Global Bond Markets

Introduction The Bond Market (also known as the debt, credit or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds. As of 31 st December, 2010, the size of the worldwide bond market (total debt outstanding) is an estimated $ 95 trillion, of which the size of the outstanding U.S. bond market debt was $ 37 trillion. Nearly all of the $ 822 billion average daily trading volume in the U.S. bond market takes place between the broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges.

Structure of the Bond Market Bond markets in most countries remain decentralized and lack common exchanges like stock, future and commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the variety of bond securities outstanding greatly exceeds that of stocks. However, the New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds. The NYSE migrated from the Automated Bond System (ABS) to the NYSE Bonds trading system in April 2007 and expects the number of traded issues to increase from 1000 to 7500 till December 2011.

Types of Bond Markets Classification of the broader bond market into 5 specific bond markets is done by the Securities Industry & Financial Markets Association (SIFMA) Corporate Government & Agency Municipal Mortgage Backed, Asset Backed and Collateralized Debt Obligation Funding

Participants in Bond Markets Bond Market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both. Participants include:- (1) Institutional Investors (2) Governments (3) Traders (4) Individuals

Participants in Bond Markets Because of the specificity of individual bond issues and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10% of the market is currently held by private individuals.

Bond Market Size Amounts outstanding on the global bond market increased by 5% in 2010 to a record $95 trillion. Domestic bonds accounted for 70% of the total and international bonds for the remainder. The US was the largest market with 39% of the total followed by Japan with 20%. As a proportion of global GDP, the bond market increased to 130% in 2010 from 119% in 2008 and 80% a decade earlier. The considerable growth means that at the end of 2010 it was much larger than the global equity market which had a market capitalization of around $55 trillion. Growth of the market since the start of the economic slowdown was largely a result of an increase in issuance by governments, with government bonds accounting for 43% of the value outstanding at the end of 2010, up from 39% a year earlier. The outstanding value of international bonds increased by 3% in 2010 to $28 trillion. The $1.5 trillion issued during the year was down 35% on the 2009 total. The first quarter of 2011 was off to a strong start with issuance of nearly $500 billion. The US was the leading centre in terms of value outstanding with 24% of the total followed by the UK with 13%.

Bond Market Volatility For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. Likewise, when interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. This is the fundamental concept of bond market volatility: changes in bond prices are inverse to changes in interest rates. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes. Economists' views of economic indicators versus actual released data contribute to market volatility. A tight consensus is generally reflected in bond prices and there is little price movement in the market after the release of "in- line" data. If the economic release differs from the consensus view the market usually undergoes rapid price movement as participants interpret the data. Uncertainty (as measured by a wide consensus) generally brings more volatility before and after an economic release. Economic releases vary in importance and impact depending on where the economy is in the business cycle.

Most Common Bond Indices A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or DJIA for stocks. The most common American benchmarks are the Barclays Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios or may be further subdivided by maturity and/or sector for managing specialized portfolios.

Types of Bonds Domestic Bonds Euro Bonds Foreign Bonds

Domestic Bonds They are issued (and traded) locally by a domestic borrower and are denominated in the local currency. They usually carry less risk as the regulatory and taxation requirements are usually known to the investors or at least to their brokers and accountants.

Example of Domestic Bond ABC Co. (incorporated & registered in US) issues a bond in US for placement in the US domestic market (ie) only for the US resident investors. The issue is underwritten by a syndicate of American securities houses. The issue is denominated in the currency of the target investors (ie) USD

Euro Bonds Bonds issued or traded in a country using a currency other than the one in which the bond is denominated. This means that the bond uses a certain currency, but operates outside the jurisdiction of the central bank that issues that currency. Euro Bonds are generally issued by MNCs and National Governments to raise capital in international markets. It is important to note that the term has nothing to do with the currency EURO and that the prefix “EURO" is used more generally to refer to deposits outside the jurisdiction of the domestic central bank. Eurobonds are often bearer bonds.

