Bond markets
In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond markets.
The bond market allows the financing of medium and long-term needs of States, local authorities and companies. In return, it offers opportunities to invest medium and long-term financing capacities. In order to understand the bond market, it is necessary to distinguish two markets. The primary market, where bonds are issued, and the secondary market, where they are traded. What are their characteristics?
The primary market
When an organization issues new bonds, it uses the primary bond market, where its securities are acquired by various investors.
The issue price of a bond is expressed as a percentage of the face value of the security. If the issue price is 100%, the price is said to be at par. If the issue price is above 100%, the price is said to be above par. If the issue price is below 100%, the price is said to be below par.
The nominal interest rate is used to calculate the coupon that will be paid to the bondholder. The interest rate at the issuance date depends on the default risk of the issuer reflecting its financial quality. This default risk is usually evaluated by rating agencies (S&P, Moody’s, Fitch).
There are two principal ways to issue bonds: syndication and auction.
Syndication
Syndication is the most common way to issue debt, widely used by companies, governments and other organizations. Syndication is when several financial institutions join together to ensure the placement of a bond with investors in order to reduce their risk exposure.
In a syndication, there are two types of financial institution: the lead bank, which arranges the transaction and manages the loan syndication, and the so-called “junior” banks, which participate in the transaction without setting the terms.
There are two types of syndication. “Full commitment” is where the lead bank commits to providing the company with the capital it needs and then subcontracts part of the financing to the other members of the syndicate to limit its exposure. “Best effort” is when the amount of the loan is determined by the commitments that the banks are willing to make in a financing transaction.
Auction
Auction is used by governments only. It is their preferred method of issuing sovereign debt. It allows the acquisition of a debt security through an auction system.
The auction can be “open”, i.e. all direct participants in public securities auctions (credit institutions, management and intermediation companies, etc.) have the possibility of acquiring part of the security put up for auction. It can also be “targeted”, i.e. the issue is reserved only for the primary dealers – banks or other financial institutions that has been approved to trade securities – of the issuing State.
A few days before the planned date of an auction, the State makes an announcement, confirming, postponing or cancelling the operation. It also gives the characteristics of the securities to be issued, i.e. the type of securities, the maturity and the amount it wishes to raise. Buyers can then submit several bids, each specifying the desired quantity and price. The issue lines are then auctioned to the highest bidders. The higher the demand is, the lower the issue rate is.
Auction is used because it provides investors, among other things, with transparency and free competition on an investment product with an attractive benefit in relation to a low risk level.
The secondary market
Once issued, a bond can be traded on the secondary bond market. It then becomes a tradable financial instrument, and its price fluctuates over time.
On entering the market, a bond will compete with other bonds. If it offers a higher return than other bonds for the same risk, the bond will be in demand, which will drive up its price. For the most part, transactions are conducted over the counter (OTC). Buyers and sellers interrogate several “market makers” who give them buying or selling prices, and then choose the intermediary who makes the best offer.
A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the CAC40 for stocks. The most common American benchmarks are the Barclays Capital Aggregate Bond Index and Citigroup BIG.
A bond is quoted as a percentage of its face value. Thus, if it is trading at 85% of its nominal value of €1,000, it is quoted at €850. In addition, the bond is quoted at the coupon footer, i.e. without the accrued coupon.
The accrued coupon is the interest that has been earned but not yet paid since the most recent interest payment. It is calculated as follows: accrued coupon = (number of days/365) x face rate – with the face rate being the rate on the basis of which interest is calculated at the end of a full year for the nominal value of the bond -.
To better understand this mechanism, let us take an example:
Consider a 6% bond with a nominal value of €1,000, with an entitlement to dividends on 12/31 (coupon payment date). It is assumed that the bond is worth €925 on 09/30.
Gross annual interest: 1,000 x 6% = €60.
The accrued coupon on 09/30 is: 60 x 9/12 = 45 €.
Quotation at the foot of the coupon: 925 – 45 = €880.
Percentage quotation: 880 x 100/ 1000 = 88%.
The quoted price will be: 88%.
In the market, bondholders are subject to risks (interest rate risk, exchange rate risk, inflation risk, credit risk, etc.). We will come back to this in a future article.
Useful resources
Rating agencies
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About the author
Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).