The US corporate bond market is the largest in the world with yearly issuance volumes of around $1.5 trillion and a total outstanding amount of $18.3 trillion.1
Fideres has analysed the issuance pricing of corporate bonds for the period 2010-2015 and found evidence which hints to systemic under-pricing of approximately 0.5%. In turn, this implies that over the same period US corporates may have paid as much as $18 billion in excess interest.
Fideres' work also shows that alternative pricing mechanisms (such as the auction system used by the US government) have the potential to deliver more competitive pricing to corporate bond issuers. It seems anachronistic that corporate bonds are still priced and sold using the same opaque system used before the internet revolution.
Why are corporate bonds overpriced?
In order to issue debt in the form of a bond, firms typically appoint a bank (also referred to as a dealer) to act as lead manager. The role of the lead manager is to advise the bond issuer on the price and placement of the bond and to sell it to its client base.
The incentives which exist that could encourage a dealer to under-price a bond are the result of two potential conflicts of interest.
- The first conflict arises because dealers are supposed to act as advisers to the bond issuer while also retaining a portion of the bond in order to provide liquidity in the secondary market. As such, a low price is both a source of lower risk (the bond is more likely to be in demand), as well as a source of potential profits (the bond price is more likely to rise after issuance if it has been under-priced).
- The second conflict of interest results from the fact that dealers have a relationship with the issuer and the investor community at the same time. Dealers face pressure from investors to provide bonds at low prices. Because dealers typically generate a large amount of trading revenues serving their respective client bases, it may be difficult to make both sides happy at the same time. In 2014, the SEC2 conducted an investigation into the allocation of corporate bonds to the customers of Goldman Sachs and Citigroup. It was alleged that investors who have close relationships with the banks receive preferential allocation over other investors when purchasing corporate bonds.
Why does this phenomenon persist?
A simple question arises: if the phenomenon is so widespread, why aren't corporate issuers keeping dealers accountable? Alternatively, why don’t dealers point out this phenomenon to corporate clients in order to take business away from their competitors?
Firstly, the potential under-pricing of bonds is driven principally by an asymmetry of information. Dealers who manage the placement of the bonds know the level of demand from investors, but the corporations which issue the bonds and access the capital markets generally do not. Since the incentives of the two parties are not aligned, there exists a principal agent dilemma, which corporations cannot overcome since they lack the relevant information. The result is that lead managers may have an incentive to price the bond cheaply at the expense of their clients in order to achieve extra profits.
Source: Thomson Reuters
Secondly, upon learning of the under-pricing, the senior management of the firm which issues the bonds are then either unwilling or unable to challenge the pricing due to their firm’s dependency on the multitude of services that are provided by banks. The issue is then entrenched by a market concentration which prevents smaller financial firms from winning business from the larger players (see chart above).
How prevalent is bond under-pricing
Fideres has found that there is a substantial price increase of over 0.50% in price terms over 70% of the time on the first day of trading. This is after accounting for any interest and credit risk. The trend then generally continues over the next 3-5 days. This compares with government bonds which show an average price increase of only 0.15% over the same period.3
Source: Bloomberg, Fideres’ calculations
Even more notable however is the fact that banks have proven considerably more effective in pricing their own bonds. Fideres found that dealers bonds increased in the period after issuance by only 0.30%.
If you would like to discuss this matter further, please contact Fideres on +44 20 3397 5160 or +1 212 796 5785.
1 Source SIFMA.
2 Source The Financial Times.
3 Fideres analysed a sample of over 700 corporate bonds issued after 1 January 2010 and valued between USD 500 million - USD 1 billion. For comparison we analysed a sample of US Treasury notes issued after 1 January 2010.