Example of Euro Bond ABC Co. (a foreign corporation incorporated & registered in US ) issues bonds to be placed internationally (ie) say a British FMCG company may issue a Euro Bond in Germany denominating it in USD or an Italian Automobile company might sell Euro Bonds issued in USD to investors living in European countries. The issue is underwritten by an international syndicate of securities houses. The issue is denominated in any currency, including even the currency of the borrower’s country of incorporation (ie) USD

Foreign Bonds They are issued (and traded) on a local market by a foreign borrower and are denominated in the local currency. Foreign bond issues and trading are under the supervision of local market authorities. For example, a bond denominated in US Dollars that is issued in the United States by the Government of Canada is a Foreign Bond.

Example of Foreign Bond ABC Co. (a foreign corporation registered & incorporated outside US) issues bonds in US for placement in the US market alone. The issue is underwritten by a syndicate of US securities houses. The issue is denominated in the currency of the target investors (ie) USD

Types of Bond Instruments Straight or Fixed Income Bonds Partly-paid Bonds Zero-coupon Bonds Floating Rate Notes (FRNs) Perpetual FRNs Convertible Bonds Bonds with Warrants Dual-Currency Bonds

Credit Rating Credit is important because individuals and corporations with poor credit will have difficulty finding financing and most likely will have to pay more because of the risk of default. Credit ratings are a tool used by lenders to determine the types of loans and rate of interest that can be extended to a potential borrower. A corporation's credit rating is an assessment of whether it will be able to meet its obligations to bond holders and other investors. Credit rating systems for corporations generally range from AAA or Aaa at the high end to D (for default) at the low end. Your credit rating is an independent statistical evaluation of your ability to repay debt based on your borrowing and repayment history. If you always pay your bills on time, you are more likely to have good credit and therefore may receive favorable terms on a loan or credit card such as relatively low finance charges. If your credit rating is poor because you have paid bills late or have defaulted on a loan, you may be offered less favorable terms or may be denied credit altogether.

Credit Rating Agencies A company that provides investors with assessments of an investment's risk. The issuers of investments, especially debt securities, pay credit rating agencies to provide them with ratings. A high rating indicates low risk and may therefore encourage investors to buy a security. Additionally, banks may only invest in securities with a high rating from two or more credit rating agencies. Fitch, S&P and Moody's are the three most prominent global CRAs. The ratings have letter designations (such as AAA, B, CC) which represent the quality of a bond. Bond ratings below BBB/Baa are called Junk Bonds.

Credit Rating Agencies The ratings given by CRAs are only their “opinions”. Thus, they are not a recommendation to buy, sell or hold a security and do not address the suitability of an investment for an investor. Regulators have “almost fully outsourced” to CRAs much of the responsibility for assessing debt risk. For investors, ratings are a screening tool that influences the composition of their portfolios as well as their investment decisions.

Credit Ratings & Basel 2 Norms The Basel 2 norms (ratings-based regulations) are much common in USA than across Europe. Regulatory changes in banks’ capital requirements under the Basel 2 norms have resulted in a new role to credit ratings. The major objective of Basel 2 is to revise the rules of the 1988 Basel Capital Accord so as to align banks’ regulatory capital more closely with their risks, taking account of progress in the measurement and management of these risks and the opportunities which these provide for strengthened supervision.

Credit Ratings & Basel 2 Norms Under Pillar 1 of Basel 2, regulatory capital requirements for credit risk are calculated according to 2 alternative approaches:- (1) The Standardized Approach – measurement of credit risk is based on external credit assessments provided by External Credit Assessment Institutions such as credit rating agencies or export credit agencies. (2) The Internal Ratings-Based Approach – subject to the supervisory approval as to the satisfaction of certain conditions, banks use their own rating systems to measure some or all of the determinants of credit risk.

