Let's explore how corporate bond issuance works.
Unlike government bonds, which are typically issued via public auctions to meet frequent and large scale funding needs, corporate bonds are not generally issued this way.
Public auctions require a broad established investor base and predictable demand, which suits government bonds, but is less practical for corporate bonds due to the varied credit risk and investment appetite associated with different corporations.
Instead, corporate bonds are usually issued through a syndicate of underwriters, typically investment banks who actively market the bonds to suitable investors.
There are two primary methods for this, the bought deal and the best effort basis.
Each method has unique advantages depending on the issuers priorities and market conditions. Let's start with a bought deal.
In a bought deal, the underwriters fully underwrite the bond issuance, meaning they guarantee to sell the bonds to investors at a predetermined spread.
Here's how it works. First, the issuer and the banks agree on the bond's, maturity, size, and credit spread.
Let's say a 10 year bond with a notional of $3 billion at a spread of 49 basis points over a benchmark rate.
The spread can be quoted over different benchmarks depending on the region.
For example, in the US, corporate bonds are generally quoted over treasury yields.
As the US treasury market is large, unified and serves as a natural benchmark for corporate bonds.
In Europe, corporate bonds are more commonly quoted over swap rates, which is the interest rate on the fixed leg, on an equivalent maturity interest rate swap.
Given the fragmented nature of the European government bond market and the need for a unified benchmark, that better reflects the broader interest rate environment for Euro denominated bonds.
The banks then announce the issuance to investors and begin the book building process, collecting bids to gauge demand.
If demand falls short of the targeted issuance size, the banks have a firm commitment to buy any unsold bonds, ensuring the entire issuance is successfully placed.
A bought deal provides certainty to the issuer as the banks guarantee to take on any unsold bonds.
This is especially valuable when market conditions are uncertain, as it minimizes the risk of an unsuccessful issuance.
However, this structure increases the risk for the underwriters as they're obligated to purchase any unsold bonds at the agreed spread, which could lead to losses.
If market demand weakens after the deal is set. To offset this risk, underwriters may charge a higher fee or require a slightly higher spread, making the issuance more expensive for the issuer.
The second method, which is more common, is the best effort basis.
Here, the banks act more like agents aiming to achieve the best possible spread for the issuer, but without a guarantee that the entire issue will be placed.
The issuer and banks agree on the bonds maturity and size as before, but for the spread, they agree an initial range.
For example, 48 to 52 basis points over treasuries for a $3 billion 10 year bond.
During the book building phase, the banks announced the issuance and collect bids from investors at various spreads within the range.
Once there's sufficient demand to cover the entire issuance, the final spread is set at a level that satisfies the target amount, which could be anywhere within the initial range.
With the best effort deal, the risk to the underwriters is lower because there are not obligated to buy any unsold bonds.
This means they have less capital at risk and don't need to charge the issuer as much in fees. For the issuer, this approach can sometimes lead to a lower spread if demand is high, as the banks can adjust pricing to achieve the best possible outcome.
However, the disadvantage is that the placement is not guaranteed.
If there is not sufficient demand, the issuer may be forced to delay the issuance or accept a higher spread than initially expected.
Beyond these two primary methods, there are other issuance methods that cater to specific investor bases or regulatory conditions.
In a private placement, bonds are sold directly to a small group of institutional investors.
This approach is foster and involves fewer regulatory requirements, but offers less liquidity in the secondary market.
Private placements are often used by smaller or unrated companies or by those seeking more flexible terms.
Common in the US, shelf registration allows a company to register a large number of bonds with regulators and issue them incrementally over time, depending on market conditions, each issuance from the shelf is called a takedown.
This method is often used by large corporations that want to raise funds opportunistically. In a club deal, the bond is issued to a small prearranged group of investors, typically without a full public marketing process.
This is somewhat similar to a private placement, but involves multiple investors rather than just one or two.
In a reverse inquiry, the issuance is initiated based on interest from a specific investor or group of investors.
The issuer may tailor the terms to meet this demand, allowing for a more customized approach that bypasses the typical public syndication process.
