The Issuance Procedure of High-Yield Bonds

When corporations need to secure funding, they have many options. There are the traditional options like applying for a loan from a bank, but many companies turn to bonds instead of stocks or bank loans because bonds offer many advantages over other forms of securing financing.

Issuing debt (in this case a corporate bond) instead an equity can provide various benefits such as the tax shield effect. As well, bonds can be clearly beneficial from the ownership standpoint. In short, a bond is an IOU written from a company to someone who loans them money. Bonds are paid back at a predetermined time referred to as the maturity date. For businesses with a less than investment-level grade standing, these bonds typically offer a high interest rate that often attracts potential investors in the fixed-income universe.

According to Standard & Poor’s Financial Services, when corporations intend to secure funding via high-yield bonds, they follow a basic three-step plan:

1. First, they draft an offering prospectus, or proposal that they use to negotiate rates and conditions with investors.
2. Once all the terms of this offering have been finalized, bondholders have securities allocated, or syndicated, to them.
3. Finally, these high-yield bonds are available for purchase on the secondary or aftermarket, from authorized dealers or brokers.

The company focuses on assuring prospective investors that the bonds are worth the risk. 

The first-time issuance of bonds to the public is considered the primary market (in contrast to the secondary or aftermarket). What this means is that the sales on this primary market result in funds going directly to the issuer. On the secondary or aftermarket, investors can resell bonds. In this case, the funds from sales go to the seller, not the issuer.

This allows banks to underwrite themselves a discount (gross spread) by actually selling bonds at a higher amount than they paid for them.

According to the Securities Act of 1933, all publicly offered securities must first be registered with the SEC. All of the following information must be contained in this registration:

• The type or nature of business
• A complete management profile of the corporation
• A listing concerning the principal investors
• All of the specific features about the security being offered
• Any/all investment risks
• Financial records and statements prepared by a CPA in accordance with U.S. GAAP.

The actual process of registering the security with the SEC takes place in two parts. First, the company must produce a publicly distributed prospectus and selected supplemental information that can be made available if requested. Then, upon approval of registration by the SEC, a company may then begin to offer the approved security for sale to the public.

Once a security is registered with the SEC, the next step in issuing the bond is to draft an offering proposal, or prospectus. This involves a process of soliciting competing bids from different banks or arrangers. In an attempt to be awarded the mandate, each bank will present the issuer with an outline of their strategy for the bond, including syndication and price offering. Banks will draw up an offering prospectus/memorandum (referred to sometimes a red herring) during this process to show the issuer their strategy.

There are several distinct parts of such a prospectus. Though not all contain all of these parts as described here, they tend to have sections according to the following:

1. Executive Summary: Most include a section with an executive summary that typically includes things like key financials, descriptions of the issuer, overviews of the offering and the rationale behind it and even risk factors. These risk factors are often quite detailed though they tend to be formulaic, or boilerplate, contract language.
2. Investment Considerations: There is typically a section to list preliminary terms and conditions. This includes things like structure, collateral, pricing, covenants or other terms of credit, and so forth.
3. Industry Overview: This is typically a description of the industry the business is in as well as critical information about their position in the market when compared to similar companies. The overview helps to educate investors who are not as familiar with the industry as to why they may want to purchase the bond.
4. Financial Model: Though the actual terms of the bond are not finalized at this stage, it’s common for prospectuses to include a pro forma coupon rate as some form of financial modeling. This includes detailed accounts of the company’s issuance history, projected financials and more. But in some cases, certain types of public information may be missing from this model. This model will be used to gauge the interest level of investors concerning the bond, which in term will be used to inform the marketing of the deal to investors.

Most of this process takes place internally–at meetings between bankers who pitch their ideas to the sales team. Discussions of the offering and its purpose and terms take place. Additionally, company management will provide vision for the offering, transaction and update. There may also be an investor call where the management gives a speech and does some Q&A with prospective investors.

This process may take a few days or just several hours. The time frame continues to shorten with the advent of the internet to facilitate roadshows, presentations, and Q&As with investors.

After this process is complete, and the terms of the bond are indeed finalized and allocations are received, the issue will become available on the secondary, or aftermarket.

This aftermarket is a well-established and very active market. In some cases, there are even “gray market” indicators of a deal before terms are finalized. The gray market refers to brokers who make deals before a bond is “freed to trade.” This has led to a push for greater transparency in pricing resulting in the Trade Reporting and Compliance Engine (TRACE) and the Financial Industry Regulatory Authority (FINRA) reporting system for bond trading.

FINRA was formed when the National Association of Securities Dealers (NASD) merged with the enforcement branch of the NYSE. The SEC approved this merger in July 2007. FINRA exists as a private, self-regulatory corporation (SRO).

TRACE is a “developed vehicle that facilitates the mandatory reporting of over-the-counter secondary market transactions in eligible fixed income securities. All broker/dealers who are FINRA member firms have an obligation to report transactions in corporate bonds to TRACE under an SEC approved set of rules.” The reporting disseminates (1) date & time, (2) volume, (3) pricing, (4) yield, and even more detailed information on trades or sales involving the FIPS 50—50 high-yield and liquid credits.

From a trader perspective, there has been a great deal of resistance to these measures made to increase transparency. They argue these measures erode profit margins whenever securities exchange hands. In general, investors prefer to trade paper exclusively at levels where the most recent executions have taken place. Regulators, on the other hand, point out that the increased information available to investors from tools like the TRACE are positive in the long run. They insist that not only institutional investors should a more detailed, and faster information flow but also retail investors should be given the crucial stream of information.