Bond Markets Essay Example Pdf

Bond markets are one of the important sources of financing an enterprise, corporate and a business entity. Bond market is also called as debt,A credit, orA fixed income market. Bond market is a financial market with different participants buying and selling debt securities which are in the form of bonds. The size of the worldwide bond market is estimated at $82.2 trillion as of 2009 and the size of the outstanding U.S. bond market debt was $31.2 trillion according to BIS. Majority of the bond markets in the U.S. take place betweenA brokers and dealers along with the large institutions in a decentralized, over the counter market. However, only a small number of bonds and primarily corporate are listed on exchanges. In this study I am going to discuss about the bond markets and their importance to both developed and developing countries in building strong economy and what are conditions that are required for the development of strong bond markets.

The study is equally discussed with the developing countries like India which has a very weak bond market and the countries like Hong Kong and United Kingdom which has a developed bond markets. We will also consider the feasibility and suitability of Bond markets being developed in India and what considerations need to be made. We will also take other factors in to consideration e.g. how the development of Bond Markets will help in financing a firm and how corporate governance can maintain effective regulation of the bond markets and keep an economy growing and stimulated. One of the important aspects of this research work is to find out the conditions that are essential for the development of bond markets and the factors that influence these conditions. Different research papers relating to bond markets are studied in order to find out the different conditions that are mentioned in their research papers. Data relating to different countries are collected, tabulated and presented in the forms of graphs in order to make the analysis part more easy and accuracy. Most of the bond markets refer government bond market due to its size, lack of credit risk, liquidity and sensitivity to interest rates. Interest rates are one of the important determinants of bond market since it is inversely related to the bond markets.

A bond is a debt instrument that is issued for a specific period for the purpose of generating capital by borrowing. Different corporations, states and governments issues bonds along with the promise to repay the principal with the coupons on maturity date. Bond markets play the role of bridge between the issuers and investors.

On the basis of the nature of market, nature of issuer and the issuance, bond market can be categorized into different classes.

It is the market place where the new securities are placed for the first time by the issuer and the buyer directly purchases it from the issuance party. Up to 1970s, bonds were issued and investors hold them until they mature. Investors enjoyed the risk free returns because of the expected nature of free cash flows connected with bonds made them more striking. In late 1970s a new type of market came into being called secondary market. Investors got the chance to take advantage of difference in prices. It is also known as resale market where bonds that already issued by different companies exchanged among the investors and the issuance companies are not involved in it.

Literature Review

Herring R,J. and Chatusripitak,N (Jan 2008) had made a study on bond markets and why there are underdeveloped when they are compared with bank and equity sector, they also investigated why there is an absence of a bond market in some countries. They also mentioned some appropriate policies for bond markets considering Thailand research example. At the beginning of there work a brief explanation about characteristics of financial intermediary was discussed as they form markets place for surplus agents & deficit agents along with the reduced information cost & transaction cost, reduced risk and the participants involved. They also made an empirical study on funds flow analysis and created a matrix between households, private sector firms, government, international sector for analysis and the results obtained from that shows the importance of multiple investments options for people and firm holding real asset. As per their study households have direct financial claim, and increased savings by households as investments in real assets turns more productive and making economy stronger and better. The second and most important aspects of their study is regarding the importance of bond markets for an emerging markets to form an efficient and effective financial markets. The authors have described that there are different policy implications for different participants (equity market, banking industry, savers, and investors) in an economy.

Absence of bond market will hinder the economy completely, as there is 1) High cost involved in banking debt financing 2) Since, it is not market determined interest rates, inefficiency in derivatives market 3) Investors or savers have no alternate options or access for better returns 4) Too much dependency on banking alone can make economy vulnerable to crisis 5) some firms issue bonds in international markets(in denominations of Dollars or Euro's in order to finance domestic investments by which firms are exposed to higher foreign exchange risk and they cannot hedge due to absence of effective and efficient bond market. The authors also suggested few measures to improve bond market which highlights about corporate governance 1) Issuing government bond-as it can be used as benchmark for other domestic bonds 2) Improve and frame judiciary and legal rights, so that it is "Fair-play" and efficient to encourage small and medium investors. 3) Overall financial infrastructure must be developed for emerging countries. And the entire statements and actions suggested and reviewed were well support by empirical analysis on Thailand (emerging market) as evidence for the need and development of bond market. Mihaljek,D , Scatigna,M and Villar,A(2002) in their study on trends in the bond market in emerging countries and their study aimed in analysing size and growth of debt market in relations with their development due to macroeconomic aspects and also including the important microeconomic factors and institutional characteristics which leads to development of bond markets. This literature is well support with our main context of relating the 3 roles as mentioned earlier.

