Bond Stuff: New Issue Shorts

File this post under "sharing expertise few people want."

As I'm in a position where I have to train a new recruit to understand the business I'm in, I figured why not post about the most basic topics as there may be others out there who want to now...

When a company (aka "Issuer") issues a new bond, typically the bank arranging the deal will sell more bonds than the company issues. For instance if the company issues $500m in bonds, the lead manager may distribute (sell) $525m in bonds thus creating a short position for themselves.

Why?

Because invariably, some of the buyers of the new bond are "flippers." This means they buy the bond and then sell immediately for a small profit. New deals are usually priced just a bit above the secondary market price (this is called the new issue premium). Whereas most investors take a longer term view, some guys just buy and flip. Banks try not to sell to these guys in the first place, but if you have a massive order book and sales people saying "please give this guy some he's a great client" it's hard to not sell to a few flippers.

The bond arranger is typically responsible for ensuring bond price stability of the new bond (for a few weeks at least) and also to make a market in those bonds.

So knowing some guys will be selling soon after the launch, the bank creates a short position for themselves and over the next few weeks buy back bonds to return to a flat position. If they didn't do this, when bonds were being sold, they'd either have to take a long position or fail to make a market. Of course it's possibly that there will be so much secondary market demand you don't have to worry about this, but a guy making a market on a new trade will not count on that.

The risk of course is if the bond rallies, the price climbs and now you lose money on the short (you have to buy at a higher price to get back to flat). If the bond price goes down you will make money on your short but as the whole exercises is to ensure price stability, you are actively working to stop this.

The gains and losses on this activity are market risk and they are a cost that most issuers are unaware of. They pay their bank a fee to arrange the bond but most don't realise that the bank will run a market risk on the deal.

So it is quite possible for a bank to lose money overall on a bond transaction because the fees from the issuer do not cover the market loss on the secondary trading activities.

Bond houses try to avoid this by setting the right fee but as competition in this space is so tight, it is not always possible to avoid a loss, particularly in good markets.

Labels: bond, finance, short, syndicate