How many times have we heard about large companies such as La Prensa, Distribuidora Eisenmann, Banco General, Petróleos Delta and Bonlac (Sociedad de Alimentos de Primera, S.A.) issuing bonds to borrow money. Or perhaps we have noticed that a good way to invest our money is buying a certain amount of callable bonds for X amount of years that mature at different times. Although almost all of us are familiar with this subject, few of us have had the opportunity to learn how a bond issuance really works and delve deeper into this interesting subject.

In the last few years, the issuance of bonds as a source of funds to finance multiple financial needs has experienced remarkable growth in Panama. The growth of the local bond market has been supported, among other factors, by the introduction of favorable fiscal legislation and by the establishment of a Stock Exchange. The development of an efficient and competitive capital market in Panama is an important element for economic growth, as it strengthens the financial system and complements the country’s well-organized banking system.

What is a bond?
A bond is a debt security that represents an obligation by the issuer of the bond to pay a determined amount (the principal) to the bondholder, based on a series of terms and conditions. When analyzing if issuing or investing in a bond issue, the following aspects should be considered: the par value or principal; coupon rate and frequency; maturity date; guarantee, if any exists; title or ownership – in registered or bearer form -; and the currency in which the bond is issued.

How are bonds issued?
The basic steps to follow for carrying out a bond offering are the following:

1. The issuer defines a financial need, and determines the general financing terms;


2. The issuer presents the undertaking to one or more investment banks and requests an interest rate quote, based on the structure presented;


3. The issuer receives proposals from different banks, chooses one and then signs a bond underwriting agreement with the investment bank, which contains the terms and conditions of the bond (including the coupon rate), as well as the terms under which the offering will take place.


4. The investment bank structures all documentation; it purchases the bonds from the issuer and places them with their clients (the buy-sell transaction by the investment bank and the initial placement with the clients make up the primary market).


5. After they are first issued, bonds are bought and sold in the secondary market.

As we have seen, a bond issuance begins with the primary market, in which the initial sale of the bonds that make up the issue takes place. There exists three basic methods for underwriting a bond issue: first is negotiating the underwriting with a firm commitment on the part of the investment bank, in which the bank buys the issue and guarantees the distribution of the same under agreed terms; second is the agreement of an investment bank that will underwrite and sell the issue based on a "best efforts" basis, but without a guarantee of purchase from the bank; and third is restricted underwriting, in which the direct sale on the part of the issuer without the participation of an investment bank takes place, with the condition that if the issue is not sold, the bank is committed to buying it ("standby underwriting"). At the moment, in mature markets, more than 98% of issues in the primary market are made under the firm commitment method by the investment bank.

In the case of a firm commitment from the investment bank, the bank is committed to buying the issue from the issuer and placing it with clients. Just like a traditional bank loan is negotiated, the issuer negotiates with the investment bank the terms of the issue, establishing a mutual compromise to buy and sell the bonds based on those terms and conditions. This way the issuer has confidence that he will obtain the resources required to finance his needs.

How is the interest rate determined? The negotiation of the terms is based fundamentally on the determination of the bond yield. Determining the bond yield is based on two factors: the interest rate of a government bond with an equal term to the bond in question and the level of risk that the issue represents. The level of risk or credit rating determines the pricing differential to pay on the interest rate of a government bond. Thus, an issue of a client with an AAA bond rating (small degree of risk), at a 3-year term, when the yield of a 3-year government bond is 5.75%, will entail a rate of between 6.15% and 6.35% -- since the average differential between a government bond and an AAA bond fluctuates between 0.40% and 0.60%.

Evaluation of the issue
It is important to emphasize that the investment bank performs a critical task in evaluating the credit quality of an issue, for which it must perform an exhaustive analysis of the issuing entity and the issue itself. When a bank emits a commitment to buy bonds from the issuer, by underwriting the issue, that bank is giving its seal of approval to the credit quality of the issue under the agreed terms.

Moreover, although investors have the responsibility of undertaking their own analysis of the issue’s credit quality, they base their decision to buy bonds, to a great extent, on the approval of the investment bank regarding the issue it is underwriting. Regarding the latter, the reputation that an investment bank establishes when properly evaluating the new bond issues it underwrites make up its main asset.

Depending on the size of the issue, banks form syndicates (group of banks that make a commitment with the issuer and between themselves), which participate as much in the underwriting (buys bonds from the issuer), as in the distribution of the issue to clients or investors). See the following example: A US$50MM issue can be underwritten by four banks in equal parts; on the other hand, a syndicate can be formed by ten selling banks (in which the underwriting banks participate), which will sell the bond issue to their clients. Usually the syndicates lead manager negotiates an underwriting fee with the issuer, and then splits the underwriting fees between the syndicated banks to cover the underwriting on the one hand, and the sale to their clients on the other. For example, a bank negotiates with the issuer an underwriting fee of 1.25%; internally, the banks determine that the underwriting fee will be of 0.75% of the subscribed amount, and that the sales or distribution commission will be 0.50%.

The secondary market

After bonds are first issued in the primary market by the investment bank (or the bank syndicate), they can be bought and sold on the secondary market. In general, the secondary bond markets are decentralized; meaning, a stock market does not exist (nor physical or electronic) in which dealer agents congregate to buy and sell securities. Generally, each brokerage house carries bonds in inventory, and buys and sells directly to their clients. The usual method consists of clients arranging a market order with their broker; the broker goes to the agent(s) or market maker(s) of the debt security within that company and requests a bid or offer price, and the market order is executed. The nature of the bond market has as an end result, the spreading of bond prices between the different brokerage houses making the market, as there is no centralization in buying and selling the securities. The buying and selling of stock, for example, generally takes place in a structured market, in which these securities are negotiated. In this case, an agent or “specialist” is responsible for maintaining a balanced market for this security, existing only one price at a determined moment.

Undoubtedly, the development of an efficient money or debt market has important benefits, not only for the participants, but most importantly for the economy of a country. The main benefit is that it allows the channeling of funds from different savers towards the most productive entities of the economy that require capital. Thus we see, for example, that with the creation of a mortgage bond market the depositors/savers have the opportunity to place their funds in safe investments with good returns; simultaneously, the availability of capital for granting mortgage loans is guaranteed, which allows more people to buy their own home. The second function of capital markets is its capacity to efficiently distribute the financing risks between a wide number of creditors. There are multiple projects or financing needs that by their nature and risk profile can only be financed by many investors who contribute small sums.

Finally, one of bond’s main attractions and one of the foremost attributes of a mature market is the liquidity that it grants investors. Bonds, being negotiable instruments, provide bondholders an opportunity to turn their investment into cash. Thus, an investor who buys a mortgage bond with a 20-year term has the opportunity to negotiate said bond at any time. Liquidity is the soul of the market; and therefore, the factors or mechanisms that strengthen it are the pillars of an efficient and dynamic capital market.

The development of an efficient bonds market in Panama will be a crucial element in financing locally important infrastructure projects (such as ports, hydroelectric, water treatment plants, highways, etc.), the privatization of companies and activities, and other needs such as home mortgages.