What Is the Difference Between Term Loans and Bonds?

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Skeleton and mortgage bond certificate
Skeleton and mortgage bond certificate (Image: Scott Rothstein/iStock/Getty Images)

While both term loans and bonds represent some form of indebtedness, their features and holder's rights are different. In addition, a business' size and relative creditworthiness can affect which form of debt might be more useful, or for that matter possible. A further consideration is the proposed use of the proceeds. In general, term loans are often "tied" to a particular asset or purpose, while bond proceeds might be less constraining.

Term Loan Vs. Bond Attributes

Term loans by their design often require a regular payment, or amortization, of both principal and interest, often monthly or quarterly. Most term loans are collateralized by readily-valued assets. The collateral might be equipment, real estate or rolling stock. In many cases, the amortization is constructed so as to reduce debt quicker than the depreciation/reduction in value of the loan's collateral. In contrast, bonds are debt which in many cases carry no specific liens against assets. In fact, bondholders must stand behind secured creditors in the event of a liquidation. Many bonds have interest payable quarterly or semi-annually. Principal may not be due until maturity, or until a scheduled partial redemption of the bond issue arrives.

The Borrower: Initial Considerations

The potential borrower must in most cases be larger -- having a greater revenue, borrowing need or project scope -- to merit the use of bonds versus a term loan. Most bonds are issued with some kind of sale feature, meaning the ownership of the debt can change from one holder to another via some kind of market. Any legitimate holder becomes a creditor of the issuer. The cost to arrange and execute a bond issue can be much more than a simple term loan documentation, so the borrower's scale of need, and creditworthiness, must be greater.Conversely, a business who will utilize term debt must have sufficient lendable assets to secure the desired term loan. Costs may attach up front in the form of appraisal or documentation fees to enable the lender to evaluate the proposed pledged collateral.

Timing and Documentation

The timing and documentation issues surrounding the extension of a term loan versus the issuance of a bond can be quite disparate. Even in large amounts, term loans are relatively quick to document and fund. The lender will assess collateral, review/approve the loan and document the credit with a note, lien filings and a closing with proceeds passed to the borrower. In contrast, bond issuance requires due diligence, market assessments, market presentations and public or private sale of the bond issue. This scope of activity could easily require twice the time as that expended to document and fund a term loan.

Summary: Decision Issues

A business with the ability to borrow on either a term loan or bond issuance basis may need to give consideration to the use, purpose and need for the funds requested. As to usage, the amortizing nature of term debt puts some pressure on management to spend funds immediately, or not borrow until plans are very detailed. Bond proceeds may not carry that stigma. The purpose of the planned expenditure may favor using bonds if the funded activity or project has a multi-stage execution, or if collateral is unavailable. Lastly, the perceived immediacy of need may favor term debt if quick action is required on the part of the borrower, such as opportune pricing on needed equipment or available assets.

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