Get an overview of how bond investors interact with the fixed income market
Investors are institutions or individuals who provide capital for corporations or government entities, with the expectation of generating return on their capital. Investors include governments, corporations, financial institutions, and any other individuals or groups, such as ETFs, hedge funds, pensions, mutual funds, family offices, and institutional investment managers.
There are a unique set of risks associated with investing in fixed income securities. There is typically a direct relationship between risk and return. Higher risk yields higher return (high-yield bonds) and lower risk yields lower returns (investment grade bonds). Depending on the investor’s investment profile and risk appetite, certain fixed income investments are more suitable than others.
A credit rating is an objective, third-party measure of an issuer’s financial health, its ability to meet its debt obligations. The credit rating accounts for business and financial risks involved with investing in an issuer’s bonds. Investors should use credit ratings to supplement issuer-specific research and analysis.
Covenants are the terms of agreement between the issuer and bondholders (investors). They are in place to protect investor interests and provide remedies in the event of negative events (e.g. issuer default). Investors should be familiar with standard covenants (e.g. limitation on liens, Change of Control provisions, financial covenants, etc.) to understand the degree of protection afforded to them if they invest in a fixed income security.
The offering document and other legal disclosures are drafted and filed by the issuer, dealers, and their legal counsels to aid investors in their investment decisions. These documents provide all pertinent details regarding the new issue and provide legal protection such as covenants to investors as well as the appropriate enforceable legal actions (indenture). The offering document, also known as the prospectus, provides an exhaustive record of documents and details relating to the new issue.
Investors can participate in new bond issues directly from the issuer in the primary bond market. Dealers facilitate the debt issuance process by enabling issuers to communicate information regarding their new issue to investors and allowing investors to provide specific needs and feedback (reverse inquiry) to the issuer.
Investors can participate in secondary market trading by buying and selling existing new issues amongst themselves. Bonds are traded in decentralized, over-the-counter networks facilitated by dealers. Investors interested in trading in the secondary level should be considerate of the bid-ask spread – the difference between buying and selling price of a bond – when trading in the secondary level.
As reported by PwC, from 2004-2015, global alternative investments grew from $3.4 trillion to an estimated $10.8 trillion, representing 273% growth over that time period. The strong demand for high yield alternative investments can be attributed to many structural factors including the low interest rate environment and the evolution of portfolio management. Investments in Private Equity, Hedge Funds, and Real Estate have led alternative investment growth and contributed a combined $5.9 trillion since 2004.
Specifically, demand for leveraged loans (http://www.bloomberg.com/quicktake/leveraged-loans), which offer attractive yields to investors, quadrupled from 2004-2014 and hit an all-time high of $830 billion in the U.S. in 2014. This market is particularly interesting as it has thrived despite relative inefficiencies. For example, the average leveraged loan issuance takes ~20 days to complete, almost 7 times longer than a high yield bond issuance, with many leveraged loan issuances being completed via facsimile.