And from their work, Financing Firms it is found that bond markets has grown double in size(especially Asia) from mid 1990's to early 2000 which is a clear proof of increase in the size which represents the demand for bond markets & very much in action for financing the firms. From empirical analysis it can be noted they found that emerging markets are really growing rapidly, however smaller in size when compared with industrial countries in both domestic and international as well as private and public sector. Adding to the above, bond issuance activity can also be compared; it shows massive increase in percentage of emerging countries however their volume of contribution is still less when compared with industrial countries. These bond markets have always acted, as catalyst innovation and introduction of new financial services. Implementation of corporate governance these things in-turn lead to implementation of rules and regulations, corporate governance over fair play. Evidence of United States is included as importance on formation of laws and constitutions for overall development bond market & overall financial market of economy and showed positive results. Corporate governance becomes very important, as these bonds are very complicate with their features, well framed legal & judiciary systems is significant to mechanise payments and settlements procedure, maintain fair-trade policy, lay principles for effective and efficient functioning, international trade procedures and so on. A sound secondary market is essential for bond market to work efficiently and effectively, the authors have mentioned measures like proper legal and judiciary system, intervention of central bank, develop fund management industry ,develop efficient clearing and central depository system , all these aspects will automatically develop secondary market which is the most difficult part of bond market in emerging countries as there is proper trade policies the bond prices do not signal exact information to investors and market participants about the bond prices. Hawkins,J(2001) states in his work paper that, financial system in most emerging economies is based on banks and these banks are influenced by the development of bond market. John Hawkins raises questions about whether the bond markets are taking the business away from the banks. On the other hand he also feels that firms are helping banks by issuing corporate bond to central banks.

Banks also play a vital role in developing a private sector bond market as they are also involved as issuers, holders, dealers, advisers, underwriters, guarantors, trustees, custodians and registrars in this market. In fact banks are obtaining more profits by performing the above mentioned activities and less from lending. For this reason, it is important to have healthy banks to have a sound bond market. And a bond market can improve banking activities. John Hawkins also addresses some of the questions in his work paper which are as follows: Do bond markets substitute for bank lending? For answering this question he uses the explanation given by Greenspan (2000). He says that bond markets can act like a "spare tyre", it can substitute bank lending for corporate during the times when banks' balance sheets are weak and banks are rationing credit. This was the case in the early 1990s in the United States, and there were some signs of it in Hong Kong in the late 1990s, but John Hawkins finally concludes that bond markets cannot replace the entire banking sectors as it affects the economy of the country. Do bond markets take good lending business away from banks? He says that highly rated companies issue more bonds than the lower-rated companies. In general people prefer to buy the bonds of only blue chip companies which are rated very high and they do not believe in the low rated companies .in fact it is low rated companies requires funds than the high rated companies which has many ways to obtain funds. Finally he concluded that bond markets do not affect banks in turn it develops economy of the country by supporting the banking activities whenever the banks are in crises. Turner, P(2002) writes in his work paper, "bond markets in emerging economics: an overview of policy issues" that bond markets are developing because of their benefits to the central banks. In general the government bond market helps to fund budget deficits in a non-inflationary way and thereby protects the effectiveness of monetary policy. They also act as an agent for the government in various aspects of the management of government debt.

They oversee clearance and settlement systems, and they are responsible for the stability of the financial system. MR. Philip mainly explains about the corporate bond market and the role of banks in his work paper. He says that apart from the few Asian countries, there is no much more development of corporate bonds in emerging markets. In his own view Korea has a well developed bond market in the Asian region. According to him banks need to be fully involved in bond underwriting and in the sale of capital market products to households. Another concern about the increased bond issuance may just take profitable business away from the banks. He concludes that bond markets are going to support the banks in difficult times and also helps in the development of the economy of the country. Patil.R.H(2008) in his work paper 'Broad basing and Deepening the Bond Market in India' states that India has a well-knit structure of national and state level development which is regulated by the Reserve Bank of India and Government of India supports and regulates the infrastructure" which manages all aspects of governance . The main objective of all the structure and the regulatory measures is to provide much needed long-term finance to the industry which the "older existing commercial banks were not keen to provide due to the fear of asset-liability mismatch" (R.H Patil) which has negative implications on financing a firm's investment. Since deposits with the banks were mainly "short/medium term, extending term loans was considered by the banks to be relatively risky" (R.H Patil). The interest rates charged by the commercial banks were "appropriately aligned in such a way that the project loans were relatively lower than the actual loans" (R.H Patil) extended by banks for such purposes as working capital for industrial and other units. Similarly, the rates that the corporate entities could offer on their bonds were fixed By the Finance Ministry which used to regulate the capital markets until the independent capital market regulator "Securities Exchange Board of India (SEBI) was set up almost a decade ago" (R.H Patil).

