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In almost all bond markets, new issuances exceed bond repayments. New bond issuances are made either through a public offering, in which bonds are issued to the public at large, or private placement, in which bonds are issued to a select group of investors. The popular bond issuance mechanisms include underwritten offering, best efforts offering, and auctions.
An underwritten offering (also called firm-commitment offering) in an offering in which the investment bank guarantees to sell the bond at an offering price negotiated with the issuer. It is typical for corporate bonds, some local government bonds, and asset-backed securities.
The first step in the underwriting process is a determination of the amount of funding needed, type of bond offering and mechanism.
Next, the issuer selects an investment bank that acts as an underwriter and negotiates a sale price with it. The underwriter earns a profit from the resale price (offering price) of the bond and the price it negotiates with the issuer. If an issue is large, a lead bank invites other investment banks to join in the process in which case it is called a syndicated offering.
In the third stage, the issuer and underwriter structure the bond issue by deciding about the notional amount (total amount of bonds), coupon rate and expected offering price. The underwriter typically manages all the necessary documentation and the issuer appoints a trustee. A bond issue is announced via a press release highlighting the bond’s terms and conditions, expected coupon rate and offering price. The issuer also releases the prospectus.
One of the most important considerations in a bond issue through underwriting is to determine the offering price. It should be set such that the amount of bonds available equals bonds demanded. If the price is set too high, the issue may be undersubscribed in which case the underwriters must buy the bonds for themselves. However, if the price is set too low, the issue may be oversubscribed. Even though a small oversubscription is normal, very high oversubscription may mean that the issuer received unfavorable terms and that it could have issued the bonds at a lower coupon rate.
Between the announcement date and the issue date, the underwriter reads the market to determine the best offering price for the bonds by (a) marketing them to the potential investors through mainstream media in case of popular issuers, or through roadshows aimed at institutional investors; and (b) tracking the bond price in the grey market, the futures market for yet-to-be-issued bonds.
The pricing date is the last day on which an investor can subscribe to a bond and the final terms of the bond are agreed-on, which is followed by the issuing day, on which the underwriting agreement is signed. Once the underwriting agreement is signed, the underwriter starts distributing the bonds and the bond issue process completes 14 days later on the closing day, on which all bonds have been issued.
Some authorized issuers in certain jurisdictions are not required to prepare offering circular (prospectus) for each bond issue separately rather they can issue a single all-encompassing document listing all the expected bond issues through a process called shelf-registration. Each new issue must offer a brief introduction and confirm that no material change has occurred in the issuer business.
In the best effort offering, the investment bank does not guarantee the sale of all bonds but acts only as a broker and tries to sell as many bonds as it can for a commission.
In an auction-based offering, investors place their bids for bonds. Such a mechanism is most common for sovereign bonds. Some countries (such as the US) have a single-price auction while others have multiple-price auction (such as Canada and Germany).
In the US, the Treasury arranges auctions in which investors place either a competitive or non-competitive yield quote. A competitive quote is one in which the investor specifies the highest acceptable yield while in a non-competitive quote, an investor commits to accept whatever the market-clearing price is. At the close of the auction, all non-competitive bids are accepted, and any excess is allocated to competitive bids in ascending order (of yield). Most of the US Treasury issues are purchased by primary dealers, large dealers authorized to deal in new issues of US Treasury and US Federal Reserve open market operations.
In private placements, non-underwritten and unregistered bonds are sold to a single investor or a select group of investors. The transaction may be through an investment bank or direct, and in most cases, no public secondary market exists in such securities. Such bonds typically attract pension funds and insurance companies whose assets need not be all liquid. Feature-wise, private placements fall between syndicated loans and public offerings.
Private placements are particularly attractive for issuers who are new to capital markets and whose offering amount is small and hence does not have a very large investor base. It attracts investors because (a) they know that they will get a bond (and it won’t be up to chance), (b) they can negotiate credit enhancement, collateral and customized covenants, (c) they offer higher yield due to illiquidity.
by Obaidullah Jan, ACA, CFA on Mon Feb 17 2020
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