Fixed Income · Reading 53
Fixed-Income Issuance and Trading
CFA Level I · Fixed Income · Reading 53 · about 31 min
What you'll learn
- LOS 53.a Describe how bond markets are segmented (issuer type, credit quality, original maturity and other features) and where issuers and investors sit on the credit/maturity spectrum.
- LOS 53.b Describe aggregate and narrower fixed-income indexes and how bond indexes differ from equity indexes (constituents, turnover, weights, benchmark fit).
- LOS 53.c Compare primary bond issuance (public offerings, private placements, underwritten, best-efforts, shelf, auctions) and OTC secondary trading with equity markets.
Module 53.1
Fixed-Income Issuance and Trading
This reading maps the bond market by issuer type, credit quality and original maturity, shows where different issuers and investors sit on that map, and compares bond indexes and bond trading with their equity counterparts. A candidate must be able to classify a bond by segment, match a funding need or an investor to a part of the spectrum, and explain how primary offerings and dealer markets work.
LOS 53.a — Market segments, issuers and investors
Global bond markets are split mainly along three lines: the type of issuer (also called the sector), credit quality and original maturity. Other ways to classify bonds include currency, the issuer's geography (for example developed market versus emerging market bonds) and environmental, social and governance (ESG) features.
Key concept
| Dimension | Main categories |
|---|---|
| Type of issuer | Governments (sovereign and non-sovereign), corporates, and special purpose entities issuing asset-backed securities (ABSs) |
| Credit quality | Investment-grade bonds: AAA down to BBB− (S&P) or Aaa down to Baa3 (Moody's). High-yield bonds (speculative or "junk"): BB+ or lower (S&P), Ba1 or lower (Moody's) |
| Original maturity | Short-term, 1 year or less (money market securities); intermediate-term, 1 to 10 years; long-term, over 10 years |
Credit ratings come from credit rating agencies such as S&P and Moody's.
Exam convention: money market securities have an original maturity of one year or less; the same segment is also described as maturities of less than one year. Current practice: the money market label is used for instruments issued with maturities of up to about one year, such as Treasury bills, commercial paper and repos, so the two descriptions differ only for an original maturity of exactly one year.
The issuer credit/maturity spectrum
| Credit segment | Short-term (≤ 1 year) | Intermediate-term (1–10 years) | Long-term (> 10 years) |
|---|---|---|---|
| "Default risk free" | Treasury bills | Treasury notes | Treasury bonds |
| Investment grade | Repos, commercial paper, asset-backed commercial paper (ABCP) | Unsecured corporate bonds, ABS | Unsecured corporate bonds, MBS |
| High yield | — | Secured corporate bonds, leveraged loans | — |
- Secured new corporate issues sit in the high-yield row. An issuer with less dependable operating cash flows has to pledge collateral to attract lenders.
- ABCP is commercial paper backed by financial assets, so it counts as a short-term asset-backed security. The spectrum places it in the investment-grade row, not in the default-risk-free row.
- Fallen angels are bonds of issuers that were investment grade but have since been downgraded to high yield because their credit quality deteriorated. They are part of the high-yield sector.
Issuer choices
What a corporation issues depends on its access to capital markets and on what the money is for. A well-established investment-grade company can match funding to use:
- Commercial paper funds short-term (including seasonal) working capital needs.
- Intermediate-term debt funds medium-term investments and permanent working capital.
- Long-term debt funds capital investment in fixed assets.
Short- and medium-term borrowing is often arranged, for a fee, with a syndicate of banks that provides credit facilities, so the company can draw funds when it needs them. For a riskier company whose operating cash flows are less stable, access to secured short-term financing and leveraged loans is likely to be limited.
