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      Endnote

      1 Often attributed to Charles Dickens’ Mr Micawber, who should have heeded it. [return to text]

      Chapter 4: The life cycle of a bond

      The timeline of a new issue

      Corporates and other bodies have funding programs, dictated by both their future capital requirements and the need to roll or re-finance expiring and maturing sources of funding. With this in mind, chief financial officers (CFOs) will be constantly in touch with the primary issuance, or debt origination, departments of investment banks.

      The CFO’s primary duty is to obtain the funding the business needs, with the right maturity profile and at the right price. In addition to this, a good CFO will consider factors such as funding diversity, in order to make sure that the company is not over-reliant on one type of investor.

      The bond market, and its participants, operates internationally. Frequently, a UK borrower will opt to issue into non-sterling markets if there is sufficient price advantage, swapping the proceeds back into its own base currency to match assets against liability. The same is true for the sterling markets, overseas operators will issue bonds denominated in pounds as and when the price is right – this will be influenced by numerous complex factors including local interest rates and yield curves, the degree of domestic demand for the individual credit and the complex and ever-changing market of cross-currency interest rate and basis swaps.

      The lead managers and the selling group

      Turning to the gilt market first, new issues are handled by the government’s Debt Management Office (DMO). There is a straightforward issuance procedure for gilts where the market makers and members of the approved group may bid for the new bonds and auctions are held on a scheduled basis with the calendar determined just after the budget in March.

      The process of launching new corporate bonds is somewhat different. A Eurosterling corporate bond will usually be launched through the route of a lead manager (usually a large investment bank) and one or more co-leads,co-managers or syndicate members. The lead manager will take on most of the risk and the workload of bringing the new issue to market. The co-managers and syndicate members will help ensure that the bond is distributed across a wide range of investors, and also provide a buffer of liquidity in the first days or weeks of the distribution process with syndicate members taking the bonds onto their own books for a few days or weeks to smooth the process of selling large blocks of bonds to investors.

      Primary issuance is a profitable business for investment banks. The fees charged by the various members of the issuance syndicate vary, but a UK corporate might pay 0.35-0.45p in the pound to issue a ten year bond. Retail-targeted bonds are typically smaller in size and thus fees will be higher in percentage terms. Here the fees may be around 1% of the total (and in some cases higher). These fees will be shared with a distributing group of brokers, with 0.25%-0.5% being a typical distribution.

      Above and beyond these fees will be the profit (or loss) booked on the trading books during the syndication process. This will be a factor of the bank’s decisions in selecting the right issues to participate in and the skills of the trader in hedging and trading the positions over the distribution period.

      Note – The new issue process in bonds is intended for professional investors and moves quickly. For instance, exploratory talks between the issuer, the investment bank and key investors on pricing etc. may be held on the Wednesday. By the following Monday the outline pricing and terms of the new issue will be announced on the screens. This announcement will take the form of;

       Acme Corporation to issue seven-year sterling straight, guidance is 160-170bp over gilts. Co-leads Barclays Capital and RBS.

      This means that Acme will be issuing a conventional fixed coupon bond with a seven year maturity. The term pricing basically means the yield and is a combination of the level of coupon and the discount/premium to par. In this case, it is expected to be an equivalent to yield equating to 1.7% (170bp) more than gilts of an equivalent maturity.

      By Tuesday morning the issue will have been priced – i.e. the final margin over gilts or LIBOR/Swaps set and the bonds sold at a fixed price. By eleven o’clock the entire issue may well have been placed. This rate of progress makes it hard for private investors to get in at an early stage.

      An exception to this is the new retail targeted bonds that we are now seeing in the UK. The issuance procedure here is set over one or two weeks in order to allow private investors (and their brokers!) time to react. Typically, the broker will not charge commission to his client for purchasing such new issues. The broker will receive a selling commission from the issuance group by way of recompense as detailed above.

       Tip

      Pricing on retail bonds is set at launch. Over the 1-2 week offering period, the underlying gilt and credit market may move, making the issues relatively cheap or expensive by the time the issue launches. Speculative traders, take note. “Stagging” is not just for equities!

      The life cycle of a bond

      Below is a typical timeline of an imaginary seven-year bond’s life cycle.

      Note – in the equity markets spread refers to the bid-offer spread – the difference between the buying and selling price. This is also true for the bond market, although the term is more usually employed to describe the incremental yield of a corporate bond when compared to a gilt of equivalent maturity or other benchmark interest rate.

      Chapter 5:What happens if interest rates move?

      Investors will generally buy a bond for two reasons. The first is to lock-in a known future income stream. The second is to attempt to benefit from rising bond prices. But what would cause the value of a bond to rise?

      As with all traded assets, it will be down to our old friends, supply and demand. There are two main variables affecting the price of bonds

      1 interest rates, and

      2 the perceived credit quality or risk of default for the bond.

      We’ll consider the effect of the former on bond prices in this chapter, and we’ll look at credit quality in the next chapter.

      As interest rates fall, a bond paying a fixed rate of interest every year will become increasingly sought after by investors and therefore the price of the bond will rise. Conversely, rising interest rates, perhaps accompanied by inflation, will make the fixed income stream unattractive to investors and the market price of the bond will fall. This relationship between price and yield is the key to understanding the factors moving the fixed income markets.

      Price & yield

      The key to understanding the return on all fixed income instruments is to view a bond as a series of discounted cashflows. Understanding discounted cashflows is the key to all investment analysis. The core concept is the current value of a future sum of money, after allowing for interest, capital growth and/or inflation.

      With equities, these future cashflows are unknown, but the accurate calculations can be performed for bonds. Consider that at the start of the investment, the investor pays out cash to purchase the bond. Over the course of the bond’s life, the investor will then receive several payments, usually one or two a year from interest payments, known as coupons, and a final

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