Corporate bonds are more complex to invest in than stocks. Essentially, corporate bonds represent a promise from the company to pay back the money plus interest. The bond market is also known as the debt market because companies use debt (bonds) to finance their operations.
New Bond Issuance Market
The corporate bond market consists of two distinct levels. The first market or primary market represents new bond issuances. When a company decides to sell bonds to raise capital, it negotiates with investment banks and large institutional investors to place those bonds in the market.
The pricing of these new issuances, which is similar to initial public offerings (IPOs) of stocks, is easier to understand. Anyone who buys a new bond issuance pays the same price, known as the offering price.
Note: Buying a new bond issue is quite challenging – it’s akin to buying shares in an IPO before public trading begins. To purchase a new bond issue, you will need connections with someone at a firm managing the initial bond offering. Small investors will find it difficult to play this game easily.
The chart below shows the yield of Moody’s AAA corporate bond from 1919 to 2020.
The Secondary Market
The secondary market involves buying and selling bonds after the initial offering. Small investors can access this market but should approach it with caution.
The secondary bond market consists almost entirely of what is known as the over-the-counter (OTC) market. In OTC bond markets, most trades are conducted on closed proprietary bond trading systems or via telephone.
The average investor can only participate through a broker. Importantly, the pricing of bonds in the secondary market can be complex to track and understand.
Do Secondary Market Research: If you are interested in buying corporate bonds in the secondary market, perform sufficient research to determine if you are paying a reasonable price for the bond. Especially look at recent bond sales to calculate the “markup” or “spread” on the bond.
The markup refers to the difference between what the bond broker paid for the bond and the price they want for it.
Before agreeing to buy a bond through a broker, look at the recent offers for that bond or a similar issue. Then make an approximate calculation of how much spread your broker is charging.
Note: Unlike stock commissions, the spread in bonds is built into the bond’s price, making it difficult to know how much profit the bond seller is making.
After you determine what the spread or commission you are likely to pay is, if your broker does not hold the bond but promises to acquire it for you in the market, your work has only just begun.
Buying a corporate bond requires a significantly higher level of study and analysis than buying a stock. Follow the advice of trade associations that monitor the market and conduct thorough research on your financial professional.
The Public Exchange
A series of scandals among bond sellers has led to increased transparency in how the industry operates. Gradually, the bond market is evolving and beginning to resemble the stock market.
Today, it is possible to buy and sell bonds on the public exchange. The New York Stock Exchange launched the NYSE Bonds system in 2007, replacing the old automated bond system with something that works better for small investors.
Note: The number of bonds sold through NYSE Bonds has significantly increased since its launch, with new bond issues added regularly. However, exchange-traded bonds remain a small percentage of the overall market.
Bonds can be a wise investment, although thriving in the corporate bond market requires a great deal of caution and effort. Consider mutual funds for bonds or government-backed debt as an alternative that provides bond safety without the complexities of purchasing individual corporate bonds.
Authorities
Regulation of the Bond Market
When trading bonds, it is helpful to know the agencies that regulate the markets and find information that can help protect you from unethical brokers or dealers. Restricting your trades to regulated exchanges significantly reduces your exposure to risk and unethical practices.
The Financial Industry Regulatory Authority (FINRA), a non-governmental regulatory body, provides information on recent bond transaction prices through its Trade Reporting and Compliance Engine (TRACE), offering some insight into spreads. The agency also provides alerts to investors to help them protect their money.
Each of the exchanges on which you can trade has regulatory programs to ensure that trading is conducted fairly and honestly, and complies with federal, state, and exchange regulations. For example, the bond market on the New York Stock Exchange is regulated by NYSE Regulation, which monitors all trading activities on the New York Stock Exchange. Be sure to check the information on the websites of the exchanges you decide to trade on.
Source: https://www.thebalancemoney.com/how-to-buy-a-corporate-bond-417098
Leave a Reply