A well-functioning and self-sustaining Capital markets are the underlying building blocks of a progressive economy. Capital markets predominantly debt and equity are vehicles for the critical functioning of market and economy and provide liquidity, depth, transparency, the legal and regulatory framework for a smooth and continuous flow of credit across actors. As economies become more matured, capital markets become more sophisticated and intangible factors become more prominent including increased financial innovation, a tradition of public ownership and enhanced culture of trading, etc. 1
As capital markets develop, they undergo two phases of development; an early and late phase. In the process, the role of operation infrastructure, policy analysis, and its implementation, legal and regulatory enforcement, presence of domestic investors especially institutions play a paramount role in driving participation among foreign (ancillary players) and retail investors. Furthermore, markets serve as a backbone for funding both central/federal
and state-level deficits and as a mechanism for raising capital for corporates. And yet one of the critical functions of the capital markets is to judiciously allocated capital optimally across the society significantly micro, small and medium enterprises which remain underserved even in advanced economies. However, one key aspect often overlooked is the importance of a stable risk-free rate. 1 With capital markets, debt markets are by far bigger than equity capital markets. The bond market which dominates the debt market is skewed towards the sovereigns. To have a stable debt capital markets, low stable yields on treasuries are key measures to keep funding stable. The risk-free rate is the benchmark rate for estimating expected return and market premium on risky assets. A high risk-free rate makes funding more expensive in turn making projects unviable to implement. Second, the depth of the bond market does matter to some degree for driving liquidity within the system. According to BIS, a minimum of $100M to $200M of outstanding government bonds is required for the government bond market to function. A boost in the size of the bond market can be achieved through overfunding. Both Singapore and Hong Kong government used government and exchange fund paper to build the debt market. 2
Its imperative to understand how the bond markets functions to understand the sustained social change and impact of capital markets within the global ecosystem. This article builds and complements the first tutorial on Global Bond markets published under the Tutorial section on The middle Road. The educational video can be accessed here.
The global bond markets play a pivotal role in enabling a sustainable change and impact within the world. The global bond market with outstanding issuance stands at $128.3 trillion. With the sovereign bond market valued at ~ $64T, the Government remains the largest player in the debt markets. Apart from the government, Corporates, Municipalities, Agencies, and Supranational organizations play a significant role in issuing bonds in the secondary market. The size of the listed global equity markets globally stood at $60.3T by end of 2019, highlights the enormous leverage of the fixed-income securities in moving credit within the economy. Both equity and bonds are tools for all actors to raise capital from the capital markets. Central/ Federal governments use Sovereign bond markets to fund expenditure to tide over deficits or provide stimulus during adverse situations. Debt capital markets facilitate smooth movement of credit within an economy, fund expansion plans of both economies and corporates, interconnect various actors within the business and social ecosystem for enhancing socio-economic development, foster innovation to deliver efficient wide basket of solutions and products to consumers with a measurable impact. On the other hand, poorly regulated and managed capital markets create global panic through recessions and inequitable distribution of wealth. The 2008 subprime crisis is an excellent example of the destructive power of debt markets especially the use of derivatives within the collateralized debt markets.
Apart from central government, municipalities especially state and local governments and its authorized agencies use capital markets to raise capital for long-term capital-intensive projects, especially in the development and infrastructure sector. In recent years, Supranational organizations especially multilateral banks are using capital markets through the issuance of sustainable bonds for international development work. Supranational organizations are wide-ranging global organizations formed by two or more central banks backed by international treaty (Fabozzi), usually to promote global development work. Inter-American Development Bank, Asia Development Bank are excellent examples of multilateral development banks that form part of the Supranational group. With the paucity of capital along with market failures in the social sector, these organizations will play a much larger role in enabling social change and impact within society.