Credit Ratings & Basel 2 Norms Under the Foundation Version (FV), banks calculate the Probability of Default (PD) on the basis of their own ratings but rely on their supervisors for the measures of the other determinants of credit risk. Under the Advanced Version (AV), banks also estimate their own measures of all the determinants of credit risk including the Loss Given Default (LGD) and Exposure at Default (EAD).

Procedures & Methods of CRAs The processes and methods used to establish credit ratings vary widely among CRAs. Traditionally, CRAs have relied on a process based on a qualitative and quantitative assessment reviewed and finalized by a rating committee. Recently, there has been increased reliance on quantitative statistical models based on publicly available data. The key measure in credit risk models is the measure of the Probability of Default (PD) but exposure is also determined by the expected timing of default and by the Recovery Rate (RE) after the default has occurred.

Procedures & Methods of CRAs Standard & Poor’s ratings seek to capture only the forward-looking probability of the occurrence of default. They provide no assessment of the expected time of default or mode of default resolution and recovery values. Moody’s ratings focus on the Expected Loss (EL) which is a function of both PD and RE. Fitch’s ratings also focus on both PD and RE. They have a more explicitly hybrid character in that analysts are also reminded to be forward-looking and to be alert to possible discontinuities between past track records and future trends. The credit ratings of Moody’s and Standard & Poor’s are assigned by rating committees and not by individual analysts.

International Regulations on CRAs International Organization of Securities Commission (IOSCO) has formulated a Code of Conduct Fundamentals for the working of CRAs. The Code Fundamentals are designed to apply to any CRA and any person employed by a CRA in either in full-time or part-time capacity. It focuses on transparency and disclosure in relation to CRA methodologies, conflicts of interest, use of information, performance and duties to the issuers and public, the role of CRA in structured finance transactions, etc. It does not dictate business models or governance but rather seeks to provide the market with information to judge and assess the CRA activities, performance and reliability. The IOSCO Code of Conduct broadly covers the following 4 areas:- (1) Quality and integrity of the rating process (2) CRA’s independence and avoidance of conflicts of interest (3) CRA’s responsibilities towards the investing public and issuers (4) Disclosure of the Code of Conduct and communication with the market participants

Investment Grades of Bonds A bond is considered investment grade or IG if its credit rating is BBB- or higher by Standard & Poor or Baa3 or higher by Moody's. Generally they are bonds that are judged by the rating agency as likely enough to meet payment obligations that banks are allowed to invest in them. Ratings play a critical role in determining how much companies and other entities that issue debt, including sovereign governments, have to pay to access credit markets, i.e., the amount of interest they pay on their issued debt. The threshold between investment-grade and speculative-grade ratings has important market implications for issuers' borrowing costs.

Investment Grades of Bonds Bonds that are not rated as investment-grade bonds are known as high yield bonds or more commonly as junk bonds. The risks associated with investment-grade bonds (or investment-grade corporate debt) are considered noticeably higher than in the case of first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. It is an indicator for the market's belief in the stability of the economy. The higher these investment-grade spreads (or risk premiums) are, the weaker the economy is considered and vice-versa.

Criticism on Credit Rating Agencies Until the early 1970s, bond credit rating agencies were paid for their work by investors who wanted impartial information on the credit worthiness of securities issuers and their particular offerings. Starting in the early 1970s, the "Big Three" ratings agencies (S&P, Moody's & Fitch) began to receive payment for their work by the securities issuers for whom they issue those ratings, which has led to charges that these ratings agencies can no longer always be impartial when issuing ratings for those securities issuers. Securities issuers have been accused of "shopping" for the best ratings from these three ratings agencies, in order to attract investors, until at least one of the agencies delivers favorable ratings. This arrangement has been cited as one of the primary causes of the sub-prime mortgage crisis (which began in 2007), when some securities, particularly mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) rated highly by the credit ratings agencies, and thus heavily invested in by many organizations and individuals, were rapidly and vastly devalued due to defaults, and fear of defaults, on some of the individual components of those securities, such as home loans and credit card accounts.