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How deals are made in the fixed income market?

There’s a certain art to bringing corporate bonds to market.

It’s a journey that comes with equal parts precision and showmanship, and with players whose roles are as different as they are vital.

Unlike a stock, a bond isn’t a promise to hold a piece of the company. It’s more of a partnership between a company and a handful of investors who agree to lend that company the money it needs to get something done. It’s also a deal that comes with fewer restrictions than the company would face if it were borrowing from a bank.

These deals are also done in private on an “over the counter” market between dealers who “make” that market – not on a public stock exchange that everyone can see.

A bond’s origination is therefore more fluid than that of a stock, and it hinges on a few key players: the company that wants to raise money (the issuer or seller), the investors who want to buy it (the buyers, who are typically large asset managers/) and the bond dealers who act as intermediaries.

Big dealers and banks typically dominate this market, so smaller investors don’t play as big a role. Dealers can also trade among themselves on the secondary market once the issue has been launched.

“There are some deals that are initiated by the company, and there are other deals that are initiated by the people who are looking to buy securities, and the investment dealers are the intermediaries,” said Laurence Booth, a professor of finance with The University of Toronto’s Rotman School of Management.

“It’s a constant flow of information from the buyers of the securities and the sellers of the securities and in between are the investment banks – they’re the intermediaries that put everything together.”

For the company, the motivation is raising money at a better rate than it may get from a bank and to diversify its pool of investors. With any new issue, potential investors will have to do due diligence on a company and may be more likely to buy into future issues the company makes once they’re comfortable with its fundamentals. If the issue is made abroad, the company may also be able to take advantage of interest rate differentials and raise money at a cheaper rate.

Institutional investors are always looking for high-quality issues, and also want to diversify their holdings. These investors – typical pension funds, life insurance companies, large fund managers and hedge funds – invest on behalf of their clients, so their return is a combination of coupon paid on bonds and any price appreciation or depreciation in the bond.

The bankers and dealers are the ones in charge of selling the deal. If they’re the ones pitching the deal, they’ll have to sell the issuer on the idea first. Once the deal goes ahead, they will have to go out and canvas investors for orders and decide how much each one will get.

Bond dealers and investment bankers will make money not just on fees and commissions but also on the spread between what they bought the bonds for and what they sell them at.

“When you buy a pair of shoes, the price that the shoe company buys them at is not at the price that you buy them at,” said Booth.

“They make their money on the spread between what they buy at and what they sell at. Bonds are exactly the same thing: (Dealers) will buy the bond from you at one price – that’s the price that’s listed as the ‘ask price’ – and the ‘bid price’ is the price that they’re willing to buy at. The difference between the buying and the selling price is where the bond dealers make their money, exactly the same as a company selling shoes or anything else.”

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