How does the bond market work?

The issuance of bonds is the largest source of capital for corporations and governments. In fact, according to Investor Learning Centre of Canada, the Canadian bond market is 35 times larger than all of Canada’s stock markets combined.

Bond markets are often referred to as Over-the-counteror Dealer markets.

Unlike common and preferred shares, bonds, with the exception of Convertible or Exchangeable bonds, do not trade on an organized exchange or trading floor. Rather the bond market is a network of bond traders, at investment dealers, banks, insurance companies, etc., connected by phones and computers.

For bonds that have a Convertibleor Exchangeable into common shares feature, these bonds will trade on an organized stock exchange (such as the Toronto Stock Exchange) under a trading symbol.

The bond market is divided into two basic markets – the primary and secondary bond markets.

When an issuer (corporate or government) decides to borrow funds by issuing a new bond, they will contract an investment dealer to provide advice about the bond market and the bond features demanded by the market, as well as, to lead the search for potential investors.

The investment dealer will also assist with the preparation of the issuer’s prospectus (a legal documentthat describes the issuer and the new bond issue in detail). The issuer is required by law to prepare the prospectus and provide to investors when a bond issue is to be marketed to the public.

The dealer and issuer will also review the current bond market environment, the issuer’s financial qualities and the potential demands of investors. From this assessment the dealer and issuer will decide the best type of debt security to be issued and what features will need to be imbedded in the issue.

The investment dealer will also be responsible for the successful marketing of the bond issue to investors. In this regard, the dealer can purchase the entire amount of the new bond issue (referred to as Bought Deal) and then sell the bonds to investors or the dealer can act as the issuer’s agent and market the securities directly to investors.

An issuer may choose to sell the whole issue as a bought deal to eliminate uncertainty and receive the funds sooner. An investment dealer may decide to buy the issue as a bought deal, rather than acting as the issuer’s agent, because they can place the bonds with a single large purchaser, or they may feel they can earn a higher return. When an investment dealer purchases the bond issue as a bought deal and they in turn sell the bonds to investors, they do so not as an agent, but as a principal. By acting as a principal, the investment dealer has purchased the bonds from the issuer and then sells them to investors. By acting as an agent, the investment dealer does not own the bonds, but simply is a salesman hired by the bond issuer to sell the bonds to investors.

A new bond issue is marketed to investors accompanied by a prospectusand this is known as the primarybond market. The primary bond market moves monies from investors directly to the issuing corporation or government.

The secondarymarket provides an opportunity for investors to buy and sell their bond investments at anytime prior to the bonds maturity date. Here investors buy and sell bonds between each other with none of the money going to the original issuer of the bond.

The secondary market is the resale market for debt securities, which is important for the success of the primary bond market.

For the individual bond investor, the secondary bond market is established by the bond traders at their selected full-service or discount brokerage firm. The full-service or discount broker will provide a list of the bonds available for purchase, within their bond inventory, and the same bond traders will be the purchaser of any bonds an investor wishes to sell. In the secondary bond market, the brokerage firm is acting as principal, buying and selling bonds for the brokerage firm.

The bond market operates through the interaction of the individual bond traders employed by the bond dealers. Because this is a less open and transparent platform than those of the stock markets, The Investment Industry Regulatory Organization of Canada (IIROC) and the various securities administrators have implemented rules and regulations to govern bond market operations.

Related Questions