In earlier posts, we compared the pricing of corporate loans and corporate bonds. Here, we’ll look at how these markets interact, both in primary issuance and secondary market trading. First, some definitions:
- The Primary Market is where financial instruments are sold from the issuer to investors. This is often referred to at underwriting (in the bond and equity markets) or syndication (in the loan market). As part of this process, securities often pass through an intermediary, such as an investment bank.
- The Secondary Market is where financial instruments are sold from investor to investor. The issuer is not involved, and there is no underwriter (although there are brokers, and many underwriters also trade securities in the secondary market).
The Investors
- In the loan market, banks and institutions (such as collateralized debt obligations (CDOs) and prime rate funds) are the most active investors.
- In the bond market, institutions (such as mutual funds, pension funds, insurance companies and CDOs) are the most active investors; banks rarely buy corporate bonds.
The key to rational pricing in these markets are the crossover investors – institutions, such as CDOs and certain other investment funds, that can buy loans and bonds in the primary and secondary markets. By analyzing the relative value of loans and bonds, they decide which to buy. For example, if the spread between loans and bonds is very large, investors may buy the bonds and shun the loans. This increased demand for bonds will bring down their spreads in the secondary market, while the lack of demand for loans will increase their spreads in the secondary market. Eventually, the spread between loans and bonds will narrow. Thus, the secondary markets for loans and bonds are related.
Likewise, the primary and secondary markets are related. The spread a company will pay on new bonds or loans should be about the spread at which its existing debt is trading in the secondary market (or, if the company has no debt outstanding, the spread at which the debt of companies with a similar risk profile are trading).
Risk Flows Through All Markets
Thus, if debt investors becomes more risk averse, as happens at the beginning of a recession or credit crunch, we would see it first in the most active market, say the secondary market for corporate bonds, where spreads would widen dramatically. This would lead to a sharp rise in spreads in the secondary market for corporate loans, and finally to the primary markets for both loans and bonds. Finally, investors will also be comparing loan and bond prices to the other market for corporate credit risk, credit default swaps (CDS).