We’ll start with the primary market and by this we mean the offering and sale of a brand new bond. There are two ways that a company or country initially issues and sells their bonds to investors: a “bought deal” or an “auction.”
In a bought deal, an investment bank (like Goldman Sachs or Morgan Stanley) buys the entire lot of bonds at a set price. Usually, the different investment banks submit bids to the bond issuer indicating how much they would pay for all the bonds being offered. The issuer chooses the best deal for them—based on price, experience, and the ability to resell to other investors.
In a bond auction, buyers bid to purchase a portion of the bonds for sale. In a “single-price auction,” all winning bidders pay the same price for the bonds being issued. In a “multi-price auction” winning bidders may pay different prices. Bond issuers conduct auctions to access investors directly and design them to raise capital at the lowest possible rate of interest. Of course, bond issuers don’t always succeed in this endeavor—whether an auction or bought deal is the best option depends on individual circumstances.2
Demand for a bond auction is judged by what is known as the bid-to-cover ratio. The bid-to-cover ratio is the total dollar value of all bids divided by the dollar value of the bonds being auctioned. If there is $300 million worth of bids for $100 million worth of bonds, the bid-to-cover ratio is 3. A bid- to-cover ratio above 2 is considered strong demand for a bond issue. Thus, if you read a story about the latest issuance of, say, Spanish sovereign debt and demand is considered weak, it reflects a low bid-to-cover ratio.
Buying bonds over the counter
After being initially issued, bonds then trade in secondary markets. This is where ordinary investors purchase them alongside large investors. However, there is a key difference between how stocks and bonds are traded on secondary markets: stocks are traded on exchanges while bonds are traded over the counter.
Stock exchanges centralize all buying and selling orders in one place, and every investor can see these orders. Orders to buy are called bids, while orders to sell are called asks or offers. All traders can transact at the best available price, and once a trade takes place it is immediately recorded publicly so everyone can see the latest trade and price at which it was transacted. Exchanges aren’t without their problems, but they generally encourage wide participation, promote transparency, and help create a level playing field.
But most bonds don’t trade on an exchange. They trade over the counter—which means that investors engage in one-off deals with each other often through informal networks of bond dealers. Unlike exchanges, bids to buy and sell a particular bond are not centralized or seen by all market participants. Dealers can quote different bid and ask prices to different customers, and the latest trades aren’t centrally posted for all bonds immediately after a trade takes place. The Financial Industry Regulatory Authority (FINRA), a self-regulatory body with jurisdiction over many over-the- counter bond dealers, posts the transaction prices for many corporate and municipal bonds with a slight delay through its TRACE system. TRACE stands for Trade Reporting and Compliance Engine, and bond dealers are required to submit trade records for many different types of bond transactions to this system. Yet TRACE does not display bids and offers from dealers pre-trade and excludes certain types of bonds, such as those with a maturity of less than one year.3 Over-the-counter markets remain less transparent than exchanges.
Why are bonds traded over the counter?
First, there are a lot more bonds than stocks. GE has only one stock but more than 1,000 types of bonds with different yields, maturities, and even currency denominations.4 There are roughly 5,000 stocks trading on major exchanges in the U.S., while there are likely hundreds of thousands of different bonds.5 An exchange for all of them would be enormous.
Second, bond trades are typically much larger than stock trades. The average size of a stock trade is less than $10,000.6 The average bond trade exceeds $500,000, which means most bonds are purchased by large institutional investors.