What it means
When a company needs money, it can sell shares or borrow. Loan stock is a way of borrowing in smaller pieces from many lenders, or from a few investors, using a formal instrument rather than a single bank loan.
Each holder receives interest at an agreed rate and gets their money back at maturity, which is the repayment date. Loan stock can be secured or unsecured.
Secured loan stock is backed by specific assets, such as property, which the lenders can claim if the company defaults. Unsecured loan stock relies only on the company's promise to pay, so it usually carries a higher interest rate to reflect the extra risk.
In private companies, loan stock often appears in buyouts and venture-style deals, where investors take a mix of shares and loan notes. The loan stock gives them a fixed income and a stronger claim than the shares, while the shares provide the upside.
Some loan stock is convertible, meaning the holder can swap it for shares on agreed terms. For the company, interest on loan stock is usually a tax-deductible cost, which is cheaper than paying dividends from after-tax profit.
The downside is that interest and repayment are obligations, and missing a payment can trigger default. Lenders therefore often insist on covenants (promises, such as keeping debt below a set level) in the terms.
Because the term is flexible, always check the paperwork. Two instruments both called loan stock can differ in security, ranking, interest and conversion rights, and the label alone says little about the real risk.
Investors compare loan stock by its yield, which is the return actually earned given the price paid. If a certificate with a $100 face value is bought at $95 and pays a 7% coupon, the yield is higher than 7% because the buyer also gains $5 at maturity.
Comparing yields lets lenders judge whether the interest rate fairly rewards the risk.
In practice
Real-world examples.
Example
A regional property developer issues $5,000,000 of secured loan stock backed by a completed office building. Local investors buy the stock for the steady 6% income. If the developer fails to pay, the lenders have a claim over the building. The stock is repaid in full when the building is sold or refinanced.
Example
A management team buys a printing business with help from a private equity fund. The fund provides $3,000,000, split between shares and unsecured loan stock paying 9%. The loan stock gives it regular income while the shares give it a share of the sale proceeds. The management team owns the remaining shares and works to repay the loan stock first.
Example
A small brewery raises $400,000 from supporters through convertible loan stock. Holders receive interest each year and can convert into shares if the brewery is later sold. The brewery avoids a bank loan with strict security requirements. Supporters also enjoy a small discount on beer as part of the deal.
Formula
Calculation
Annual interest = Nominal value x Coupon rate
A company issues $2,000,000 of loan stock with a 7% coupon (the stated annual interest rate) and a five-year life. Annual interest is $2,000,000 x 0.07 = $140,000. Over five years the company pays total interest of $140,000 x 5 = $700,000, and then repays the $2,000,000 at maturity. The total cash paid to lenders is $2,700,000.Case study
Seen in the real world.
Wexcombe Foods is an illustrative, fictional family-owned bakery business that wanted $1,500,000 to build a second production site. The banks would lend only $600,000 against its existing premises, which left a gap.
The finance director proposed issuing $900,000 of unsecured loan stock to local investors at 8% over six years. The terms included a covenant that total borrowing must never exceed three times annual operating profit, and a right for the company to repay early with a small premium.
The stock was fully subscribed within a month. The interest of $72,000 a year was manageable from the new site's cash flow, and the company repaid on schedule. The founder noted afterwards that offering shares would have given away part of the business. The family kept full control, and the investors received a steady return.
Watch out
Common mistakes.
- Treating loan stock as equity, when holders are creditors with a legal right to interest and repayment.
- Assuming all loan stock is secured, when many issues rely only on the company's promise to pay.
- Ignoring the ranking, so that an investor is surprised to find bank debt is paid before their loan stock if the company fails.
Questions
People also ask.
Is loan stock the same as a bond?
In practice, they are very similar, as both are debt instruments paying interest, though loan stock is the older UK term and is often used for smaller or private issues.
What happens if the company cannot pay?
Holders can enforce their claim, and if the loan stock is secured they can claim the assets pledged, with unsecured holders ranking behind secured lenders.
Does loan stock pay dividends?
No, it pays interest, which is a legal obligation, whereas dividends on shares are discretionary.
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