The Indian Bond Market : A Primer

Bond markets play a vital role in building a country’s financial system. They have attained increased importance in the last few years as a consequence of several crises in the financial markets. Of late, the need for an efficient bond market is being felt by the emerging economies. Much of this concern stems from the perception of the policy-makers that the absence of an efficient bond market makes the economy more vulnerable to financial crises.

A bond is a contractual loan instrument issued by a borrower promising to pay interest and repay the principal according to pre-specified terms to a lender. However, it is not the only source of credit to the borrower. It only serves as a means to diversify the borrowers’ risk by borrowing from various sources. The bond market acts as a bridge between the borrowers, such as government and corporations and the investors or lenders.

Bond markets have been in existence for the last few decades. Bonds served as a tool for fulfilling governments’ growing financial appetite as a consequence of wars. They outgrew loans in this period, as banks were not in a position to finance the growing needs of government. The Bank of Venice issued the earliest known bond in order to fund a war with Constantinople in the year 1157. Governments felt it easier to borrow money from many individuals rather than a handful of banks. The investors were also assured of their returns and hence were more comfortable lending to government.

The Asian financial crisis brought to light the problems of excessive dependence on banks for funds. Consequently, the need for a balanced mix of bonds and equities as sources of funding and also investment avenues were required. Hence, bonds became an alternative source of funding and countries started developing deeper, more transparent, stable and efficient debt markets.

Classification of Bond Markets

Bond markets can be categorized into different classes based on the nature of the market, nature of the issuer, and nature of issuance. They can be classified as primary bond market and secondary bond markets based on the nature of the market; government and corporate bond market based on the nature of the issuer; and domestic, foreign, and eurobond market based on the nature of bond issuance.

Primary and Secondary Bond Markets

Bonds are first issued in a primary bond market. In this marketplace, a borrower issues or sells bonds to the investor or buyer. As the name suggests, it is a first-sale market, where the issuer places his bonds with the investor for the first time. Until 1970s, only primary bond markets existed and bonds were issued in the form of plain vanilla products. Investors used to purchase bonds and hold them until maturity. The predictable nature of the future cash flows associated with bonds made them more attractive. Investors enjoyed the risk-free returns.

A secondary market for bonds came into existence in the late 1970s. Since then, investors started taking advantage of price differences. Unlike primary market, secondary market is a re-sale market, where the buying and selling of already existing bonds take place. There is no fresh issue of bonds; instead, the already existing bonds are exchanged among investors.

Bond dealers and banks are the major participants in a bond market. They act as intermediaries, by buying bonds from issuers and selling the same to investors in a primary bond market. Bond dealers also maintain active secondary bond markets. Bond trading is largely done “over-the-counter”, where bond dealers bid for bonds that investors are willing to sell and offer them to investors willing to buy. Secondary bond markets are equipped with highly sophisticated networked counters.

Bond markets can be segregated into government bond markets and corporate bond markets based on the issuers of bonds.

Government Bond Markets

According to many studies, governments are the largest issuer of bonds worldwide. Government bonds, also known as ‘sovereign debts’, play an important role in enhancing the liquidity of a bond market. These are the backbones of healthy domestic debt markets.

From a macroeconomic perspective, government bonds enhance stability in an economy by acting as one of the sources for funding budget deficit. Market-oriented funding of budget deficit reduces debt-service costs. A government bond market also facilitates the implementation of monetary policy. Development of a deep and liquid government bond market helps in ironing out the friction caused by financial shocks. Such a market, coupled with sound debt management, can help governments reduce exposure to currency, interest rate and other financial risks. Figure 1 depicts the government bond market growth in emerging economies.

Figure 1: The Growth of the Government Bond Market in Emerging Markets

Source: International Organization of Securities Commissions, May 2002

From a microeconomic perspective, a government bond market enhances financial stability in the market. It also improves financial intermediation by adding up the menu of investment avenues. A government bond market develops a healthy competitive environment in the financial system, hitherto dominated by banks. It reduces over-dependence on banks for funding requirements and lays down a path towards complementing bank finance.

Industrialized countries have their own nicknames for government bonds, for instance, Treasuries in the US, Gilts in India and UK, OATs or obligations assimilables du Trésor in France, JGBs in Japan and Bunds in Germany.

Corporate Bond Markets

Private and public corporations issue corporate bonds in order to fund their business purposes, ranging from building facilities to purchasing equipment for expansion. Investors generally go for corporate bonds due to their advantages of attractive yields, marketability, dependable income, safety and diversity. Moreover, credit ratings of the corporate bonds enhance the safety factor associated with them. Investors in this market include individuals, and large financial institutions e.g., pension funds, endowments, mutual funds, insurance companies and banks.

