Welcome to Fixed-Income Issuance and Trading!
In our previous studies, we looked at what a bond is and how its price behaves. Now, we are going to look at the "lifecycle" of a bond: how it is born (issuance) and where it spends its life (trading). Think of this as the "behind-the-scenes" tour of the bond market.
Don't worry if the terminology seems a bit dense at first. We’ll break it down into simple pieces. By the end of these notes, you'll understand why some bonds are sold in auctions, why most bonds don't trade on a stock exchange, and how banks borrow money overnight to keep the lights on.
1. Classifying the Bond Markets
Before we dive into how bonds are sold, we need to know where they live. We classify fixed-income markets based on who the issuer is and where the bond is sold.
Internal vs. External Markets
Internal Market: This is the "home" market. It consists of two parts:
1. Domestic Bonds: Issued by a local company, in the local currency, and sold in the local market (e.g., a US company issuing USD bonds in New York).
2. Foreign Bonds: Issued by an entity from outside the country, but in the local currency and following local rules. They often have fun nicknames like Yankee bonds (issued in the US in USD by non-US firms) or Samurai bonds (issued in Japan in Yen by non-Japanese firms).
External Market (Eurobond Market): These bonds are issued outside the jurisdiction of any single country and are usually sold in a currency different from the country where they are issued.
Did you know? Despite the name, a "Eurobond" doesn't have to involve Europe or the Euro. A bond issued in USD and sold in London is a Eurobond!
Key Takeaway: If it's in the local currency and follows local laws, it’s Internal. If it bypasses specific national regulations and is sold internationally, it's likely a Eurobond.
2. Primary Markets: The Birth of a Bond
The Primary Market is where newly created bonds are sold to investors for the first time. The issuer gets the money here.
Public Offerings vs. Private Placements
Public Offering: Any member of the public can buy these. It usually involves a lot of paperwork and regulation. There are two main ways to do this:
1. Underwritten Offering: An investment bank (the underwriter) buys the whole bond issue from the company and then tries to sell it to investors. If they can't sell it, the bank is stuck with it. This is called firm commitment.
2. Best Efforts Offering: The bank just acts as a broker. They try their best to sell the bonds, but if they can't, they don't have to buy the leftovers.
Private Placement: The bond is sold directly to a small group of wealthy or institutional investors (like insurance companies). It's faster and cheaper because there are fewer regulations, but the bonds are harder to sell later (less liquid).
Auctions
Most government bonds are sold through auctions. In a Single-Price Auction, everyone who wins pays the same price (the lowest winning bid price).
Step-by-step auction process:
1. Investors submit bids (how many they want and what yield they want).
2. The government accepts the lowest yield bids first (because lower yield means cheaper borrowing for the government).
3. The "clearing yield" is the highest yield accepted that fills the total amount needed. Everyone gets that yield!
Quick Review Box:
• Primary Market: New bonds only.
• Underwriting: Banks take the risk.
• Auctions: Common for government debt.
3. Secondary Markets: Where Bonds are Traded
The Secondary Market is where investors buy and sell bonds from each other. The original issuer is NOT involved in these trades and gets no new money.
OTC vs. Exchange: Most stocks trade on an Exchange (like the NYSE). However, most bonds trade Over-the-Counter (OTC). This means they trade through a network of dealers.
Analogy: Think of an Exchange like a giant supermarket where everyone sees the same price. Think of OTC like a used car network—you have to call around different dealers to see who has what and at what price.
Liquidity: This is the ease of selling a bond quickly without a big price discount. Government bonds are usually very liquid, while small corporate bonds can be illiquid. A big bid-ask spread (the difference between the buy and sell price) is a sign of low liquidity.
Key Takeaway: Secondary markets provide liquidity. Without them, investors would be scared to buy bonds in the primary market because they'd be stuck with them until they mature!
4. Types of Issuers and Their Bonds
Not all bonds are created equal. Who issues them matters for risk and return.
Sovereign and Non-Sovereign Bonds
Sovereign Bonds: Issued by national governments (e.g., US Treasuries). They are usually backed by the government’s ability to tax. They are considered very safe (low credit risk) if issued in the local currency.
Non-Sovereign Bonds: Issued by states, provinces, or cities (e.g., a bond to build a bridge in Seattle). They aren't as safe as sovereign bonds but are usually safer than corporates.
Agency and Supranational Bonds
Agency Bonds: Issued by organizations the government created but doesn't technically own (like Fannie Mae in the US).
Supranational Bonds: Issued by international organizations like the World Bank or the IMF.
Corporate Debt
Companies issue bonds to fund operations. There are two main categories:
• Financial: Issued by banks and insurance companies.
• Non-financial: Issued by manufacturers, tech firms, etc.
5. Short-Term Funding: The "Money Market"
Sometimes companies or banks need money just for a few days or months. This is where Short-Term Funding comes in.
Commercial Paper (CP)
CP is a short-term, unsecured promissory note. Only companies with high credit ratings can issue it. It’s usually used to pay for immediate needs like payroll.
Bridge Financing: This is a term for using CP to get temporary cash while waiting for long-term funding to be arranged.
Repurchase Agreements (Repo)
A Repo is like a pawn shop for big banks.
1. One party sells a security (usually a government bond) to another party with an agreement to buy it back later at a slightly higher price.
2. The difference in price is the Repo Rate (the interest).
3. The security acts as collateral. If the borrower doesn't pay back the money, the lender keeps the bond.
The Repo Margin (Haircut): If a bond is worth \$100, a lender might only lend \$98. This \$2 difference is the "haircut." It protects the lender if the value of the bond drops.
Memory Trick: A haircut makes the "loan amount" shorter (smaller) than the "collateral value."
Key Takeaway: Repos are the lifeblood of the financial system's daily liquidity. They are essentially collateralized short-term loans.
Final Summary Table
Market Classification: Domestic, Foreign (Yankee/Samurai), or Eurobond.
Issuance: Underwritten (bank takes risk) or Best Efforts (bank is just a middleman).
Trading: Mostly Over-the-Counter (OTC) through dealers, not on central exchanges.
Short-term: Commercial Paper (unsecured) and Repos (secured with collateral).
Don't worry if this seems like a lot of definitions! The CFA exam often focuses on the differences between these types—such as understanding why a Eurobond is different from a Foreign bond, or how a Repo works as a collateralized loan. Keep practicing the practice questions!