What is fair value? Price discovery for smaller issuers gets tougher

Calculations are complicated by increased subjectivity

The topic of ‘fair value’ – or the price of a new bond transaction by an issuer – will always stir up debate. This is because determining fair value is subjective, to an extent. But this subjectivity has significantly heightened this year, particularly for smaller public sector issuers. There has been a wide divergence in calculations, which have ranged by up to 20 basis points in some cases.

The challenges of the price discovery process and ways to boost liquidity were discussed at the European sub-sovereign agency and forum, hosted by OMFIF’s Sovereign Debt Institute in Frankfurt. This exclusive event brought together senior funding officials, investors, investment banks and other market participants for engaging discussions on the key issues facing this market.

‘Agreeing objectively on the right fair value has really become an issue in primary markets this year,’ said a debt capital markets official at an investment bank. They added that some of the bid sides from banks have ranged by up to 5bp.

However, in other cases, this range has been significantly higher. ‘We had a difference of 20bp for the same maturity and credit,’ said a funding head at a European agency. ‘We had to find a fair value between 20bp and ask: who’s wrong and who’s right? So it has been extraordinarily challenging from that perspective.’

The price discovery process is perhaps the most important aspect in the issuance of a bond as it influences the execution, demand and how the bond performs in the secondary market. For example, pricing the bond too tightly can result in poor demand and weak trading, which can subsequently affect the issuer’s liquidity.

One issuer found this out when it priced a five-year transaction earlier this year, which did not go as well as hoped. ‘That was really down to the fact that these fair value discussions were really difficult at the time,’ said a funding official at the European issuer.

So how can banks and issuers improve the price discovery process to calculate a more accurate fair value? The secondary market is usually the first reference point, but that is being dismissed due to its lack of reliability resulting from an increasing acknowledgement that secondary turnover does not always equate to better liquidity.

‘When we look at larger benchmarks, we certainly see them reacting with more sensitivity and maybe with more precision to certain market moves,’ said a DCM official at an investment bank. ‘But is this really a representation of where a larger number of investors are willing to buy larger ticket sizes in primary markets, particularly if you add to that consideration that most of the large issuers actually track that turnover through the investment banks? There’s an artificial incentive for the investment banks to keep turnover high.’

One solution adopted by some banks has been to focus on liquid reference points by the likes of the European Union and KfW and then attach an historical spread to derive fair value.

Another solution is increasing the use of taps of outstanding lines. ‘That’s a convenient vehicle for issuers because you tend to know who the investor is behind the enquiry and it’s a safe way of execution,’ said a funding official at a European issuer.

The execution of taps is less risky because issuers can directly communicate with the investor what the right level is compared to a large syndication where the level at which every investor is willing to participate at is unknown.

Issuing small taps directly into trading books was also mentioned as a way of improving liquidity and to help determine fair value. ‘I think that’s one thing that possibly could help for some of the smaller issuers,’ said a DCM official at an investment bank.

During the course of the year, public sector issuers at SDI events have increasingly mentioned the need to allocate more of their bonds to fast money accounts to boost liquidity. ‘It was rude to allocate to fast money one, two, three, four years ago,’ said a head of funding at a European agency. ‘Now I’m looking for fast money. I’d love to get fast money.’

Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.

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