on equity will increase. This is because the issuance of bonds does not alter the amount of shares outstanding, so that more profits divided by the company's equity results in a higher return on equity.
- Interest deduction. The interest expense on bonds is tax deductible, so a company can reduce its taxable income by issuing bonds. This is not the case when it sells stock, since any dividends paid to shareholders are not tax deductible. The interest deduction can make the effective cost of debt quite low, if a company can issue bonds at a low interest rate.
- Known payback terms. The terms under which bonds are to be repaid are locked into the bond agreement at the time of issuance, so there is no uncertainty about how the bonds will be paid off at their maturity date. This makes it easier for the company treasurer to plan for bond retirement. This is not the case with stock, where the company may need to offer a substantial premium to investors to convince them to sell back their shares.
- Ownership protection. When the existing group of investors does not want to have their ownership interests watered down by the sale of shares to new investors, they will push for a bond issuance. Since bonds are a form of debt, no new shares will be sold. However, this is not the case when the bonds are convertible into the common stock of the issuer; bonds with this feature are called convertible bonds.
- No bank restrictions. A company directly issues bonds to investors, so there is no third party, such as a bank, that can boost the interest rate paid or impose conditions on the company. Thus, if a company is large enough to be able to issue bonds, this is a significant improvement over trying to obtain a loan from a bank.
- Trade in for a better rate. If interest rates fall after bonds are issued, and if the bonds have a call feature, the company can buy back the bonds and replace them with lower-priced bonds. This allows the company to lower its financing cost. This is not the case with stock, where the company may be paying dividends to investors for the life of the company.