How are bonds priced when first sold in the primary market?

Question

Suppose company A wants to raise $50 million dollars using bonds. It decides to issue 50,000 bonds, where each bond is given a yearly coupon of $60. How will these bonds be priced when they are first sold in the primary market? I can think of two ways:

1. Fixed price: The company decides to price each bond at $1,000. Then, whoever wants to buy the bond can buy one at $1,000 each. Potential problems:

   • What if the company fails to sell all 50,000 bonds it planned to sell? If it sells less than 50,000 bonds, the company will be raising less cash than it had hoped to raise.

2. Variable price: The company lets an audience bid for the 50,000 bonds. The auction goes on until all 50,000 bonds are sold. Potential problems:

   • What if the average price paid for each bond is less than $1,000? The company will be receiving less than the $50 million it had hoped for.
   • What if the average price paid for each bond is more than $1,000? The company will have raised more cash than it needs.

In reality, how are bonds priced on the primary market? Is it by method (1) or by method (2)? How do companies deal with the potential problems I listed above?

Answer 1

The initial purchase is most commonly done by the underwriting bank(s) that set up the bond issue. The bank(s) buy the bonds directly from the issuer for a slight underwriting discount, then resell the bonds to other investors in the open market. The underwriters "price" the bond by setting the coupon in such a way to increase their odds of selling the bonds for close to their par value.

It is possible, though, for companies to sell bonds directly (which is more common in smaller "private placements"), to use the underwriter as just a broker rather then making the initial purchase, or to sell through auction, but the legal expenses involved in creating a bond offering may make the underwriting option the most cost-effective.