Investor positioning
Investors choose where to sit on the spectrum according to the interest rate and credit risk they want and the timing of the obligations they must meet.
| Investor | Typical position | Why |
|---|---|---|
| Pension funds, insurance companies | Long-term, investment grade | Match long-dated liabilities (pensions, claims); regulation often bars high-yield holdings |
| Money market funds | Short-term, at the boundary between default-risk-free and investment-grade instruments | Hold short, high-quality paper for liquidity |
| Corporations | Short-term investment grade (commercial paper, repos, ABCP) | Earn a return on excess liquidity |
| Central banks | Intermediate-term Treasury notes | Monetary policy: buying adds to banks' reserves, selling drains them |
| Bond funds and ETFs | Intermediate investment grade (excluding Treasuries), per mandate | Stated fund objective |
| Asset managers seeking higher returns, hedge funds, distressed debt funds | Intermediate high yield; distressed debt at the lowest credit quality | Higher expected return |
| Financial intermediaries (banks) | Treasuries across all maturities | Manage interest rate and liquidity risk |
Example. Orchard Valley Foods, rated A, has three funding needs: (1) a build-up of inventory ahead of its peak selling season, repaid within five months; (2) a four-year warehouse-automation project; (3) a processing plant with a 30-year useful life. The natural matches are commercial paper for (1), an intermediate-term note for (2), and a long-term bond for (3).
Common exam traps
- BBB− (S&P) and Baa3 (Moody's) are the lowest investment-grade ratings. BB+ and Ba1 are the highest high-yield ratings.
- Classifying a bond as a money market security because little time is left to maturity. Only the original maturity (one year or less) counts.
- A fallen angel has been downgraded to high yield. That alone does not make it distressed debt, which requires the issuer to be in, or expected to file for, bankruptcy.
- Placing central banks in the short-term segment. On the investor map they sit in intermediate-term Treasury notes.
LOS 53.b — Fixed-income indexes
Bond indexes differ from equity indexes in three ways:
- More constituents. One corporate issuer may have dozens of bonds outstanding but only two or three share classes. Because a full replica would be impractical, bond index tracker funds use sampling to keep transaction complexity reasonable.
- Higher turnover. Bonds mature, get called or retired by sinking funds, and new bonds are issued far more often than new shares appear. Constituents are therefore removed and replaced (turnover) more often than in equity indexes, and the bond universe is less stable than the stock universe.
- Weights driven by issuance. Governments are usually the largest borrowers, so broad bond indexes carry large weights in sovereign bonds. As issuance trends in maturity and credit quality shift, index weights shift with them.
Key concept
| Feature | Equity index | Bond index |
|---|---|---|
| Number of constituents | Fewer | Many more |
| Turnover | Lower | Higher |
| Tracking method | Full replication common | Sampling |
| Largest weights | Largest listed companies | Usually sovereign issuers |
Aggregate indexes hold a broad selection of bonds across many sectors and currencies, but they still apply entry rules. Narrower indexes concentrate on a particular geography, sector, credit quality or maturity range, and some also apply ESG screens. Three well-known indexes show the range:
| Index | Type | What it holds | Credit rule | Other rules |
|---|---|---|---|---|
| Bloomberg Barclays Aggregate Index | Aggregate | Bonds from all sectors in 28 currencies | High-yield and unrated issues excluded | Minimum issue size |
| JP Morgan Emerging Markets Bond Index Plus | Narrower: geography and credit quality | US dollar-denominated emerging market sovereign debt | Baa1/BBB+ or lower | Minimum size and maturity limits |
| Bloomberg Barclays MSCI Euro Corporate Sustainable SRI Index | Narrower: ESG | Euro corporate bonds | Baa3/BBB− or higher | Minimum ESG rating of BBB; sectors such as alcohol and thermal coal generation screened out |
A bond fund's benchmark should have the same sector focus, credit quality and maturity profile as the fund.
Common exam traps
- Reversing the index comparison. Bond indexes have more constituents and higher turnover than equity indexes.
- An aggregate index is broad but does not hold everything. High-yield, unrated and small issues are left out.
- The benchmark-matching dimensions are sector, credit quality and maturity. Coupon level and return volatility are not on the list.
LOS 53.c — Primary and secondary bond markets
Primary market
In a primary market transaction the issuer sells newly created bonds and receives the cash. Two routes are available:
- Public offering: the issue is registered with securities regulators and sold to the public.
- Private placement: the issue is sold only to one investor or a small group of selected investors.
Both routes normally use investment banks as intermediaries. A company selling its first-ever bond is a debut issuer. It is typically a growing firm replacing bank loans with bonds. A debut issue needs weeks of investor roadshows and is usually slower to complete than later issues. Repeat issues are much quicker. When an investment-grade issuer that borrows frequently has a fully underwritten shelf registration, a deal can be agreed, completed and allocated within hours, because investors already know the issuer and the regulatory registrations are already in place. A small high-yield issue with detailed covenants and collateral, sold on a best-efforts basis, takes far longer.
