During a new bond issue how do the bankers/advisors determine an initial price for the bond? I know that during an IPO the investment bankers will guage demand for the issue, and price the issue according to the demand. Is this the same process that is applied for a new bond issue, or is there another way that the initial price is determined using the present value formula and overall market conditions? Thanks!
Assuming you're talking about corporate bonds (not government), the general process is as follows:
- The company hires one or more (usually several) investment banks to underwrite the bonds. This bank(s) agree to buy the bonds initially from the company then sell them on the secondary market.
- The underwriters determine an appropriate coupon rate for the bonds by looking at the yields of the company's current bonds (if any), the yields of bonds from other companies with similar credit risk, and talking to active market participants to see what prices they might be willing to pay. The coupon rate is usually designed to get a price close to "par" for the bonds (remember that the higher the coupon rate, the higher the price the company gets for the bond, but the more the company has to pay in interest).
- Once a coupon rate has been determined, the underwriter buys the bonds from the company (less a fee for the underwriting) and proceeds to sell them on the open market. The market is the ultimate determinant of the actual market value.
Different bond issues work different ways. The auction process for US Treasuries is described pretty well on the Bureau of the Fiscal Service's TreasuryDirect site. Basically, institutional investors put in bids ("I will loan $X millions at Y%) and Treasury accepts them in order from lowest interest rate to highest until their funding target for that auction is met - with all bidders receiving the rate of the highest accepted bid.
There are also non-competitive bids, but those are a small portion of any auction and don't affect the prices.
Is this the same process that is applied for a new bond issue, or is there another way that the initial price is determined using the present value formula and overall market conditions?
It is similar and not same. Generally in IPO there is a price band recommended and the book building results in the actual price.
On Treasury bonds, the Govt / Central Bank will price these similar to the yields currently available for older bonds. If they offer more yield, it will get over subscribed and Govt/Central Bank has to pay back more interest. If the yield is low; it will not get subscribed.
On Corporate Bonds, depending on the company ratings as well as company brand, a specific company may choose to offer lesser yield or more yield.