Fixed Income Debt
Looking beyond the IPO stage, as the company is listed, a more sophisticated capital raising takes place. There are various instruments that are created beyond a pure loan from banks – bonds. Bonds have evolved beyond a plain vanilla and straight instrument of a regular interval payment and principal payback at maturity. Structurers in investment banks have been creatively structuring new instruments that serves different risk appetites and ways to value a debt instrument. As the demand for capital grow by corporates, the debt instruments issued have to be attractive as well and makes sense for the issuer and the bond holders. Reasons could pertain towards cost of financing instruments and attract enough demand from investors.
Some of the common structures include:
- Foreign currency bonds typically called Eurobonds, are issued by corporates to finance projects in the foreign currencies. Depending on the currencies, the bonds have been named such as Samurai Bonds (JPY), Kangaroo Bonds (AUD), Dim Sum Bonds (CNY), etc.
- Convertible bonds are issued with an option to convert debt to equity when it hits a price cap. Thus, having this option typically lowers the cost of financing the debt as investors are buying the value of converting to stocks when the company is valued well on the stock market.
- Floating rate bonds are typically issued by corporates because they deemed that it would have a lower cost of financing if they deemed that interest rates will fall over time. The buy side investors will have to weigh out the interest rate environment in its decision to have an “axe” on these bonds.
US Treasuries are instruments used by the US government. There are different uses of these instruments depending on the economic policy. It can be used to fund government projects such as infrastructure development and military operations or as a monetary policy instrument. Most recently in the 2008 financial crisis, the term quantitative easing has been mentioned a lot. This is a practice of debt issuance by the government and immediate buy back by the government from an open market. In the case of US, the US Treasury issued the debt through the auction market that the primary dealers purchase and were bought back from the open market by the Federal Reserves to hold the US Treasuries. The primary dealers funds their purchase through deposits issued by the bank. The sellers to the FED are typically the Primary Dealers with spare inventories and secondary market owners such as hedge funds, mutual funds and other investment firms. Through these action, the government wants to create a multiplier effect as the primary dealers would have higher capital at a lower cost to issue out more loans as a broker. (“On-the-run” treasuries are typically the most recently issued and most liquid bonds. They are the most actively traded on the market. The treasury actives curve, I25, is the benchmark to how corporate bonds are priced and valued against.)
Similar to the launch of an IPO, the investment banks also have to underwrite and service the issuer to sell these bonds. Roadshows will be conducted to gather interest in buying these bonds. One of the key players to valuing the bonds are the rating agencies. Rating of the companies and subsequently the bonds will determine the credit quality of these bonds. This is essential for bonds to be band under “Investment Grade” or “Junk”. “Junk” bonds will typically be deemed as high risk and high chances of default in coupon payment and principal at maturity. Because of the poorer financials of the company, the cost of issuing debt is also higher. Junk bonds are usually issued with higher coupon to ensure it is competitive and more attractive than Investment Grade bonds.
On a daily basis, the sell side bond salesman sends out “runs” to their clients on the buy side. “Runs” includes the daily inventory and price that the bond salesman has on his list. These prices are important especially for bonds that are illiquid and do not have active prices on electronic. The buy side players who received these runs would typically communicate over email, an instant messaging chat or phone to make the purchase. Once a price is struck, a buy or sell ticket can be sent from either party to confirm the deal. For the more liquid and actively traded bonds, the sell side banks could price them electronically to ensure efficiency and speed. Another mechanism is the Request for Quote (RFQ) process where the buyside player can request quotes from multiple dealers. Given the scrutinies from the 2008 financial crisis, regulators are pushing towards an RFQ process to ensure that the buy side players have transparency in trading at the best price.
The financial market is undergoing changes every time and more so in the post-2008 financial crisis. Dodd-Frank, Volcker Rule and the Basel III are names of new regulations that are in the midst of implementation and changing the way how the securities are being traded and valued. The cost of issuing and trading bonds have increase with changes in capital requirements and regulatory reporting is required. In addition to this, the state of the leading economies have shaken since the global oil glut and restructuring of China’s economy. The environment is not the best for corporates to issue new debt for many reasons relating to cost and self-sustainability.
(Obviously, this is brief and the complexity of the products and relationships of the players is huge. I’ll recollect my thoughts again and add more information over time. I hope this gives a quick overview of the products and the market.)