2.7Primary and Secondary Markets forDebt

One of the biggest financial markets in the world is the bond market, but corporate

bonds are not the big draw. Instead, U.S. government bonds and the government

bonds of a few other key nations such as Japan are the major focus of bond trading

activity.

Grinblatt136Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw136Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

56Part IFinancial Markets and Financial Instruments

The Primary and Secondary Market for U.S. Treasury Securities

The prices of U.S. Treasury securities are set initially in Treasury auctions. The sec-

ondary market functions because a few hundred dealers actively trade these securities

through a telephone-linked network and telephone-linked brokers who exist primarily

to provide anonymity when these dealers trade with one another. Because this second-

ary market is not an organized exchange, it is described as overthe counter(OTC).

²²—

The Federal Reserve designated about 40 OTC dealersmany of which are com-

mercial banks and investment banks—as primary dealers because of their participation

in Treasury auctions, financial strength, and customer base. These primary dealers make

markets in Treasury securities by quoting bid-ask spreads. They finance many of their

purchases with repurchase agreements(or repos or simply RPs)—loans that use Trea-

sury securities as collateral and thus need cash for only a small fraction of the purchase

price, typically about 2 percent.

,²³

Short saleswhich involve selling bonds that the seller does not own, make use

of reverse RPs, the opposite side of a repurchase agreement. Dealers use these short

sales in complicated trading strategies to offset interest rate risk from the purchases of

other debt securities. The dealers borrow the Treasury securities, usually overnight, and

provide loans to the security lender. The loan proceeds come out of the short sale.

The Primary and Secondary Market for Corporate Bonds

In contrast to the initial pricing of Treasury securities, the initial prices of U.S. corpo-

rate bonds, including notes, are typically set by the syndicate desk of the investment

bank, which issues the bonds to its largely institutional clients. The syndicate deskis

the place where the sales and trading side of the investment bank meets the bank’s cor-

porate side. The members of this desk price securities, talking simultaneously to the

corporate issuer and the investment bank’s salespeople, who are obtaining from insti-

tutional clients the prices at which they are likely to buy a particular issue. Up until

the moment of issue, the likely pricing of these bonds is quoted to the borrowing firm

and investors as a spread to the on-the-run Treasury security of closest maturity because

the interest rate level, which is set in the Treasury market, is volatile. In contrast, the

spread to Treasuries is more stable and thus a better indicator of how hard the invest-

ment bank has worked to keep the firm’s borrowing costs low.²⁴

The secondary market for corporate debt is largely an over-the-counter market con-

sisting of many of the secondary market dealers in Treasuries. The dealers also are

linked by phone and computerized quotation systems. Corporate bonds also are traded

on exchanges, but the number of exchange-listed bonds has been dropping over time,

and it is now a negligible part of the market.

Exhibit 2.17 provides secondary market pricing for Treasury securities on the over-

the-counter market.²⁵

Most corporate bonds are not actively traded. The illiquidity of

these bonds stands in marked contrast to recently issued Treasury notes and bonds and

the common stock of large corporations, which are all actively traded.

22

This number changes from time to time.

23

For more information on short sales, see Chapter 4.

24

The issuance process, described in more detail in Chapters 1 and 3, is similar to that for U.S. equities.

²⁵The

numbers after the colon for the bonds and notes in the Treasury Bonds, Notes, and Bills section

of TheWall Street Journal,Exhibit 2.17, represent 32nds. Hence, a price quote of 117:04 means $117 plus

4/32nds of a dollar per $100 of face value. Both bid and ask prices are presented in the exhibit.

Grinblatt138Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw138Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 2

Debt Financing

57

EXHIBIT2.17Secondary Market Pricing forTreasury Securities

Source: Reprinted by permission of The Wall Street Journal, ©2001 by Dow Jones & Company. All Rights Reserved

Worldwide.