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I am interested in Debt Capital Markets but I am struggling to understand how bonds, particularly corporate bonds, are priced initially. I know that a company will tap an investment bank as book runner to place a bond on the market.

Does the book runner take the bond onto its books, i.e. does it initially underwrite the bond? And only then does it place the bond on the market?

Further, once the bond is placed onto the market, I know that the potential lenders will send bids regarding ticket size, but will the interest rate be included? Once all bidders have submitted, how is the interest rate of the bond determined? And furthermore, is the bond always issued at par? Or is the coupon always initially determined, and then adjusted. So many questions. I realize Quantitative Finance may not be the correct forum, but I would be extremely grateful if someone could answer my questions.

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2 Answers 2

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I am not an investment banker, but usually the procedure is something like this:

(0) The IB knows the yield of existing bonds with the same maturity and credit rating, so it is not too difficult for them to estimate the yield of the new bonds. They usually announce this as a spread above a benchmark (Ex: "We estimate the new bonds will yield 25 to 50 bps above Treasuries") They tentatively assign a coupon rate such that the bonds will sell approximately at par (at a price of 100).

(1) They contact a large number of institutional investors who might be interested in the new bonds, asking them how much they would be willing to buy and at what price. If demand is low they usually increase the coupon but sometimes lower the price (increase the yield) a little and vice versa if demand is high. This is called the book building process.

(2) Once they have established that they can sell the entire issue to specific buyers, they announce the final price and "underwrite" the bonds, meaning they commit to buy the bonds from the issuer at that price (minus fees, of course).

(3) The buyers send in orders to buy bonds, specifying the quantity only (the price is already set). Of course they have already discussed with the IB the quantity they had in mind in Step (1) in a general way.

(4) The IB breathes a sigh of relief if all the bonds are sold, or is stuck with unsold inventory if things go wrong. The bonds begin trading in the market.

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  • $\begingroup$ So they do not necessarily underwrite bonds at par, but rather at a level that ensures the entire notional goes through the market? $\endgroup$
    – MinaThuma
    Commented Aug 13, 2019 at 5:56
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    $\begingroup$ First the origination team announces that the new bond will be in he range l-h basis points above risk-free benchmark (US treasury or mid swaps) (spread chosen by looking where similar bonds trade). The risk-free benchmark is one of the moving parts to keep in mind while talking to the people who might want to buy the new bond. At the end, the fixed coupon is the sum of the last benchmark level and the spread over the benchmark chosen so the bond would initially trade very close to par once it becomes free to trade. $\endgroup$
    – Dimitri Vulis
    Commented Aug 13, 2019 at 10:45
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    $\begingroup$ Thank you @Dimitri_Vulis for your suggestions to improve the answer. $\endgroup$
    – Alex C
    Commented Aug 13, 2019 at 12:34
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In addition to @AlexC answer there are 2 additional key points.

1) if the issue is oversubscribed the IB / syndicate team will choose the allocation to each client usually based on their relative importance in terms of future business.

2) There is a specific pricing call that takes place between the issuer and investment banks trading teams. This establishes the precise level of the benchmark bond/swap which then derives the exact new issue price at a specific point in time. Usually this moment is marked with large swap/bond future activity if either investors or the issuer hedge the issue at the point in time.

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