The Finance Ministry, however, used to informally consult RBI before it fixed the interest rates on corporate bonds suggesting regulatory influence. Financial sector policies were revamped and deregulation was introduced after 1991 and DFIs no longer had the comfort of the protective policy climate in which they operated. They no longer have access to "concessional sources of finance like government guaranteed bonds or budgetary support" (R.H Patil) and they now they have competition from commercial banks which keeps competition high and lending rates low helping keep an economy stimulated. Batten,J(2000) in his work paper 'Expanding Long-Term Financing through Bond Market Development: A Post Crisis Policy Task' states that, The Asian financial crisis suggests many policy tasks not only to its worst hit Economies but also to other developing countries" (Jonathan Batten) and highlighting some governance issues. One of these tasks is the need to diversify the source of long-term industrial financing for firm, which historically is concentrated in the form of short-term bank borrowing and the potential for maturity transformation. "This form of financing behaviour historically has entailed currency mismatches, financial inflexibility and vulnerability to external shocks" (Jonathan Batten) which highlights some further governance issues.

While there is a large ongoing requirement for infrastructure investment in the post-crisis period, there is evidence of a rebalancing of the asset portfolios of financial Intermediaries away from Asia. Specifically, international bank financing peaked in 1996 at US$248 billion and was reduced to US$161 billion by June 1999 which shows how well managed and regulated the world's strongest economy was. In this post-crisis environment the challenge is to direct the high levels of regional savings to meet this refinancing need. We argue that the appropriate mechanism to redirect these savings is through the development of "viable domestic and international bond markets" (Jonathan Batten). The financial systems of crisis economies display different characteristics and respond differently to the reduced liquidity that arose following the crisis e.g. in the Republic of Korea which has the largest domestic bond market, and Malaysia has the largest market for bank loans and equities. All crisis economies increased levels of international bonds post-crisis though Korea was the most successful, increasing outstanding from US$23.4 billion in 1996 to US48.5 billion in 1999. This suggests that there is a degree of substitutability between international bank borrowing and international bond issues, though the degree of substitutability varies between different classes of issuers. For example Korea was able to replace the reduced levels of bank lending with international bond issues, though the other crisis economies were not able to do so. This highlights the need to develop more viable domestic bond markets as well as improving the access to international bond markets.

Background of Indian bond market

A capital market is said to be well-developed only if it has a proper composition of both the equity market and the bond market. Risks involved in the banking systems and the limited public finances have created a huge scope for bond markets in India. Both macroeconomic and microeconomic levels can be developed by the corporate bond markets and hence the development of these corporate bond markets will develop the Indian economy. Traditionally developing country banks use Plain vanilla bank lending to raise corporate debt. Even though India has a developed regulatory framework and a financial system, the bond markets in India comprises of only 0.4% of GDP when it is compared to Korea which has 21.1% of GDP. The Indian Bond Market is the third largest bond market in Asia after Japan and South Korea. The government continue to be the largest borrower in India when compared to South Korea which has a private sector as main borrower. There is a satisfactory level of savings in the Indian Economy at around 23% and according to the RBI (Reserve Bank of India) an average of 78% of the financial savings of household sector were invested in fixed income assets. The debt instruments have supported Indian market for very long period and the most popular financial services are Bank Deposits, insurance, provident funds, income orientated mutual funds and postal saving schemes. Even after having the successful debt instruments the Bond markets in India is not strong may be because of the absence secondary market for debt instruments. Liquidity of Bonds is one of the major issues leading to a classic "chicken and egg problem".

