The world bond markets are many times larger than the collective stock markets, both in monetary value of bonds outstanding and in dollar value of bonds traded on a daily basis. Yet, investors seem to know relatively little about bonds as compared to stocks. The issue of federal bonds, known as Treasury bonds (T-bonds) in the U.S., compose a significant portion of the entire bond market, but they are not free from obscurity, even though they are considered the safest fixed-income investment. In this article we'll shed some light on this unfamiliar area and explain the process by which the federal government issues bonds.

SEE: 5 Basic Things To Know About Bonds

Preliminary Questions for a New Bond Issue
Federal bond issues are coordinated by the central bank. When it's anticipating a new federal bond issue, the central bank first conducts an informal survey about current market conditions and the type of issue investors might prefer. These informal discussions are held with investment dealers, banks and other market participants who have experience with bond issues of the size and type being considered.

SEE: What Are Central Banks?

Before the details of the new bond issue are decided, several important questions have to be answered. Most importantly, the federal government must determine the precise purpose for the issue. Often, it will relate to a specific capital project being planned by the government - a major new road or bridge, for example. But the purpose can also be something as general as refunding prior debt - that is, paying for past borrowing with new funds that are presumably borrowed at a more favorable interest rate.

Other preliminary questions concern the legal parameters surrounding the potential issue, as defined by federal legislation. There must be a legal precedent that outlines the conditions under which the bond issue can be undertaken. Such a legal precedent relates to the issue's purpose. When its purpose is to fund a capital project, the legal precedents must function to determine whether the funds raised are used for an endeavor that serves national taxpayers and the greater good of federal constituents. In the case of the refund of a prior debt issue, the question is whether or not the debt is refundable under federal tax rules.

SEE: Advanced Bond Concepts

Finally, government officials must decide how the bonds will be sold. In some cases, if the government has a pre-existing working relationship with a certain investment firm, it may choose that firm to be the sole underwriter for the bond issue. A single underwriter relationship can also make sense under other conditions. For example, if the issue is simple enough or if its denomination is small enough that involving multiple underwriters would be more trouble than it's worth. By contrast, if it is a large bond issue the government will host a bond auction and invite multiple underwriters to attend and participate in the bidding process.

Marketing Phase
Whether the government chooses to use one underwriter or several, the method chosen for the bond issue plays an important role in the marketing phase. The first step of this phase for the government, as the bond issuer, is to prepare a preliminary official statement, or disclosure document, to deliver to potential purchasers. The bond issuer typically employs the services of a specialized bond counsel firm to work with its usual solicitor on the legal aspects of the financing. Together the bond counsel and solicitor work on matters, such as federal and state law and tax approvals, ensuring proper legal procedures are being followed.

One of the most important legal requirements for a federal bond issue is that a public meeting be held after a reasonable marketing period. During this marketing period, usually lasting about a week, potential purchasers thoroughly review and evaluate the disclosure document. The procedure followed for the public meeting depends upon whether the government used a single underwriter or invited several underwriters to participate in a competitive tender.

In the case of a single underwriter relationship, the underwriter comes to the public meeting with a firm purchase proposal. The purchase proposal contains specific and precise terms of the bond issue, including the principal amount of the bonds, interest rates to be paid, the amortization schedule and details about any prepayment provisions. These matters can be further negotiated and refined at the meeting and the proposal can then be approved, making the meeting the official confirmation of terms. By contrast, if the government has invited several underwriters to participate in the issue, each group submits its purchase bid on the day of the public meeting, and a full-fledged auction takes place until all the bonds are duly distributed.

SEE: Bond Basics Tutorial

Preparation of Closing Documents
In the last steps of the federal bond issue process, the underwriter or underwriters wire the purchase price for the bonds to the paying agent. The paying agent then pays the costs of issuance, at the direction of the issuer. The paying agent plays an important practical role in the bond issue: it sees that funds are properly distributed according to the intended purpose of the bond issue. For example, the paying agent applies the balance of the bonds' proceeds to the construction project's accounts, or it applies the proceeds to debt holders if the bond issue is meant to refund prior debt. After the closing of the bond distribution, the bond counsel distributes a complete set of closing documents to each participant.

This brings us to the final step in a federal bond issue: the preparation of closing documents. As you might expect, these documents are highly technical in nature, written according to a very specific legal framework. Without going into extensive detail about their contents, it suffices to say that closing documents reiterate the terms of the approved purchase proposal, in addition to laying out the procedure by which the bonds are paid for and distributed.

The Bottom Line
Why should you care about federal bond issues? Because from the perspective of any bond purchaser - including the retail investor - federal bond issues tend to be the safest fixed income investments available. After all, they are backed by the tax-generating powers of the government. However, the particular nature of each bond issue must still be closely analyzed. An encyclopedic knowledge of the processes and procedures surrounding a federal bond issue is not absolutely necessary to participate in retail bond purchases, but it is still useful to have some understanding of the oft-confusing bond market.

SEE: How To Create A Modern Fixed-Income Portfolio

Governments have an obligation to purchasers to ensure that the issues are liquid, marketable and of a size sufficient to ensure easily tradable markets. Ultimately, all of these factors combine to improve the marketability of a particular bond issue and make it more attractive to potential purchasers.

Related Articles
  1. Bonds & Fixed Income

    Junk Bonds: Everything You Need To Know

    Don't be fooled by the name - junk bonds may be for you if you know how to analyze them.
  2. Investing

    The Advantages Of Bonds

    Bonds contribute an element of stability to almost any portfolio and offer a safe and conservative investment.
  3. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  4. Options & Futures

    Callable Bonds: Leading A Double Life

    Find out more about these dangerous and exciting cousins to regular bonds.
  5. Bonds & Fixed Income

    Dragons, Samurai Warriors And Sushi On Wall Street

    From samurai to sushi, there's no denying the East Asian influence on investing terminology.
  6. Bonds & Fixed Income

    Convertible Bonds: Pros And Cons For Companies And Investors

    Find out why businesses choose this type of financing and what effect this has on investors.
  7. Bonds & Fixed Income

    Boost Bond Returns With Laddering

    If you want a diversified portfolio and steady cash flow, check out this fixed-income strategy.
  8. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
RELATED TERMS
  1. Security

    A financial instrument that represents an ownership position ...
  2. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  3. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
  4. Coupon Rate

    The yield paid by a fixed income security. A fixed income security's ...
  5. Coupon

    The interest rate stated on a bond when it's issued. The coupon ...
  6. Bond

    A debt investment in which an investor loans money to an entity ...
RELATED FAQS
  1. What are the proven ways to ease the effects of hyperinflation?

    On November 16, 1923, Germany stopped its hyperinflation by switching out its old currency, the Reichsmark, with a new currency ... Read Full Answer >>
  2. Where can I buy government bonds?

    The type of bond determines where you can purchase it, so you need to decide which type of bond you would like to purchase ... Read Full Answer >>
  3. What's the difference between bills, notes and bonds?

    Treasury bills (T-Bills), notes and bonds are marketable securities the U.S. government sells in order to pay off maturing ... Read Full Answer >>
  4. If the price of the bond falls, does that mean the company won't pay me the par value?

    When you buy a bond, you are loaning money to the issuer. Because a bond is a loan, the interest paid to the bondholder is ... Read Full Answer >>
  5. Why do commercial bills have higher yields than T-bills?

    The reason that commercial bills have higher yields than T-bills is due to the varying credit quality of each bill type. ... Read Full Answer >>
  6. Are long-term U.S. government bonds risk-free?

    For any debt obligation to be considered completely risk-free, investors must have full faith that the principal and interest ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!