Corporate bonds serve as a readily available source of financing for companies hunting for long-term funds. These reduce companies’ over dependence on banks for short-term borrowing and instead facilitate long-term financial planning. In order to issue corporate bonds, companies approach investment bankers with their proposal to issue bonds, who in turn send recommendations to exchanges after a due diligence analysis. Figure 2 shows the growth in corporate bond markets in emerging countries. Minimum or zero interference of the government, sound financial reporting system companies, efficient community of financial analysts and rating agencies, existence of private placement mechanisms, and an efficient and fair mechanism for reorganization in case of defaults and bankruptcy of the borrower are the primary ingredients of a well-developed corporate bond market.

Figure 2: Growth of the Corporate Bond market in Emerging markets

Source: International Organization of Securities Commissions, May 2002

Although international bond markets have been in existence for a long time, there is still a lack of a unified mechanism. Bond markets can be divided into three types based on the nature of their issuance, namely domestic bond markets, foreign bond markets and Eurobond markets.

Domestic Bond Markets

Bonds in domestic/local markets are issued by a domestic borrower usually in the local currency. There has been a rapid growth in the local bond markets over the past few years. This growth is the immediate upshot of the financial crises. The blows dealt by the financial crises made countries realize the need for an efficient domestic debt market that could act as a substitute for external sources of funding. These markets could shield against the on-and-off nature of international capital markets during the crises period. It could also help in creating a wider list of home-grown instruments to overcome inherent currency and maturity mismatches. Countries are poised to develop a strong domestic bond market to reduce dependence on international markets. To what extent the domestic bond market can prove to be a substitute of international sources of funding in crisis still remains a point to ponder.

Domestic bond markets were full of lacunae, such as, restricted demand for fixed income products, limited supply of quality bond issuances, and last but not the least, inefficient market infrastructure. These loopholes were overlooked till the Asian crisis, but as an aftermath, many governments are making consistent and determined efforts to plug them. Nevertheless, there have been differences in the rate of growth and factors driving the growth in different countries. Financing expansionary fiscal policies, the need for re-capitalizing the banking system and a lack of bank credit have been the major drivers to the growth of domestic bond markets in the Asian region. Whereas, the increased participation of domestic institutional investors and corporate sector’s refinancing needs have been the main drivers to bond market growth in the Latin American region. In the EU region, the harmonization of regulations for the accession to the EU, has been the primary driver for growth.

Foreign Bond Markets

Foreign bonds are issued by a foreign borrower in a local market in the local currency. Foreign bonds have interesting nomenclatures indicating the local markets where they are issued. Bonds issued in US dollar by a borrower located outside US are called Yankee bonds, bonds issued in sterling by a borrower residing outside UK are known as Bulldog bonds. Similarly, bonds issued in yen by a borrower residing outside Japan are called Samurai bonds.

Ninety years ago, international bond markets were confined to foreign bonds. Erstwhile international bond markets were not very different from today’s markets in terms of types of issuers and subscribers, and underwriting and syndication practices. In the post-World War I era the US economy witnessed a tremendous growth and so did its currency. The US foreign bond market, also called the Yankee bond market, continued dominating the world’s capital markets. It grew more rapidly after World War II. The Yankee bond market remained the most dominant and largest foreign bond market for many years. But of late, it is being overtaken by CHF (Swiss franc) foreign bond markets. Table 1 gives the history of foreign bond markets in major countries.

Eurobond Markets

Loans arranged through a syndicate of banks of international repute and placed in the countries not corresponding to the currency of issue are called Eurobonds. The history of Eurobonds dates back to the early 1960s, when Eurodollar bonds (USD bonds issued outside US) dominated the Eurobond market. The first Eurobond was issued in 1957. Presently, Eurobonds are denominated in almost all the major currencies. Today, the Eurobond markets are well developed and more sophisticated than they were at their inception.

Table 2 gives the history of the Eurobond market in major countries. Borrowers or issuers seek Eurobond markets to meet huge capital requirements, as they are free from regulations and exempt from national taxes and reserves. Eurobonds are basically bearer bonds. Whoever bears it can claim ownership. Hence, international banks can take advantage of lower cost of funds and lend to borrowers at lower rates than available in domestic markets. The Eurobond market is an offshore market that faces competition from the onshore market for domestic and foreign bonds.

