Secondary bond market: definition, how it works and its role

Please refer to the fund prospectus and Key Information Document before making any final investment decision. This content is provided for general information only and does not constitute personalised investment advice. All investments involve risks, including the risk of capital loss.

The secondary bond market is the market on which bonds that have already been issued are bought and sold. Unlike the primary market, where a government, company or other entity issues new debt securities to raise finance, transactions on the secondary market take place between investors.

A bond purchased when it is issued is not necessarily held until maturity. Subject to finding a counterparty, it may be sold to another investor before maturity at a price that may be higher or lower than its purchase price.

This is one of the main features of the bond market: even when a bond’s contractual characteristics, such as its coupon, remain unchanged, its market price and the yield required by the market, or its yield to maturity — the rate of return calculated from the bond’s purchase price and its future contractual cash flows — calculated from that price, may change.

Interest rates, the issuer’s credit quality, the security’s liquidity and its remaining maturity are among the factors that influence its valuation.

Understanding how the secondary bond market works therefore helps investors better understand how bond prices are formed, their yields and liquidity, and the main risks associated with holding them.

An already-issued bond changes hands

When an investor buys a bond, they acquire a debt security issued by a government, company or other entity. The security generally has a maturity date, a nominal value and remuneration terms determined when it is issued.

However, the investor is generally not required to hold the bond until maturity. They may decide to sell it to another investor before it matures.

That transaction then takes place on the secondary market.

One of the key differences from the primary market concerns the role of the issuer. When an already-issued bond is resold, the company or government that originally issued the security does not receive new capital. The price paid is transferred between the seller and the buyer of the security.

The secondary market may cover government bonds, such as French government OATs (Obligations Assimilables du Trésor), corporate bonds and other categories of fixed-income securities.

What is the secondary bond market used for?

The secondary market plays a central role in the operation of the bond market. In particular, it can:

• Enable a bond to be sold before maturity, where a counterparty is available;
• Support the liquidity of securities by allowing them to circulate between investors;
• Contribute to bond valuations through supply and demand;
• Contribute to the formation of market prices and yields where securities are actually traded or quoted;
• Reflect changes in the market’s perception of an issuer’s credit risk;
• Indirectly support the functioning of the primary market.

This last function is important. An investor may be more willing to participate in a new bond issue if there is subsequently a market on which the security could potentially be sold before redemption.

However, the quality of the secondary market can vary considerably from one bond to another. Some issues trade frequently, while others have more limited liquidity.

The primary market: when the bond is issued

The primary bond market is where a bond is first brought to market.

The process can be summarised as follows: Issuer → investor

A company, government or other entity wants to raise capital. It therefore issues new debt securities, which investors subscribe to under the terms set at issuance.

The amounts paid by investors therefore contribute directly to financing the issuer.

The main characteristics of the bond are set when it is issued on the primary market: nominal value, maturity, coupon where applicable, and the other terms of the security.

The secondary market: when investors trade the bond with one another

Once the bond has been issued, it can subsequently be traded on the secondary market.

The process then becomes: Investor → another investor

The issuer does not issue new debt with each transaction and does not receive the price paid by the new buyer. The existing bond simply changes hands.

Its price may, however, have changed since issuance. Depending on market conditions, an investor may therefore buy or sell a bond at par, at a premium or at a discount.

The primary market therefore primarily meets a financing need, whereas the secondary market mainly allows already-issued securities to circulate and be valued.

A market largely traded over the counter

The bond market operates somewhat differently from the equity market.

A significant proportion of bond transactions are carried out over the counter, or OTC. The buyer and seller do not therefore necessarily trade through a centralised order book on an exchange.

Transactions may in particular be carried out through banks, brokers, financial institutions or other market professionals.

This structure is particularly suited to a bond universe comprising a very large number of different securities: two bonds issued by the same company may have different maturities, coupons, seniority levels or other characteristics.

It would therefore be incorrect to treat the secondary bond market as a single centralised stock exchange.

