Break Prices Confirming Weakness in the Bond High Yield Market


Research Highlights

The price at which bonds are breaking for trading in the secondary market shows a clear downtrend year to date.

The price at which bonds are placed with initial investors is given by the original issue discount (OID) and sets the bond's yield to maturity. The break price, on the other hand, refers to the price at which the bond first trades in the secondary market after its initial placement in the primary market.

The OID is intended to give initial investors an incentive to buy the bond in the primary market rather than waiting to buy it in the secondary market after it's been priced. Additionally, it also provides a small cushion in case the price declines once the bond starts trading in the secondary market.

In bullish environments, the bonds break at a premium to issuance, easily at 101% and approaching 102% of par. These prices drop as the market becomes bearish and can go below par. During the second half of 2009, several bonds broke for trading as low as 95% of par, though several of those bonds were issued at OIDs in the low 90s.

The data as of mid-June shows that the break price is in a decreasing trend, which highlights the weakness in the market. While just a few months ago investors would bid up the price of bonds they could not get in the primary market, the market is now showing less demand for new bonds once they break in the secondary.

Over the past month, there has been an increased number of bonds issued below par, after several bullish months of issuances at par. As the market declines, the OID will become more steep and break prices will fall as well. As conditions deteriorate, the spread between the OID and the break price will decrease since break price is driven entirely by investors while OID is driven partially by issuers, who would rather issue as close to par as possible.

The decline of the OID-break spread has been in line with the diminished inflows into mutual fund flows. Lower inflows translate into declining break prices as cash available for investing drops.

The narrowing of this spread confirms the market weakness, which translates into overall loss of momentum in the market. In the short-term this will probably only get worse as fears of higher interest rates heighten and investors demand for bonds drops.

While the high yield market falls, leveraged loans remains a good alternative. Click here to learn more about this phenomenon.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Commodities

Referenced Stocks:

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