Bond Market Instruments: A wide variety of bonds are available in the marketplace. Issuers can issue bonds according to the specifications of an investor, such bonds are not publicly traded and are privately placed. The most popular instruments of bond markets are:

• Straight bonds: These are the fixed income bonds with specific interest payments on specified dates over a specified period of years. Straight bonds are also known as debentures. These are the basic fixed income bonds, where the owner receives a predetermined interest amount from the issuer at regular intervals, either annually or semi-annually. The issuer doesn’t have an option to redeem the loan prior to maturity. The issuer has to redeem the bond at its face value, also known as par value at a predetermined date.
• Perpetual bonds: These bonds have no maturity date. A steady stream of interest on these bonds is paid forever and these cannot be redeemed.
• Callable bonds: The issuer has an option to call back or buy back all or a part of their bonds under specified conditions before the maturity date. Corporations and municipal corporations issue these bonds in order to capitalize on the fall in interest rates. When the issuer calls back his bonds, then the owner is obligated to sell them back to the issuer at a price specified when they were issued, which usually exceeds the market price. The difference between current market price and the call price is the call premium.
• Zero-coupon bonds: These are the straight bonds with no periodic interest payments. These bonds are issued at less than par value and redeemed at par value. They serve to eliminate investment risk to the investor. The investor does not receive any interest payments on these bonds. Hence the investor bears no reinvestment risk till the maturity of the bond. Greater certainty of the returns is the major attraction to the investors of these bonds.
• STRIPS: A Separately Registered Interest and Principal of Securities is an innovation to zero-coupon bonds. This is issued by the borrowers and deposited with a trustee, who in turn, divides the bond into separate individual payment components that allow the components to be registered and traded as separate securities. Then the trustee directs the appropriate amount of interest or maturity payments to investors.
• Floating rate notes: These notes are issued by banks and building societies. FRNs are similar in structure to the straight bonds except for their interest calculations. Coupon rates of FRNs are linked to the London Interbank Offered Rate (LIBOR). The coupon rates are reset at regular specified intervals, normally 3 months, 6 months, or one year. Investors benefit from lower pricing of bank loans and larger maturities of straight bonds.
• Convertible bonds: Convertible bond, as the name suggests, can be converted to or exchanged for another security at the bondholder’s option under specified conditions. Convertible bonds are generally exchanged for an issuer’s common shares. Issuers can have an advantage of lower funding costs and possibility of non-repayment of the principal amount.
• Junk bonds: Junk bonds are high-yield bonds issued by companies and are considered highly speculative because of high risk of default. The credit rating for these bonds are either ‘speculative’ grade or below ‘investment’ grade. Although these bonds have higher default risks than others, the returns associated with these are relatively higher than those of other bonds. Hence the risk of default is more than compensated by high yields.
• Catastrophe bonds: These are insurance linked debt instruments used to raise money in case of a catastrophe. The catastrophe could be an earthquake or hurricane of sufficient magnitude and within a particular region. Usually, insurance or a reinsurance company is the issuer of a catastrophe bond. The special condition linked with such a bond is that, if the issuer suffers a loss from a catastrophe, then the investor is obligated to either defer or completely forgo the principal and/or interest payable by the issuer.

Role of Credit Ratings in Bond Markets

Bond markets are considered to be a less risky than equity markets. Denizens of bond markets seem to never get carried away by the euphoria that affects the equity market investors.

Bonds are not completely ‘no-risk’ assets, as there is always a chance of delayed coupon payment and sometimes non-payment of the coupons. Credit ratings issued by rating agencies provide a caution to investors about the creditworthiness of the issuers.

Rating agencies are external companies appointed or charged to assess and analyze the issuers financial position and overall credit of the issuing company. Rating agencies play a significant role in bond valuation. Standard and Poor’s, Fitch and Moody’s are examples of major rating agencies.

Credit rating agencies help the investors in determining the security and safety of the issue. They play a significant role in the efficient functioning of the bond markets. Gone are the days when an investor used to have only the company balance sheet at his disposal. The pressures to maximize shareholder returns have driven companies to obtain better credit ratings.

Factors, such as coupon rates, yields, maturity etc., can be measured by the investors before investing, but factors concerning the creditworthiness of the issuer need substantial subjective assessment. Credit rating agencies help investors in assessing the creditworthiness of the issue by aggregating and analyzing both subjective and objective factors. Thus, the assessment conducted by credit rating agencies gives market participants additional sources of information to assess the credit risk of the issuer. The role of credit rating agencies cannot also be over-stated, as they are one of the main sources of additional information to evaluate credit risk.

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.

Policy actions can also impact bond markets significantly. A conscious policy move or increase in the forex reserves makes the bond markets more volatile. Liquidity created by such policy actions drives investors to trade more frequently and actively. In an uncertain interest rate scenario, created by conflicting signals from different policy makers, bond investors tend to become increasingly risk-averse.

Conclusion

Though bond markets are considered by many to be havens of investment, fears remain over risk – mainly interest rate risk. The global economic slowdown has had its own impact on bond market development, and overall development in bond markets over the past few decades has been positive. There has been significant success in terms of market size, lengthening of maturities and the number of countries developing their own domestic markets. But, in spite of all this, the increase in issuance has not led to a deeper and more liquid market in many countries. There is no one simple answer to the question of how the markets can be made deeper and more liquid. Countries need to realize their potential to grow and reassess their policies and practices to enhance the growth of bond markets.

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