Empirical study and discussion

From the above table, we see that when the volume of transaction in Indian stock market is reaching higher peak every day. On contrary the bond market was sliding down in volume of transaction from 19911.57 crore (10m Indian Rupees) in August 2003 to a mere Rs 605.23 crore in July 2006 and corporate bond market is just 3% of sliding volume. The major obstacle for active bond market is policy structure of the debt market. This was a feature of all the emerging countries that debt market developed slowly than stock market in overall capital formation of the country. It is evident that US has 50% of worlds total bond market , followed by Japan having 15% and UK has long standing bond markets which concentrates more of bond market activities are very alien to these emerging countries. To note, South Korea is the only emerging economy with a reasonably well developed bond market Figures are turnover on the wholesale debt market segment of NSE. Source: NSE Figures are bond issuances with one year or more maturity in the primary market in the first quarter of 2006-07. Source: Prime Database However from the other research papers and articles, it states that limitations and systemic risk awareness of the bank lending in emerging countries have led to development of bond market. Evidence from the issuance activities of bond in India which has doubled itself in recent past. These bond markets have helped India in various long term economic development activities both at micro and macro economic levels. Though bond markets are in existence from 1947, it was only from last 30 years state owned enterprises started to issue PSU bonds for financing or as instrument to raise funds for investment purpose. However due to lack of liquid and undeveloped secondary bond markets these bonds and bond investments have been unpopular among large population.

Corporate Bond Markets

Corporate bonds are issued by both private and public entities in order to release funding to benefit their business. Corporate Bonds are most popular amongst investors as they have attractive yields, greater guarantees on return and risks which increases their marketability and dependability. Corporate Bonds also have the added advantage they are being offered by dependable and reputable institutions. Investors in this market include individuals, financial institutions, different types of funds as well as Insurance Companies and Banks. Corporate Bonds are the perfect source of finance to fund long term aspirations of a business. This offers the borrowers flexible and relatively cheap lending to benefit the company in the long term. Corporate bonds are issued from surplus agents to deficit agents via Investment Banks who place suitable lenders and borrowers together after taking the necessary precautions and analysis. Figure 2 shows how and what rate corporate bonds are issued in emerging Markets. Growth of the Corporate Bond market in Emerging markets Source: International Organization of Securities Commissions, May 2002 There still appears to be a unified mechanism even though Bond Markets are very mature. There are three different types of Bond which are named according to their issuance namely Domestic, Foreign and Eurobond markets

Foreign Bond Markets

In this case foreign borrowers approach a domestic market in the related currency and the bonds have different names which show which market they were issued to. Bonds issued in US dollars by a borrower located outside US are usually known as Yankee bonds, bonds issued in ponds sterling by a non UK lender are referred to as Bulldog bonds and similarly, bonds issued in Japanese yen by a non Japanese issuer are referred to as Samurai bonds.

Eurobond Markets

These bonds are issued by a consortium of reputable financial institutions and are not related to the currency of issue are known as Eurobonds. Eurobonds relate back to the 1960's when Eurodollar Bonds (USD Bonds issued by non American entities). The first Eurobonds were issued around 1957 and they are currently being denominated in to almost all currencies. This suggests that they have become more sophisticated over time. Table 2 shows how Eurobond markets have evolved over time and their presence globally, these Bonds are popular as they help meet capital requirements and they also operate outside most levels of governance and are exempt from taxes etc. So, Eurobonds are Bearer Bonds, the bearer has complete rights over the bond and this allows financial institutions to take advantage of lower borrowing costs which undercut those bonds available in domestic markets.

Factors Influencing Bond Markets

The fluctuations in bond markets are caused by several economic factors, the most significant factor being a change in interest rates. Interest rates have an inverse relation with the bond price: as interest rates rise, the bond price falls and vice versa. Changes in interest rates could be due to changes in demand and supply of credit, fiscal and monetary policies, exchange rates, market psychology and inflation expectations. Inflation is considered to be yet another major factor affecting bond markets. Bond investors always have an aversion towards inflation. They fear inflation, as it lowers the value of bonds by reducing the future purchasing power of fixed interest payments they receive. Hence, any economic development that is likely to result in inflation causes panic in the bond markets. International bond markets are exposed to exchange-rate risk. Cash flows associated with foreign bonds are dependent on the exchange rate at the time the payments are received. Hence, fluctuations in the exchange rates cause changes in the value of bonds. India is expected to be a leading world economy (along with China) in the 21st century. India's share of the world's gross domestic product (GDP) is expected to rise from 6% in 2005 to 11% by 2025, making it the third largest economy in the world behind the US and China.

