Bill Chepell | Chicago, Illinois

Corporate Bond Market – Understanding how it works

Why is the bond, or fixed income, market so opaque?  This is most easily explained by detailing the two primary differences exist between the equity and bond markets.

(1) Bonds are not traded on exchanges.  While the equity markets have exchanges which provide a centralized settling function in which buys and sells are matched, the bond markets operate under an OTC (over-the-counter) approach.  This means a dealer who is usually the bond desk of a major bank provides a potential bond investor with a price quote.

Under this arrangement, the dealer owns an inventory of bonds and sells these securities to investors.  Typically, banks are involved as a significant investment is required to build up an inventory of bonds which is needed to service investor demand.  This provides the market with liquidity as the dealer provides “ask” prices for all the bond issues in the desk’s inventory.  In trading jargon, the desk is referred to as a “market-maker”.

This allows price transparency to be considerably easier for equity markets.  For the OTC bond market, dealers hold the prices of their recent transactions without a central entity such as an exchange consolidating the prices and reporting this information.  Transparency into daily bond prices is dependent on financial information providers such as Bloomberg or Reuters performing this consolidating and reporting role.

(2) The 2nd primary difference is the extraordinary number of available debt issues.  Companies tend to issue new bonds whenever financing needs or market opportunities (ultra-low interest rates) arise.  A well-diversified debt maturity structure allows companies to reduce refinancing risk.  However, the end result is that large corporate issuers have a sizable number of issues outstanding and trading is fragmented across the universe of bonds.  For instance, while GE has only one common stock security available for investors, there were 905 GE bond issues outstanding recently.  Each is unique in regards to the coupon rate, issue amount, maturity date, security interest, covenants and possible provisions (convertible, callable, putable).