Debt Issuance Costs
What is debt issuance?
While the term sounds more technical, debt issuance really stands for borrowing money. It is an approach widely used by both governments and companies to raise money by selling bonds with the promise of paying back with interest.
Governments often call these Treasury bonds, and the money raised is usually spent on services and facilities to the public, such as building roads, public schools, or even to spend on government workers who eventually serve the public.
On the other hand, a company might offer to sell bonds in order to raise capital for a new investment or a property. These are all legitimate reasons and debt issuance is a successful approach to funding new projects.
Interest Rate vs. Credit Rating
Credit rating often plays an important role in determining the interest rate on the bonds. A successful company typically has a higher credit rating, which corresponds to lower interest rates on their bonds.
The exact opposite applies to companies that aren’t performing very well. This is essentially because buying bonds from a company that is not performing generally well includes more risk.
There are fewer guarantees that the company will pay back, so the company has to pay for the risk in form of higher interest rate on their bonds.
How do companies issue debts?
There are two main approaches undertaken by companies when issuing debt:
- Underwriter Placement: in which a bank takes the risk of buying the entire debt and reselling it to investors. The bank imposes a fee on the company in return.
- Private Placement: in which the company sells its debt directly to the public. This also may include companies, but the transaction is done directly between both. This is less costly as the placement doesn’t need to be registered with the Securities and Exchange Commission (avoiding additional fees)
What are debt issuance costs?
Whether the placement is private or through an underwriter, the process still involves fees and expenses such as legal fees, registration fees, underwriter fees in the case of having an underwriter placement, and even printing papers.
All of these fees are expenses that don’t create any revenues on the long term. In order to account for those expenses, the company creates an asset of the expenses and pays for it over the term of the bond.
If a company incurs $100,000 as debt issuance costs associated with 10-year bonds, it will amortize the expenses over 10 years. Thus, paying $10,000 a year.
Debt Issuance vs. Bank Loans
While most companies can borrow from banks, issuing bonds is viewed as a smoother and easier way to fund projects or operations. This is because banks often impose greater fees and put restrictions on what the company can do with a loan.
Banks are typically more concerned about how a certain company will meet payment deadlines. This doesn’t help smaller companies that might be trying to take a risk on the market.
On the other hand, bondholders are less concerned with repayment and are generally easier to deal with. This makes debt issuance more popular to finance operations.