Loan vs. Bond: What’s the Difference?

Two business women looking at a laptop discussing small business loan options
At SouthState, we are routinely asked by our governmental and not-for-profit clients, ‘Should I do a bond for this?’ The question is often in reference to financing larger capital projects or bridging some type of funding gap. While the question diminishes the complex convergence of tax law, market forces and structural nuance, it does expose the confusion that exists between borrowing in the bank/private market versus borrowing in the public market. Reducing complex finance into a simple answer is difficult – and not always definitive, given continual changes in tax law, market forces and available structures. However, there are certain criteria that can help a client differentiate between the two approaches and when each might be considered.

Regardless, SouthState Bank and its experienced professionals are here to help you untangle this challenge. In this document, we highlight four strategic follow-up questions that can help an organization understand or determine, ‘Should I undertake a direct bank placement for this, or should I consider issuing bonds in the public market?’ (That’s the real question!)

Where is The Money Coming From?

This may be the most fundamental – and important – question to consider. When a client engages the bank market for funding, a single lender is making a loan to the client. Conversely, when a client approaches the public market, the funding comes from as few as one to as many as, say, 30 individuals or companies that purchase their municipal securities (actual bonds, representing an obligation to repay and a specific repayment stream). The size of the transaction principally determines how many investors are needed, but the credit quality of the issuer/ borrower/offering may as well. The concept of interacting with one lender versus 30 investors begins to frame the complexity of accessing the public market.

However, the real confusion stems from this fact: a bank can make a loan under or within the legal construct that exists for a publicly offered bond to achieve many of the same structural features! This hybrid approach is what leads to the confusion and misplaced references. Some of the common, favorable characteristics of this method include long amortization, interest-only periods, tax-exempt financing rates, longer credit commitment periods and the like. But borrowing within this construct does not change the fact that a bank is making a loan (and there are several regulations and precedent cases that help validate this). So, for most of our clients, obtaining a loan that looks and acts like a bond is the path they are contemplating, not going to the public market.

What are The Structural Differences?

The main difference here also centers around where the money is coming from. When a client issues bonds in the public market, they are actually selling (a set of) obligations to investors that have disparate return objectives. Meaning, a pension fund that is buying the bond maturing in year 30 has no concern for an individual buying the bond that matures in year 7; both are making an independent investment decision. The public market therefore can afford clients longer amortization schedules, rates committed through maturity, alternative repayment schedules (escalating or wrapped), minimal tax law change implications, no repayment acceleration and limited covenants (versus metrics prescribed to maintain a rating).

However, to accomplish these public market features, a client must work closely with industry professionals – an underwriter or financial advisor – to literally piece together a financing that, when aggregated, achieves its financing objectives; and then those securities must find their way to investors. While an investor maintains critical liquidity – by selling its bond to another investor – transactional challenges become quite complicated for the borrower or issuer when the aforementioned finance professionals do not aggregate the pieces correctly! Or the interest rates are not accepted by the market upon initial offering or, possibly over time, a credit rating downgrade occurs or there is an event of default.

When a bank makes a loan, it is a single facility that the lender plans to hold to maturity. The reality here is that a single lender may not be willing to accept certain of the structural differences available through the many investors. So while the bank offers slightly more restrictive features in the categories above, working with a lender that you can build a relationship with, can become even more beneficial! Not only can banks offer features like draw-down construction terms, flexible prepayment provisions and re-amortizing structures, lenders also have the option to adjust loan provisions, accept prepayments, extend terms and, most importantly, waive defaults during difficult times – all without triggering an Event of Default. The bank loan market is undoubtedly a kinder and gentler alternative, as this treatment is very difficult to replicate in the public market.
Icon for open quote Icon for close quote
The bank loan market is undoubtedly a kinder and gentler alternative, as this treatment is very difficult to replicate in the public market.

What Does it Cost?

Borrowing money either way can be costly. Larger borrowing amounts generally come with added transactional participants to make sure everyone is doing and getting what was intended. For instance, there could be as few as two or as many as five law firms participating in a standard transaction! This is particularly true when structuring a tax-exempt financing. Tax-exempt financings provide rates that are approximately 80% of taxable rates (estimated, based on standard bank pricing). However, interest rates achievable in the public market can range from, say, 80% to as low as possibly 60% of the going taxable rates. Paying 80¢ – or 60¢! – on the $1.00 is quite attractive for bigger deals borrowed over a long period of time. From this perspective, the lower, ongoing interest cost makes the higher upfront costs justifiable. However, just a note on timing, a bank can offer a fixed rate when it submits a term sheet, while the public market deal will bear the rates available on the day of pricing, possibly several weeks or months into the financing schedule.
Going to the public market may also entail additional studies to verify the proposed plan of finance, securing credit ratings, and certainly an underwriter or placement agent to distribute the bonds. That last party cited generally results in the ‘costs of issuance’ going up 25-50%. As such, if it takes $200,000 to arrange a transaction, it may take another $100,000 to market and sell bonds in the public market! The good news is that a portion of the upfront costs can be included in the financing (a tax-exempt financing generally allows up to 2% of the borrowing for costs of issuance) and amortized throughout the life of the financing. Your SouthState banker can help you evaluate these alternatives by providing an analysis incorporating these variables.

When Should I Consider Issuing Bonds?

Assuming this truly means offering bonds in the public market, the client should consider three criteria. First, if the borrowing is large enough and the significant upfront costs can be recovered in the first few years, then a public market offering may be justified, financially. Secondly, if the client has undeterred conviction regarding the terms it needs, they can likely be found among investors in the public market (versus a single bank lender). However, it should be noted that this approach can be both costly and inflexible. And finally, if the client is really at the end of its growth/maturation and is seeking ‘terminal debt’ – meaning they are keen on arranging their debt and (basically) forgetting about it – then the public market may be ideal. However, if these criteria are not met or are too stringent, the client may want to consider a loan – the kind that looks and acts like a bond.

If this all sounds confusing, that is because it is! We could fill several pages with answers to the ‘real question.’ However, rather than write extensively, we invite you to have a conversation with one of our SouthState Banking Specialists to explore alternatives and address your specific concerns.

About the Author, David Adams: David Adams currently serves as the Director of Governmental and Not-for-Profit Banking at SouthState. He has worked in the not-for-profit and governmental finance industry for more than 30 years. While he has experience working in many facets of governmental affairs, his passion is in education finance.

David is a native of Charlotte, North Carolina, where he is an active member of the community, serving on the Board of Trustees at the Greater Charlotte YMCA. He earned his Bachelor of Business Administration from the University of North Carolina at Chapel Hill and his Master of Business Administration from Wake Forest University.

Secure Log In

Close login menu
Login Error

Your username is valid but has a problem. Please call customer support

Our website uses cookies to ensure your online experience is as informative and relevant as possible. Please review our Privacy Policy to learn more about the information we collect.