Why don't bond makers just get loans?

Benubird 08/14/2018. 6 answers, 6.197 views
investing united-kingdom bonds interest fixed-income

I was just looking at investment opportunities, and I found a number of places offering bonds paying up to 12% interest over two years. My first thought was, I can get a loan from my bank for 5% interest - so if I get a loan to use to buy the bond, it's free money!

Except, if I can do it, so can they - and paying 5% on the loan is a better deal for them than offering 12% on the bonds, so why are they doing it? Why sell bonds rather than get a loan?

Bonds offered by the government seem to be paying less than 3%. So are these other bonds all just a scam?

Edit: For clarification, in response to comments.

  1. 12% interest means that, if I invest $100, then at the end of the year, I will receive back $112.
  2. My local bank is willing to loan, both secured and unsecured, at a rate of approximately 5%. If they are willing to offer this to me, an individual, I see no reason why they would offer significantly worse terms to a corporation.
  3. The company offering the bonds is offering them at significantly worse (for them) terms - i.e. 12% is bigger than 5%. The bonds they are offering are usually secured by some sort of tangible asset, e.g. property, which a quick google says can be mortgaged for only 4% interest.

Leading to my question: Why are they offering the bonds at such good rate, rather than going directly to a bank or other lender and arranging a mortgage? Dealing with large numbers of small investments from individuals is much more work than doing a single deal with a large institution, so there must be some reason why they are not able to do so. What is that?

I had included an example link, but someone removed it so I guess I'm not supposed to do that. So if you want to see an example, just google "bond investment", and at the top are a bunch of ads saying things like "Fully Asset Backed and Secured Bond Investment Up to 14% Per Annum Returns‎", which is so good that has to be a catch somewhere.

This is not a duplicate question, because I'm not asking whether it's possible for me to borrow money to invest with them, I'm asking why they don't.

6 Answers

Eric Nolan 08/14/2018.

They are not necessarily a scam, or even likely to be. There is a reason they didn't just borrow the money at 5% though and this is virtually certain to be because they are higher risk.

There was a recent question along these lines which I unfortunately cannot find. A number of points were raised.

  1. The investment is higher risk
  2. Your bank may not be willing to loan you money to invest like this
  3. The repayment schedules may not line up, meaning you will have to make payments on the bank loan before you get any returns from the bond and this affects the profitability.
  4. A good rule of thumb is that if something looks like unlimited free money you are probably missing something.

AxiomaticNexus 08/14/2018.

It doesn't necessarily have to be a scam. The most likely scenario is that the issuer of the 12% bonds is higher risk, so you have to take that into consideration in your calculations.

If you borrow money from a bank at a 5% rate, lend it to someone else at a 12% rate, what happens if they default and don't pay you back?

The same concept applies to credit cards. Why do some people decide to carry a balance at a 20% interest rate on a credit card, when they could get a conventional loan from a bank at a much lower rate? Well, because they have a bad credit history, so it is too risky for a bank to lend them money at the lower rate. A credit card is willing to take on the risk, but it's going to cost the borrower 20%.

Galendo 08/14/2018.

Plenty of other people have mentioned that the bond issuer might be a bigger risk. That's a possibility, but there are other factors -- probably more important factors -- in play as well.

First, consider the size of the loans involved. Your bank is probably offering to loan you...maybe ten grand, unsecured, at 5%? Probably not more than 100k at the most. The company, on the other hand, is probably trying to raise tens or hundreds of millions of dollars. Not every bank has the assets to make this loan even if they want to. So immediately supply and demand kick into play: with fewer suppliers able to loan out that kind of money, the "price" of the loan (i.e., the interest rate) goes up.

But it's worse than that. Even if a bank could afford to make a giant loan, they might not want to. There's a couple of factors at play:

1) Opportunity cost. If the bank loans out a huge portion of its reserves to this customer, what happens if interest rates go up next year? Now the bank doesn't have the resources to make even more money, because they foolishly tied up their resources into one giant loan.

2) Risk. Let's say that both you and the company are 3% to default. If you default, the bank is out a few grand, shrugs its metaphorical shoulders, and continues to make tons of money. If the company defaults on a $100,000,000 loan, though? That's a pretty big chunk of change and could easily cripple or bankrupt the entire bank. A 3% chance to be mildly inconvenienced is one thing, a 3% chance to go bankrupt is something entirely different.

There are some other factors at play as well (for instance, if a single loan makes up a large portion of a company's business, that has to be reported in their financial statements, which might spook investors), but the above represents the gist of it.

borjab 08/14/2018.

Make sure that you are comparing apples to apples. 12% over two years or 12% annually. 5% yearly over two years is (1.05)² -1 = 10.25% ~= 12%

The difference between 12% and 10.25% may be due to the risk of investing in the company bonds. Also double check any commisions, fares and risks on your side both in the loan and the bond.

Also. Is this bond in the same currency? I could get better interests in turkish liras but I will recieve the money in a currency that has a higher probability of going down.

Furthermore. Your bond earnings will probably have to pay taxes. Double check before doing it. The company have some fiscal benefits by having debt but this may be very complex.

stonemetal 08/14/2018.

You can get a loan at 5%, can they get a loan at 5%? Probably not or they would be getting a loan, or selling a bond at 5%. Borrowing cost reflect credit worthiness, so they probably have some financial issues that make their borrowing cost higher. Government debt is usually considered the safest kind of debt in a given country, so it usually has the lowest rate.

A bond's interest rate also has to do with how much demand there is for a bond. If there is high demand then the interest rate on the bond will go down. So if you took out a large loan to buy bonds the interest rate on those bonds would fall until you quit buying.

jamesqf 08/14/2018.

Since the bond interest rate is 12%, there's a good chance - say 1 in 10, just to make the numbers simple - that the borrower will default on it. So if I loan $1 million, there's a 1 in 10 chance that I'll lose the entire sum.

OTOH, if I buy $100K worth of 12% bonds from 10 different companies, and 1 defaults, I've still made $80K profit from the other 9. Looking at it from the other direction, it might difficult for the bond maker to find a single entity that would loan $1 million, but much easier to find 10,000 individuals who're willing to risk* $100 on a bond.

*Taken to an extreme, this is why people buy lottery tickets, even though the expected rate of "default" (that is, not winning) is much higher than 12%.

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