The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

Setting the interest rate

The interest rate on a bond issue can be determined by a variety of methods. The most common is for the underwriter to set the rate based on market rates on the day of issuance. This, however, involves a certain amount of guesswork, and can lead either to excessive costs for the issuer if the interest rate is set too high, or to the underwriter being stuck with unsold bonds if the rate is set too low. Most syndicates prohibit their members from selling the bonds at less than the agreed price for a certain period of time, to keep the syndicate members from competing against one another. An alternative method of determining interest rates involves auctions. There are several auction techniques used in the bond markets. Competitive-bid auctions allow investors or dealers to offer a price for bonds being issued at particular interest rate (or, alternatively, to offer an acceptable interest rate for bonds being sold at par value). The offered price may go higher (or the offered rate lower) in successive rounds of bidding. The bonds may all be sold at the single highest price at which there are sufficient offers to sell the entire issue, or, in a multiple-price auction, each bidder that wins a share of the bonds will pay the last price it bid. In a sealed-bid action bids are submitted in writing. One popular type of sealed bid auction is a Dutch auction, in which the issuer sets an interest rate and bidders then submit schedules stating how many bonds they would buy at various prices; the bonds are sold at the highest price at which the entire issue is taken up.

Swaps

The fact that an issuer has sold a particular bond issue need not mean that the issuer is paying the expected amount of interest on that issue.  Increasingly, issuers make use of interest-rate swaps to obtain the financing schedule they desire. For example, an issuer might issue  $100m of five-year notes at a fixed interest rate, and then immediately enter into a swap transaction whereby an investment bank meets those fixed payments and the issuer makes floating-rate payments to the bank.
Whether such a transaction saves costs or reduces risk for the issuer depends upon the swap spread – the difference between a fixed rate and the current floating rate for a swap of a given maturity.


Selling direct

New technology has made it practical for some issuers to sell their bonds directly to investors over the internet, without the intermediation of underwriters or dealers. This is likely to lead to lower costs for some issuers, and to reduce the profits of investment banks and brokers that underwrite and sell bonds. The first online issue was an offering of $55m by the city of Pittsburgh, Pennsylvania, in November 1999. Since then, volume has grown rapidly. So far, all of these sales have involved only institutional investors. The investors have been able to learn about the issues, read financial materials  and submit “indications of interest” – tentative offers – over the internet, but the bonds have not actually been auctioned online. Most electronic underwritings have involved well-known issuers. Investment banks have been involved in each bond issue, although it is believed that the banks receive smaller fees for distributing new issues online than for traditional underwritings.

No more coupons

In the past, bond purchasers were given certificates as proof of their ownership. The certificates would often come with coupons attached,one for each interest payment due on the bonds. The investor would  detach the appropriate coupon and take it to the bank or securities broker in order to receive the payment.Paper bonds are now less common. They are still used for some registered bonds, which are issued in the name of the holder, and for bearer bonds, which are not registered in a particular name and may be sold by whoever has physical possession. Most debt securities, however, are issued as book-entry bonds, existing only as electronic entries in the computer of the trustee, the bank that is responsible for making interest payments on behalf of the issuer and, eventually, for redeeming the bonds. Tax authorities increasingly insist that bonds be issued in the name of a specific bondholder, as interest payments on bearer bonds are difficult to tax.

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