The role of brokers, banks and market makers

Brokers, banks and market makers contribute to the functioning of bond trading.

Depending on their role, they may facilitate transactions between buyers and sellers or quote prices at which they are willing to buy or sell certain securities.

The difference between these bid and offer prices contributes to the transaction cost borne by the investor.

A large number of market participants and a high volume of transactions can support bond liquidity. Conversely, a bond that trades infrequently may be more difficult to sell quickly at the desired price.

Liquidity therefore does not depend solely on the quality of the issuer. It may also be influenced by the size of the issue, the number of investors potentially willing to buy the security and general market conditions.

The specific case of OATs and organised markets

Not all bond transactions are necessarily carried out over the counter.

Some bonds can also be traded on organised or regulated markets. This is notably the case for certain sovereign bonds available to retail investors.

In France, Obligations Assimilables du Trésor (OATs) are debt securities issued by the French government. An organised secondary market exists in particular for OATs available to retail investors, enabling them to be traded at market prices under the applicable market conditions.

A distinction should therefore be made between:

• The OTC market, on which transactions are conducted over the counter;
• Organised markets, on which certain securities may be listed and traded under defined rules;
• Market makers and intermediaries, which help facilitate trading;
• Different access arrangements depending on whether the investor is institutional or retail.

The precise way the market operates therefore depends on the security concerned and the market on which it is traded.

Why does a bond’s price change after issuance?

A bond’s nominal value should not be confused with its market price.

The nominal value is a contractual reference value for the security and is used, among other things, to determine redemption in accordance with its terms. The market price is the amount at which investors are willing to buy or sell the bond at a given point in time.

A bond with a nominal value of €1,000 may therefore trade below or above that value before maturity.

When its price equals its nominal value, the bond is generally said to trade at par. If it trades above this level, it trades at a premium. If it trades below it, it trades at a discount.

A bond’s market price may vary according to factors including:

• The level of interest rates;
• Supply and demand;
• The issuer’s credit quality;
• Its remaining maturity;
• The bond’s liquidity;
• Changes in credit spreads;
• More broadly, economic and financial conditions.

A deterioration in an issuer’s financial position may, for example, lead investors to require a higher yield to hold its debt. This can in turn weigh on the price of its existing bonds.

Why interest rates and bond prices generally move in opposite directions

The relationship between interest rates and bond prices is one of the fundamental mechanisms of the secondary market.

Consider a fixed-rate bond whose coupon rate — the rate applied to the bond’s nominal value to determine the coupon amount, in accordance with the terms of the security — is 3% of its nominal value. If market conditions change and new comparable bonds now offer a 5% return, the existing 3% bond becomes relatively less attractive.

For a new investor to be willing to buy it, its market price may therefore fall. This decline in price helps increase the yield associated with purchasing it.

The opposite mechanism may occur when rates fall. An existing bond offering a coupon above that of comparable new issues may become more attractive and its price may rise.

For a fixed-rate bond, the principle can be summarised simply as follows:

• Market rates rise → prices of existing bonds generally fall, all else being equal.
• Market rates fall → prices of existing bonds generally rise, all else being equal.

The extent of this change nevertheless depends on the bond’s characteristics. Its maturity and duration, in particular, influence its sensitivity to interest-rate movements.

Coupon, price and yield: three concepts that should not be confused

Understanding the secondary market requires a distinction between three concepts: the coupon, the price and the bond yield.

The coupon on a fixed-rate bond does not change simply because its market price changes.

By contrast, the yield available to a new investor depends in particular on the price paid for the security. Two investors may therefore have bought the same bond at different prices and achieve different returns depending on their purchase price and the cash flows they subsequently receive.

This relationship explains why price and yield generally move in opposite directions.

For a fixed-rate bond whose contractual cash flows remain unchanged, a fall in its price increases, all else being equal, the yield to maturity calculated for a new buyer. Conversely, a rise in the price reduces that yield. This calculated yield does not constitute a guarantee of actual performance and depends in particular on the issuer meeting its obligations.

