Bonds must be issued to be sold, and bond underwriting is a part of that process. The bond underwriting process will change based on the bond’s category, region, and regional legal regulations. The process in many nations is highly similar and can be simplified. If you are purchasing first time issues investigate the national regulations of the issuer’s home country. Any time you invest in foreign bonds, especially original issues, you will benefit from becoming familiar with that nation’s issuing regulations. The process is normally similar despite borders but unknown differences may cause big headaches.
A bond issue begins with a prospectus, which determines and describes the issue. The prospectus states the issuer, the financial condition of the issuer, and sometimes the purpose of the money acquired. It also sets the interest rate, debt payment schedule, and penalties for non-payment. In case of default, collateral will be listed in the prospectus. The prospectus is submitted to regulators, who will review the offer for its legality and determine if the prospectus is sufficient. If they think the prospectus is satisfactory the issuer continues into the underwriting process, if underwriters are necessary. If they think underwriting quality is inadequate they will block the issue until it meets regulations. Regulators do not determine the financial quality of the issue, only if it meets regulation guidelines.
The bond underwriting process separates by category. For some types of bonds, such as corporate bonds, underwriters are essential or required. For others, such as Sovereigns, and sometimes Sub-Sovereign or Municipal Bonds, underwriters are not required or are optional. National governments can skip underwriters and sell their bonds through dealers or directly to you, called a direct sale. This lowers the cost for issuers since they avoid underwriters or dealers completely and typically occurs via the internet. As investors become aware of the issue, they can purchase them from the issuer directly. However, it is common for direct sale issuers to limit the potential purchaser to institutional buyers or bulk buyers only.
Corporations are forbidden from selling via dealers without clearing the underwriting process or direct sales. Underwriters are investment banks or firms which ready an investment for sale in the market. If this includes more than one firm or bank, the group is called a syndicate. The benefit for issuers dealing with syndicates is a wider sales reach. Syndicates are usually international. They will allocate bonds to each firm or bank within the syndicate, each bank will begin sales simultaneously, typically at the same price and date. This stops syndicate members from undercutting each other.
The process used for bond underwriting is determined by how the underwriters want to get paid, which changes based on the issuer’s perceived risk. The bond underwriters can underwrite using Firm Commitment, which purchases the bonds, marks them at a higher price, and then resells them to the public. Their profit comes from the markup. This method incurs substantial risk, since the bonds may not sell at the new higher price. They may not sell at all. Underwriters generally only use firm commitment if the bond issuer seen as extremely qualified or the issue is guaranteed to do well. If they are seen as risky, they may use methods with reduced risk, such as Best Efforts. Issuers in best efforts underwriting processes receive the price investors are willing to pay. If the bonds fail to sell, or only partially sell, the underwriter incurs no loss. The underwriters receive a paid fee for their payment. To avoid risk, many underwriters attempt to sell riskier investments through this method since they are paid a set rate without worrying about sales.
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