Key concept
| Method | Price risk | Key feature |
|---|---|---|
| Underwritten offering | Intermediaries guarantee the issue price | Bank bears the risk of unsold bonds |
| Best-efforts offering | No price guarantee | Bank earns a commission for placing the bonds at the best price it can |
| Shelf registration | Either | Aggregate amount registered once with a master prospectus; bonds issued over time as funds are needed |
| Public auction | Set by bids | Used for some bonds, especially government bonds |
Secondary market
In the secondary market investors trade bonds that are already outstanding. Some trading uses electronic platforms or exchanges, but most bond trading is in over-the-counter (OTC) dealer markets. Most equity trading, by contrast, happens on exchanges. Dealers quote a bid price (at which they buy) and an ask or offer price (at which they sell). The ask is always above the bid, and the difference is the dealer's spread. It depends on liquidity:
- A fraction of a basis point applies to liquid, recently issued (on-the-run) developed-market sovereign bonds and to bonds of high-quality frequent corporate issuers.
- 10–20 basis points or more applies to less liquid, smaller or older (seasoned) corporate issues.
The dealer's spread therefore signals how liquid an issue is.
Example. A dealer quotes a bond at 97.20 bid and 97.32 ask per 100 of par. The spread is 0.12 per 100 of par, or 12 basis points. That is typical of a seasoned, thinly traded corporate issue. An on-the-run government bond would be quoted far more tightly.
Distressed debt is the debt of issuers that are in bankruptcy or expected to file for it. It has a low credit rating, high risk and a high promised yield. Distressed debt investors often buy from institutions that are not allowed to hold low-rated bonds. They hope to profit from a turnaround, a better-than-expected recovery, or a value-creating restructuring. Entering distress can temporarily lift trading in a normally quiet issue.
Common exam traps
- In an underwritten offering the price is guaranteed. In a best-efforts offering the bank earns a commission and gives no guarantee. Shelf registration concerns timing (issuing over time) and says nothing about price risk.
- Selling an entire issue to a single investor is a private placement.
- National governments are the typical auction issuers. Corporations and municipalities usually sell through intermediaries.
- A wide bid-ask spread signals illiquidity. On its own it says nothing definite about credit rating or issuer type.
Bottom line
- Bond markets are segmented mainly by type of issuer (sector), credit quality and original maturity.
- Investment grade means a rating from AAA down to BBB− at S&P, or from Aaa down to Baa3 at Moody's; a rating of BB+ or below (Ba1 or below at Moody's) is high yield.
- Exam convention: money market securities have an original maturity of one year or less, intermediate-term ones between 1 and 10 years, and long-term ones more than 10 years; current practice applies the money market label to instruments issued with maturities of up to about one year, such as Treasury bills, commercial paper and repos.
- Fallen angels are bonds of issuers downgraded from investment grade to high yield because their credit quality deteriorated, while distressed debt is the debt of issuers that are in bankruptcy or expected to file for it.
- A well-established investment-grade company can fund short-term (including seasonal) working capital with commercial paper, medium-term investments and permanent working capital with intermediate-term debt, and fixed-asset investment with long-term debt.
- Compared with equity indexes, bond indexes have many more constituents and higher turnover, tracker funds use sampling, and broad bond indexes usually carry large weights in sovereign bonds.
- In an underwritten offering the intermediaries guarantee the issue price; in a best-efforts offering they earn a commission with no price guarantee; a shelf registration registers the aggregate amount once and lets the bonds be issued over time.
- Most secondary bond trading takes place in over-the-counter dealer markets, and the dealer's spread between ask and bid widens as liquidity falls: a fraction of 1 bp for on-the-run sovereign debt of developed markets, and 10–20 bp or more for seasoned, smaller or less liquid corporate issues.
Quick check
A bond database lets users group bonds along several dimensions: type of issuer (sector), credit quality, original maturity and currency. Which of the following groups results from sorting bonds by type of issuer?