Few identified difficulties of the underdeveloped Indian bond market

Highly regulated: - the Indian bonds markets are still in control of government, administrative fiat and regulatory authorities which control and determine all the interest rates, even the interest rates in corporate bonds are determined by the government. The interest rates set are not very encouraging therefore bonds do not attract many investors. Apart from that the level of stamp duty levied by governments on secondary transactions of bonds are very high which hinders the growth and development further. Restricting policies: Indian banks are very much act on the guidelines, principles issued by the central bank and government. The policies implemented are very de motivate banks to involve in other activities. For example priority sector lending policy which mandates the banks to account 30% of their lending to these sectors, even though they are less productive like transport, agriculture are sectors Indian government recommends on. Limited Investor base; - Indian bond market have limited investor base. Generally corporate bonds are held by government, provident funds, insurance companies, banks and many other financial institutions. These institutions hold till maturity, due to which the supply of funds become limited and inadequate in market. Therefore if the bond market has to improve, the general attitude of these institutions must change, involve themselves in trading to reduce risk, improve profits so and so forth. Ease on foreign investors will again improve the bond market. Inadequate transparency: since the prices are not determined by the market forces, this discourages investors to trade and very low trading activities do not provide the economy with better flexibility and liquidity to market overall. Unreliable Information signals: Indian bond market is not well supported with information and technology systems by which it faces many difficulties and delay in flow of information. Due to the delay in complete system the participants are not aware of full information to understand their positions at end of the day which is not motivating for well timed decision making. Countries like US, Japan use various means to spread the relevant news and information like financial reports, profit statements, industrial meetings, and rating agencies and so on for enhance and smooth the flow of information through out the market.

Infrastructure Financing

Infrastructure financing in India offer a chance for developing the commercial bond markets but not depend on the growth of this market. Financing through different banks are not possible for the projects as they are for long periods. Banks cannot give 30 years loan facility as they can accept loans only for 5-10 years; this will leads towards asset liability mismatch. However, if the liquid market provide exit path, then it would be feasible for banks to purchase 30 year bonds. In contrast insurance firm or pension fund can buy long term bonds as they get the facility to sell which the secondary market can provide

Securitization

The need for a market for securitised products is another related issue for infrastructure financing. In India, three major areas - Mortgage Backed Securities (MBS), Infrastructure Sector and other Asset backed securities (ABS) are important. For financing long term projects, individuals should get entrance in debt market like Special economic zones (SEZ). Expanding in domestic demand, export growth and growth in industrial investments will ultimately boost up the requirement of bond financing. Mismatch of currencies and over dependence of ASIAN corporations on short term foreign funds were the big causes of Asian Financial Crisis. It caused the fast outflow of capital from Asian countries and confidence in these countries began lighten. If the domestic markets dominated in their own currencies and more developed in Asia, then the Asian crisis would never strong enough as it destroyed the Asian markets. One of the ways to avoid risk is development of local currency market, which will ultimately help to reduce potential currency and maturity mismatches in financial system. The development of an active debt market is required forA capital account convertibility which is also recommended by Tarapore committee.

Apart from its fundamental role of achieving allocation efficiency, a well-developed government bond market strengthens the monetary policy implementation framework by equipping a central bank with market-based indirect instruments. A vibrant corporate debt market allows a corporation to access a set of standardized rates and fees instead of making individual negotiations with financial institutions. However corporations have difficulty issuing high value bonds in India, thus resulting in the incremental credit rate increasing from Rs 2.5 lakh (100k) crore (10m) in 2004-05 to Rs 3.7 lakh crore in 2005-06. Banks may find that their appetite for lending is taken up by large issuing corporations. If the Bond market becomes stagnant and bond, securities, loans etc cannot be issued by smaller institutions. Larger corporations develop a preference for acquiring finance via the Bonds and securities markets etc and Banks will have to react to this and concentrate more of their resources on developing the SME sector.

Note: semi-annual interest rates are calculated as the bond pays the coupon semi-annually.A 3. Guess and Check:A Now we have to calculate I or the interest rate by considering bond price and the yield rather than picking the random numbers. When the value of the bond is at par, the interest rate is equal to the coupon rate. If the value is above par (at a premium), the coupon rate is said to be greater than the interest rate. In our example, the bond is at discount so the annual interest rate must be greater than the coupon rate of 5%.A Now by using the different interest rates which are greater than 5%, we obtain the different bond prices as shown in the table. Since our bond price is $95.52 that lies between 6% and 7% we have to form a new table of more interest rates that lies between 6% and 7%. When the interest rate is 6.8% the bond price matches $95.92.Hence the semi annual interest rate is 3.40 % By using these calculations investors can decide on their earnings based on their investment capacity, holding period, and the interest they want to earn. Since the bond markets are more secured because of the involvement of government, the returns are guaranteed and low when compared to the stock market.

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