This mechanism is essential to understanding how prices are formed on the secondary bond market.

Risks associated with selling a bond before maturity

Being able to sell a bond on the secondary market does not mean that the investor is guaranteed to recover their initial investment.

The price at which the investor can sell the security will depend on market conditions at the time of the transaction.

Several risks should be taken into account in particular.

• Interest-rate risk refers to changes in value that may result from movements in interest rates. A rise in rates may, in particular, reduce the value of certain existing bonds.
• Credit or default risk concerns the issuer’s ability to meet its financial obligations. A deterioration in its credit quality may lead to a fall in the price of its bonds.
• Credit spread risk refers to changes in the yield premium required by the market relative to a benchmark considered less risky. A widening of spreads may weigh on bond prices.
• Liquidity risk arises when a bond cannot be sold quickly at a satisfactory price. It can be particularly significant for less frequently traded issues or during periods of market stress.
• Currency risk may also arise when a bond is denominated in a currency different from that of the investor and that exposure is not hedged.
• Inflation risk is the risk that a general increase in prices reduces the real value of coupons and redeemed principal, particularly for fixed-rate bonds that are not inflation-linked.

A bond whose terms provide for redemption at nominal value at maturity may nevertheless experience significant price movements beforehand. Redemption remains subject, among other things, to the issuer’s ability to meet its obligations. An investor required to sell before maturity may realise either a capital gain or a capital loss.

What role does the secondary market play for bond funds?

The secondary market also plays an important role in the management of bond funds.

A bond fund is not necessarily made up of bonds purchased at issuance and then systematically held to maturity. Depending on its strategy, the fund manager may buy and sell securities on the secondary market throughout their life.

For illustrative purposes, information on the Axiom Obligataire bond fund is available on its dedicated page.

These transactions may in particular make it possible to:

• Manage the portfolio’s interest-rate sensitivity;
• Change its exposure to different issuers or levels of credit risk;
• Switch between different bonds;
• Adjust the portfolio’s duration;
• Change the allocation between different categories of securities;
• Meet investor subscriptions and redemptions, subject to the liquidity conditions of the assets held and the arrangements set out in the fund documentation;
• Implement relative-value trades that may generate capital gains or losses depending on market movements.

The degree of active management may vary according to the fund’s strategy.

An actively managed bond fund may, for example, reduce its exposure to certain bonds if the manager considers that their risk has increased, or seek to increase other positions whose characteristics the manager considers more suitable for the strategy.

The secondary market therefore allows the portfolio to evolve without systematically waiting for each bond held to reach maturity.

How the secondary market influences the value of a bond fund

The value of a bond fund does not depend solely on the coupons received by the portfolio.

The bonds held also have a market value, which changes according to interest rates, credit spreads, issuer quality, liquidity and other market conditions.

When the price of bonds held in the portfolio rises, this can contribute positively to the portfolio’s valuation. Conversely, falling prices may weigh on its value.

This is one reason why the net asset value of a bond fund may rise as well as fall. The investor is exposed to a risk of capital loss: unless a guarantee mechanism is expressly provided for in its regulatory documentation, a bond fund does not guarantee recovery of the amount initially invested.

The operation of the secondary market is therefore essential to understanding concepts such as bond yield, interest-rate risk, bond duration, credit spread and bond liquidity.

The distinction between the two components of the bond market can be summarised simply:

Primary market: the issuer sells a new bond to an investor.

Secondary bond market: investors subsequently trade that bond with one another.

The secondary market allows bonds to be traded after issuance, subject to the presence of buyers and sellers, and contributes to the formation of their market value. Liquidity and the availability of an observable price can nevertheless vary considerably from one security to another.

The key point is that a bond’s contractual characteristics may remain unchanged while its market price and the yield calculated or required by the market may change up to maturity, depending in particular on interest rates, credit risk and liquidity conditions.

This dynamic is also central to the operation of bond funds, whose valuation and management depend in part on changes in the securities held on the secondary market.