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Banking Essentials - Part I

This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

Greenwashing

Greenwashing is the act of distributing false information about something being more environmentally friendly than it actually is.

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Connect Finance Unlocked to your current platform

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Tackling the Cost of Living Crisis

In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

CSR and Sustainability in Financial Services

In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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What is the Difference Between Loans and Bonds?

What is the Difference Between Loans and Bonds?

Farouk Ramzan

25 years: Senior executive in banking

Loans and bonds have a number of key differences which lead them to be used by different issuers and investors - Farouk analyses a handful of these.

Loans and bonds have a number of key differences which lead them to be used by different issuers and investors - Farouk analyses a handful of these.

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What is the Difference Between Loans and Bonds?

26 mins 57 secs

Key learning objectives:

  • Explain the relationship angle

  • Describe pricing differences

  • Define four more key aspects

  • Identify the biggest real-world difference between loans and bonds

  • Recognise the parties to loan and bond transactions

Overview:

Loans and bonds are both used by companies to borrow money. There are many similarities between the two instruments but some very fundamental differences.

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Summary

What is the biggest real-world difference between loans and bonds?

  • A bond is drawn from day one. All key bond terms are agreed on Day 1: maturity date, coupon (interest payment), size, pricing, and settlement date.
  • A loan can be structured as committed but is undrawn so there is a lot less certainty on Day 1 since they are typically facilities where the lending bank or banks commit to provide funding over the life of the transaction – but only when the borrower wants the money.
  • Loans are more like guaranteed overdrafts. Borrowers may never draw on the loan or may draw the funds at the earliest opportunity or anything in between. This type of loan is called a Revolving Credit Facility.

Who are the parties to loan and bond transactions?

  • Large corporate loans are typically syndicated i.e. the borrower borrows from a syndicate of banks each making individual commitments to the total facility size. Lenders tend to be banks; although non-bank funds actively lend money in the form of loans.
  • Almost all bond issues are syndicated and there is almost no limit to the number of investors in a bond issue. Because bonds are freely tradable, over the life of the transaction they might end up in the hands of even more investors as they are bought and sold.
  • There is a far greater diversity of lenders (investors) in the bond market than in the loan market: insurance companies, fund managers, hedge funds, high net worth individuals and banks.

Explain the relationship angle

  • A bond may be the only connection between borrowers and investors.
  • Loans are typically provided by banks to entities with which they have a relationship and to which they already provide services.
  • Where a borrower and a bank have a close relationship, banks are incentivised to offer attractive pricing in the hope of building the relationship in other areas, such as payments or foreign exchange.
  • Relationship gives corporates that have access to loan and bond markets the most advantageous pricing and flexibility from the loan market.

Describe pricing differences

  • Bonds are priced at a level commensurate with the market’s view of where they should price. This price is discovered through a process known as bookbuilding and with reference to market data points or comparables, which provide an indication of the fair price. It is a transparent and consensual process.
  • Loan pricing is more nuanced. Rather than simply establishing a market-clearing price, loan pricing derives from a combination of inputs: market-derived pricing, reference to the lending bank’s risk/return and return-on-capital models, and the importance of the relationship. Pricing is also viewed with reference to the robustness of covenants.
  • Most loans pay interest in floating-rate format; most bonds carry a fixed-rate coupon. Banks usually manage their balance sheets on a floating-rate basis so have a natural bias for floating-rate assets. Bond investors have a natural preference for fixed-rate income as it provides cash flow certainty and helps match fixed-rate liabilities.

Define four other key differences

  • Documentation: there is far less disclosure in a loan agreement about the financial condition of the company because the lender typically already knows a lot about the company. A bond prospectus is a much longer document containing a lot of disclosure about the financial condition of the borrower.
  • Ratings: it is very difficult for any company to borrow money from the bond market if they don’t have a public credit rating conferred by a recognised credit rating agency. Most investors in the bond market are restricted to buying rated bonds only. The loan market is much more flexible and analytical. Lending banks are much less reliant on credit ratings. The entities they are lending to tend to be their customers so they know them well.
  • Transferability: bond prices can be found on the trading screens of a number of bank dealers and bonds change hands all the time. There are many market players and systems (including clearing and settlement systems) in place to help facilitate trading. Bonds also are often included in indices, which helps maintain liquidity. Loans may have transferability restrictions, which might say that loans can only be sold to other original syndicate members, or can be transferred from one lender to another lender only with the prior written permission of the borrower. For all these reasons, loans are far less liquid than bonds.
  • Covenants (legal promises borrowers make to lenders) are more prevalent in loans than in bonds. Implicit in all debt instruments is a covenant that the borrower will make good on its obligations to pay interest when due and repay the debt at maturity. Covenants go over and above these fundamental promises. When companies include covenants in contractual terms, they are making a promise to obey certain stipulations. This typically relates to limits on incremental borrowing, or for a company to run itself in a way that would make it harder to repay its debt. Covenants can also be promises not to issue higher ranking debt (a.k.a negative pledge).

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Farouk Ramzan

Farouk Ramzan

A thirty year career in Investment and Commercial Banking in London and New York focused on Debt Capital Markets. More latterly Farouk was Head of European Commercial Banking for the Lloyds Group. Farouk now focuses on diverse projects where he can demystify complex financing structures with a much more interesting social impact crowd.

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