Show answer and explanation
Correct answer: C
Classification by type of issuer (sector) separates governments (sovereign and non-sovereign), corporates, and special purpose entities issuing asset-backed securities. Bonds issued by special purpose entities are grouped by who the issuer is, so this group results from sorting by issuer. The other two groups come from the currency and original-maturity dimensions.
Why the other options are wrong
- A. Bonds denominated in euros are grouped by currency, which is one of the other ways to classify bonds. Any type of issuer can sell bonds in euros.
- B. Money market securities are defined by original maturity (one year or less). Any type of issuer can sell them.
Key takeaway Sort the labels: type of issuer (governments, corporates, special purpose entities issuing ABSs), credit quality, original maturity (money market, intermediate, long-term), and other dimensions such as currency, issuer geography and ESG features.
Practice Questions
An analyst compares bond market indexes with stock market indexes. Which of the following statements is least accurate?
Show answer and explanation
Correct answer: C
The bond universe is constantly changing. Bonds mature, are called or retired through sinking funds, and new issues come to market all the time. Bond indexes therefore have higher turnover than stock indexes, so the claim that their membership changes less often is inaccurate. This instability is one reason bond indexes are harder to build and track.
Why the other options are wrong
- A. This is accurate. Because issuers have many bonds each, bond indexes hold many more constituents than stock indexes, which is why tracker funds use sampling.
- B. This is accurate. It is the reason bond indexes have so many more constituents than equity indexes.
Key takeaway Bond vs. stock indexes: more constituents, higher turnover, and weights driven by issuance (large sovereign weights).
Which of the following issuers most likely sells its new bonds through a public auction?
Show answer and explanation
Correct answer: A
Public offerings of government debt commonly take place through auctions, and sovereign (national government) issuers sell their bonds through regular public auctions. Corporations normally issue through investment banks, in underwritten or best-efforts offerings, or through private placements.
Why the other options are wrong
- B. Corporate bonds are usually sold through an investment bank on an underwritten or best-efforts basis, or placed privately with a small group of investors.
- C. A municipality is a local, non-sovereign government. Regular public auctions are the standard method for sovereign (national government) debt, so a national government is the more likely auction issuer.
Key takeaway Auctions are the standard route for government (sovereign) debt.
Tamsin Hale wants to buy $2 million face value of a mid-sized corporate bond that was issued six years ago and now trades only infrequently. She is most likely to:
Show answer and explanation
Correct answer: B
A bond that was issued years ago is bought in the secondary market, where previously issued bonds trade among investors. Although some electronic platforms and exchange-based trading exist, most secondary bond trading still takes place in the dealer, or over-the-counter (OTC), market: dealers post bid (purchase) and ask (selling) prices, so a buyer pays the ask. The dealer's spread depends on liquidity, and for a smaller, older (seasoned), infrequently traded corporate issue it is typically 10 to 20 basis points or more.
Why the other options are wrong
- A. Auctions are a primary-market method for selling newly issued bonds, used mainly by governments. A bond issued six years ago is already outstanding, so it must be bought from another investor in the secondary market, and corporations usually issue through underwritten or best-efforts offerings rather than auctions anyway.
- C. Exchange trading dominates for shares, while most secondary bond trading is OTC. Spreads of a fraction of a basis point are found only on very liquid bonds, such as on-the-run developed-market sovereigns and bonds of frequent high-quality corporate issuers. A seasoned, thinly traded issue is quoted much wider.
Key takeaway Previously issued bonds trade mainly OTC through dealers, and the buyer pays the ask. The dealer's spread widens as liquidity falls, from a fraction of a basis point for on-the-run sovereigns to 10–20 bp or more for seasoned corporates.
This reading has 26 questions in the full bank. Practice all of them.
Key Takeaways
- Sort the labels: type of issuer (governments, corporates, special purpose entities issuing ABSs), credit quality, original maturity (money market, intermediate, long-term), and other dimensions such as currency, issuer geography and ESG features.
- Bond vs. stock indexes: more constituents, higher turnover, and weights driven by issuance (large sovereign weights).
- Auctions are the standard route for government (sovereign) debt.
- Previously issued bonds trade mainly OTC through dealers, and the buyer pays the ask. The dealer's spread widens as liquidity falls, from a fraction of a basis point for on-the-run sovereigns to 10–20 bp or more for seasoned corporates.