What is Loan Stock?
Loan stock refers to the loan, in which borrowers with the portfolio of eligible securities, secure capital, or finance from certain investors with the possession of considerable capital in hand. They are equally ready to enter a contractual agreement to park their funds with the respective borrowers in return for securities.
- The collaterals used to secure a loan are considered very critical and valuable for the lender. The collateralized stocks are of public sector enterprises listed on the major recognized stock exchanges. These are unencumbered so that they can be easily liquidated in the market.
- The lender may consider physical ownership of the collateral security during the period of the loan. If the borrower defaults on the loan, the lender will keep the collateralized stock with him. The lender is supposed to return the security to the borrower once they pay the loan amount with interest.
- The loan stock, as in the case of standard commercial loansCommercial LoansCommercial loans are short-term loans used to raise a company's working capital and meet heavy expenses and operational costs. It is a kind of financing often used by small companies that cannot afford to raise money from equity markets and bonds. Banks and well-established financial institutions often provide commercial loans against the debtor's financial statements and credit score., carries a fixed rate of interest. The Loan stock could be secured and an unsecured one. The secured loan stock can also be convertible loan stock provided in the agreement that after a specified period, the or in certain terms and conditions, the loan would convert into equity shares, which base on the predetermined rate.
The Risks for Lenders and Borrowers in Loan Stocks
Let’s discuss the risks for lenders and borrowers.
The lenders, when issuing loans, stand to lose if the value of collateralized security falls as the market value of security bound to move according to the market factors which are out of control. In such a case, the value of the security offered to secure loans does not guarantee in the long run.
When the value of collateral security falls, then these securities become insufficient to cover the outstanding loan amount. Subsequently, borrower defaults on loan, then lenders stand to experience the losses as the value of the security is not sufficient to cover the value of the issued loan.
As borrowers keep their respective shares or any other stocks as security to secure the loan amount, the lender stands to benefit from the transaction in case borrower defaults on loan. It increases the chances that the lender will become the owners of the business as they own the required security with voting rights.
It could be a terrible ordeal for business owners if the lenders have entered into the transaction with the sole intention of gaining ownership of the entire business with associated voting rights.
Loan Stock as Business
Many businesses are running and functioning with the only intention of providing finance on loan stock-based transactions. This business helps the borrower to secure finance based on the value of securities and their implied volatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model. and creditworthiness. Business generally calculates LTVCalculates LTVThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value. in line with banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. when home’s value is being assessed before securing a home mortgage.
- In the case of companies which does not have share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side. and are limited by guaranteed loan stocks are a very important tool to secure finance as they are considered quasi-equity. In these companies, financing through loan stocks is regarded as a long term investmentTerm InvestmentLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets..
- It is generally used by companies formed with the objective of social cause. Loan stock is regarded as a low-cost process to finance the project with lower investment.
- Loan stock is ideal for business with a highly ethical project; the reason being it does not seek legal advice, and therefore, it is good for small business organizations.
Following are the critical points to be noted in case of loan stock:
- The maximum amount that would be issued with loan stock;
- The maturity date when the loan would be redeemed;
- Fixed-rate of interest on the amount of loan to be charged;
Process of Doing Loan Stock Transaction
- The borrowers in need of funds from the lender write a check against the line of creditLine Of CreditA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business. and submit the same to the wire funds to a bank account. The lending process may require to deposit collateral security in addition to the security, which was not previously included in the collateral. The borrower can repay the principal, including interest to the lender, in partial or in full according to the terms agreed in the contract.
- If the borrower defaults to clear outstanding due to the lender, then the lender has the legal right to sell the security to recover his dues.
- The eligible borrowers in loan stock transactions vary from individual investors to joint investors. The amount of loan in loan stock could vary from $10,000 to $5 million or even more in case of high net worth individuals. The maturity of these loans is customized according to the requirements of parties in the transaction. 5 years is common maturity in loan stock transactions.
Advantages of Loan Stock
The different advantages are as follows.
- In today’s dynamic corporate world, every business is in dire need of capital, which business can raise through debt financing or equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.. In the stock, the finance business keeps the shares of its own as security to secure the finance.
- The major benefit for the borrowers is that they are not supposed to repay the lender for the shares being sold. To secure finance for new startups is very difficult as they don’t have any credit history. For startups, loan stock is the only option to get the required amount of loan to run the business.
Disadvantages of Loan Stock
The different disadvantages are as follows.
- Selling stocks to secure new finance means the business is giving up partial business with the lenders, which include the potential share of future earnings and profits. If the business turns positive and doing well as compared to its peers, there are chances that the value of the shares the business will increase further much higher than the value of the loan being borrowed.
- It is a well-known fact that the shareholders have legal and voting rights, which to some extent, limit the actions of the business in their favor. As the lenders become new shareholders, they are expected to take away some portion of profits that would have otherwise belong to the existing shareholders.
- Loan stocks are useful when there are larger requirements of funds, for example, to buy real estate properties or to take over any running business, etc. Loan stocks are different from securities lending in which brokers or banks lend the securities to take advantage of price movements of securities.
- For example, in short sellingShort SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen. banks lend securities to the investors to book gain when the value of the security falls and buy the same at the current lower price and return the security to the bank again.
This article has been a guide to what is loan stock and its meaning. Here we discuss the process of doing loan stock transactions and risks for lenders and borrowers. We also discuss the advantages and disadvantages. You can learn more about accounting from the following articles –