Primary and Secondary Fixed-income Markets

Primary Fixed-Income Markets

Primary bond markets are where issuers sell new bonds to investors to raise capital. This contrasts with secondary bond markets, where existing bonds are traded among investors. Debut issuers are those who approach the bond market for the first time. They often replace private debt, like bank loans, with bonds. Examples include:

1. New corporate entities formed post-merger or acquisition.
2. Mature companies with predictable cash flows.
3. Sovereign governments raising external foreign currency debt for the first time.

Issuance Process

1. Underwritten Bond Offering: Financial intermediaries guarantee the sale of the bond issue at an agreed price with the issuer. This process is usually quick for frequent issuers.
2. Best-Efforts Offering: The intermediary tries to sell the bond issue on a commission basis at the negotiated price only if possible.
3. Private Placement: Bonds are sold to a select group of investors, often when the bond size is small or the issuer is less known.
4. Sovereign Debt Issuance: Typically takes the form of a public auction led by the national treasury or finance ministry.

Secondary Fixed-Income Markets

Secondary Fixed-Income Markets are predominantly over-the-counter (OTC) in nature, although there are some electronic marketplace platforms available. The main participants in these markets are institutional investors, financial intermediaries, and central banks.

Liquidity in these markets can vary significantly across different fixed-income market segments. The bid–offer spread serves as a crucial measure of liquidity. The most liquid securities in this space are typically the on-the-run developed market sovereign bonds. Additionally, corporate bonds that have been recently issued by frequent issuers tend to have higher liquidity. In contrast, bonds from less frequent issuers or those that are seasoned from frequent issuers are traded less often.

There is also a category known as Distressed Debt, which comprises bonds from issuers that are nearing or have declared bankruptcy. These bonds are traded at prices significantly below their par value because bondholders are expected to not receive all the promised payments. Such distressed debts are particularly attractive to opportunistic investors who are in pursuit of returns similar to equities. On the other hand, a significant number of bond issues are illiquid, meaning they don’t see regular trading. For these illiquid bonds, price quotes are often based on estimates, which are derived from bonds that are more liquid in nature.

Comparison to Equity Markets

1. Equity IPOs vs. Bond Debut Issuers: Just as companies can have an initial public offering (IPO) in the equity market, issuers can approach the bond market for the first time.
2. Trading platforms: While equity markets often operate on centralized exchanges, fixed-income markets are mostly OTC.
3. Liquidity: Equity markets generally have higher liquidity than many segments of the fixed-income market.
4. Distressed securities: When a company’s debt becomes distressed, its equity securities might already be delisted from exchanges.

Question #1

Which of the following best describes the primary bond market?

1. A market where existing bonds are traded among investors.
2. A market where issuers sell new bonds to investors to raise capital.
3. A market predominantly for trading distressed debts.

Solution

The correct answer is B.

In the primary bond market, issuers sell new bonds to investors to raise capital. This is distinct from the secondary bond market where existing bonds are traded among investors.

A is incorrect: This describes the secondary bond market.

C is incorrect: Distressed debts are a specific category of bonds and not the primary focus of the primary bond market.

Question #2

Which type of bond offering involves a financial intermediary trying to sell the bond issue on a commission basis at the negotiated price only if it can do so?

1. Underwritten Bond Offering
2. Best-Efforts Offering
3. Private Placement

Solution

The correct answer is B.

In a Best-Efforts Offering, the financial intermediary tries to sell the bond issue on a commission basis at the negotiated price only if possible.

A is incorrect: In an Underwritten Bond Offering, financial intermediaries guarantee the sale of the bond issue at an agreed price with the issuer.

C is incorrect: Private Placement involves selling bonds to a select group of investors, often when the bond size is small or the issuer is less known.