What is Loan Stock?

Loan stock refers to the loan in which borrowers with a 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 collateral used to secure a loan is critical and valuable for the lender. The collateralized stocks are 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 loan period. 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 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.read more, carries a fixed interest rate. The Loan stock could be secured and an unsecured one. The secured loan stock can also be convertible, provided in the agreement that the loan would convert into equity shares based on the predetermined rate after a specified period or in certain terms and conditions.

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The Risks for Lenders and Borrowers in Loan Stocks

Let’s discuss the risks for lenders and borrowers.

For Lenders

The lenders, when issuing loans, stand to lose if the value of collateralized security falls as the market value of the security is 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, these securities become insufficient to cover the outstanding loan amount. Subsequently, the borrower defaults on the 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.

For Borrowers

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 the borrower defaults on the loan. It increases the chances that the lender will become the business owners 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 secure borrower finance based on securities’ value, 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.read more 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.read more 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. read more when a home’s value is assessed before securing a home mortgage.

  • Companies that do 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.read more and are limited by guarantee 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.read more.It is generally used by companies formed with the objective of social cause. Loan stock is a low-cost process to finance the project with lower investment.Loan stock is ideal for a business with a highly ethical project; it does not seek legal advice, and therefore, it is good for small business organizations.

Following are the critical points to be noted in the 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 needing 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.read more and submit the same to the wire funds to a bank account. The lending process may require depositing collateral security in addition to the security not previously included in the collateral. The borrower can repay the principal, including interest to the lender, in partial or full terms 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 to joint investors. The loan amount in loan stock could vary from $10,000 to $5 million or even more in the case of high net-worth individualsHigh Net Worth IndividualsA high net worth individual possesses liquid assets worth $1 million to $5 million. They are also referred to as HNWIs. In order to qualify for HNWI status, the individual’s liquid assets must be readily available in their bank or brokerage accounts. The assets must be accessible and easily converted into cash.read more. The maturity of these loans is customized according to the parties’ requirements in the transaction. Five 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.read more. In the stock, the finance business keeps 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 sold shares. 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, including the potential share of future earnings and profits. If the business turns positive and does well compared to its peers, there are chances that the value of the shares of the business will increase further, much higher than the value of the borrowed loan.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 belonged to the existing shareholders.

Conclusion

  • Loan stocks are useful when there are larger fund requirements, for example, to buy real estate properties or 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 the 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.read more banks lend securities to the investors to book a gain when the security value 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 loan stock is 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 –

  • DeleveragingCost-Plus ContractWhat is Short Position?Leveraged Loans