# Actors and selected types of bonds within the Global Bond Market
US, China, Japan, and the EU are the largest issuers of outstanding bonds in the world with respective issuance of $22.4, $19.8, 12.4, and 12.2 trillion as of August 2020 based on ICMA and Bloomberg data. Although the corporate sector is the second largest in outstanding bonds issuance data, Agencies are key players in the debt capital driving innovation in mortgage and asset-backed securities. Mortgage securities are both residential and corporate mortgages while ABS include credit card and car loan payments. The securitization sector work as a double-edged sword, on one hand, it spread the risk of mortgages among a wide set of investors diversifying risk and making mortgages cheaper and universally available. At the same time, collateralized mortgage obligations use derivatives to further customize loans into tranches with varying risk to satiate various risk profiles. Difficult to comprehend and manage their risk, these structures work like steroids for catastrophe when fueled with leverage. CMOs subprime tranches were the central piece of the credit crisis which almost brought down the house and ensured economic turmoil. Securitization is largely used within the Covered bond market which also pools mortgages and public loans as collaterals for constructing loans are hugely popular in Europe. Estimated to be about Euro 2.4 trillion, covered bonds are different in a few aspects from the residential and commercial backed securities in the US. Unlike in the US, covered bonds assets are on the balance sheet of banks rather than a special purpose vehicle used to off load securities loans from the issuer book. This feature enables higher accountability and transparency ensuing recourse for bond holders during bankruptcy. Further, the pool of assets within the parlance of covered bond market is dynamic rather than the static to mention a couple of noteworthy differences between the two. Denmark, Germany, France, Italy, Spain are some of the biggest issuers of bonds within this category.
Corporate bonds especially high yield debt also categorized as speculative debt has seen an explosion within the credit markets. Speculative bonds are rated below investment grade due to unsound business fundamentals among other things, pay a higher coupon rate compared to their peers in investment grade. The ratings of the bonds play an underlining role in defining optimum risk return role for investors structuring a framework for expected yield expectation for investors. High yield bond market began as bonds of fallen angel, i.e. companies downgraded from investments grade status due to reasons other than increase in the use of debt, have come a long way with a market size of $3 trillion dollars globally.
# International Bond Market
The international bond market also is known as the offshore bond market predominantly uses foreign-denominated bonds issued by multiple international agencies not domiciled in the country of issuance. Known as the Eurobond market, not to be confused with Euro, these bonds are issued by foreign entities/actors in a different currency keeping other factors constant.
The first Eurobond was issued by Autostrade in 1963 in Italy. Within the Eurobonds segment, the launch of Global bonds by the World Bank set up the stage for simultaneous issuance of bonds across different countries and continents. Global bonds facilitate diversification, enhanced liquidity apart from primarily bringing down transaction costs. The fund cost savings amounted to $15M for the World Bank in net present value and effectively worked across a cross-section of actors in the financial sector. Panasonic erstwhile known as Matsushita Electric; a Japanese electronics powerhouse was the first corporate to issue Eurobond.
The offshore market today includes bonds issued by domiciled actors in the home currency. Dim Sum bonds of China is an excellent example wherein the issuers tap international markets for capital through offerings in renminbi. As a thumb rule, Eurobonds are issued by actors not domiciled in the home country. A Dim Sum bond issued by a foreign entity in renminbi currency will work as a Eurobond. For example, Hungary’s CNY issue is a good example of a Euroyen bond. Indian rupee-denominated Masala bonds are another example of an offshore bond where Eurobond’s definition is blurred. For the sake of clarification, the mode of issuance is taken as a strict definition for the distinction between a Eurobond (offshore bond) and an offshore bond. The emergence of tapping foreign markets for domestic currency in Dim Sum bonds is an important step towards the internationalization of currency apart from passing the currency risk to the investor. Usually, both Dim Sum and Masala bonds offer a better coupon rate to attract investors. One key aspect of investing in these bonds is to have a bullish view of the economy and the currency. However, the size of these bonds is still minuscule with the size of Dim Sum bonds estimated to be $52 B compared to the ~13.4T onshore bond market in China. (The data as of Oct 31, 2019; Source: Bloomberg Finance L.P., FTSE Russell, WIND, J.P. Morgan Asset Management).
# Underlying Bond Fundamentals
Understanding bond fundamentals is scientifically based on valuing cash flows through intrinsic valuation. Spot rates or Zero-coupon bond rates play a pivotal role in defining the mathematical aspect of bonds. Zero-coupon bonds do not pay any coupons but are issued at a discount to the face value/. The return of the bond is calculated as the difference between the purchase price and redemption value.
Debt capital markets are one of the most important sectors within global capital markets wherein bonds are core value drivers of continuous innovation. The holistic mission of the capital markets is to drive an equitable economic growth with far-reaching impact on people. No doubt capital markets are making positive strides in innovation although I am not sure of the latter.
Link to full tutorial on the Global Bond market here.
References and Reads
- Creating Domestic Capital Markets in Developing Countries: Perspective from Market Participants by Dimitri Demekas and Anica Nerlich
- Size and liquidity of government bond markets: Robert McCauley and Eli Remolona
- The world that changed the bank: World Bank
- 2020 SIFMA Outlook
- Frank Fabozzi Bond Markets, Analysis and Strategies