Investors play an essential role in the price discovery process by providing feedback to the issuers
In the primary bond market, investors play a key role in the price discovery process of a new issue. On the launch date, the bookrunners work with investors and the issuer to set the principal amount and credit spread or coupon rate for the bond. A key determinant of bond price is investor demand for the new issue.
The bond price can be calculated by summing up future cash flows discounted to the present value. This method is used to price both new issues (primary bond market) and existing issues (secondary market). Read more about calculating the bond price here.
The coupon rate is the percentage of par value that will be paid to investors on a fixed schedule. It represents a stable source of income that bondholders will receive throughout the lifetime of the bond. Factors affecting the coupon rate include:
Bond yield is the discount rate used to convert future cash flows to present values to derive the price of a bond. The yield is comprised of the bond’s market issuance premium – the “credit spread” – and the benchmark rate (e.g. U.S. treasury yield). Bond yield has an inverse relationship with bond price. As yield increases, the bond price decreases. Conversely, if bond yield decreases, bond price will increase.
|Benchmark U.S. Treasury (UST)
|Benchmark UST Yield
|Spread to UST Curve
This corporate bond has a credit spread of 50 bps above the 10-year U.S. treasury yield. The bond yield for this bond is therefore, 2.066%. Deriving the appropriate yield is essential for the investor as it determines the price of the investment, helping them make informed investment decisions that are appropriate for their investment style.
The benchmark rate represents a similarly termed rate for a federal government bond. These benchmark bonds typically have low risk of defaulting (e.g. U.S. treasury, government of Canada). Major factors affecting the benchmark rate include:
The benchmark rate reflects the relative health of the economy and is largely influenced by macroeconomic factors. Despite having little influence on the benchmark rates, investors need to maintain an up-to-date knowledge of these rates and the implications on their respective portfolios.
The credit spread is the portion of the bond yield that an investor would require to invest in a non-government benchmark bond offering. It is measured in bps (0.01%). Credit spread is determined by the issuer’s credit strength, comparable bonds in the market, and investor sentiment. Major factors affecting the credit spread include:
Determining an appropriate credit spread is essential to the investor’s investment analysis. If the credit spread is too low, the investor will receive unattractive yield. Conversely, if the credit spread is too high, the investor should be considerate of the credit risk of the issuer. The credit spread for a new issue is derived by:
The fixed income market is an over-the-counter (OTC), bilateral market in which trades occur between counterparties at negotiated prices. As a result, multiple transactions of the same bond may yield greatly varying prices. In contrast to the exchange-traded equity market, investors in the fixed income market may experience pricing and liquidity challenges.