Chapter 12 Development of Private Sector Bond Markets
- International Monetary Fund
- Published Date:
- September 2001
The issuance of debt securities by private sector entities has considerable public policy benefits. Such securities help the private sector contribute to economic development through more efficient reallocation of capital. In particular, they improve access to capital for housing and infrastructure at a time when privatization and deregulation in many developing countries are shifting the financing of these projects from public to private hands. Private sector securities also help diffuse stresses on the banking system by matching long-term investments with long-term capital. There is thus a strong public interest in a viable bond market for private sector issuers. Authorities can support private sector bond market development by maintaining a well-functioning market for government securities and by helping to establish disclosure procedures and a credit-rating system for private sector securities, bankruptcy laws, avoiding public sector crowding out, and limiting statutory restrictions on the issuance of private sector debt securities.
Private sector debt securities generally include short-term debt instruments, such as commercial paper, and longer-term debt securities, such as private sector bonds (with maturity of one year or more).258 These debt securities can be classified into floating rate and fixed-rate instruments, secured or unsecured, senior or subordinated to other liabilities of the issuer, and publicly offered or privately placed. This chapter focuses on policy issues associated with local currency bonds issued by private sector entities in developing countries, with an emphasis on the linkage between the public and private sector bond markets.
Development of a well-functioning government bond market in developing countries will often precede and facilitate development of a private sector bond market. At the same time, private debt markets need other elements to be successful, most notably a disclosure system, a credit-rating system, and bankruptcy laws. Authorities should also avoid possible crowding out and statutory restrictions that impede private sector bond market development.
12.2 Benefits of Private Sector Debt Issuance
The issuance of debt securities by private sector entities yields public benefits at the macroeconomic as well as at the corporate level. Governments are increasingly unable to finance the massive investment required for major infrastructure projects, utilities, and housing. Privatizations and deregulation have intensified the need for long-term investment. Securitizations are another source of increased issuance. The Asia crisis also demonstrated to corporations and governments the perils of relying on foreign currency or bank loans for long-term investments without proper hedging. All of these developments are creating a growing demand for well-functioning private sector bond markets.
12.2.1 Benefits to the Economy and Financial Sector of Private Sector Bond Markets
Corporate finance theory shows five categories of benefits from private sector bond markets. Private sector debt markets can (i) diffuse stresses on the banking sector by diversifying credit risks across the economy, (ii) supply long-term funds for long-term investment needs, (iii) provide long-term investment products for long-term savings and lower funding costs by capturing a liquidity premium, (iv) endow financial products with flexibility to meet the specific needs of investors and borrowers, and (v) reallocate capital more efficiently. These are all features that should emerge as an economy develops and grows. By providing longer-term, fixed-rate, local-currency funding, private sector debt bonds help reduce interest rate, foreign exchange, and refunding risk and contribute in mitigating the kinds of problems that brought about the Asian financial crisis.
12.2.2 Private Sector Financing—Equity Versus Debt and Bonds Versus Bank Loans
A proper mix of equity and debt is vital for efficient corporate growth under normal business circumstances. Corporate growth would be constrained without debt financing.
Private enterprises have two basic means of securing debt financing—indirectly by loans from banks and directly by issuing bonds in the capital market. Debt securities, especially bonds with maturities of greater than a year, are generally cost effective for long-term, large-scale, and opportunistic financing by issuers with a high credit rating, while bank loans are cost effective for short-term, small-scale, and recurring financing by borrowers with a lower credit rating or without a credit rating. Some of the major differences between these two types of debt financing are shown in Table 12.1, although many debt instruments are hybrids or do not fit this neat dichotomy.
|Bond Financing||Bank Loan Financing|
|Size of financing||Substantially large; no particular limit; small issues are impractical||Smaller than bond financing unless syndicated; limited by a credit line available to a borrower, industry, country, and other category to which the borrower belongs|
|Term||Usually one year or longer||Usually shorter than bond financing and rolled over; limited by credit policy of a bank|
|Repayment||Bullet or limited prepayment patterns; generally inflexible||Generally flexible|
|Interest rate||Fixed or floating rates||Floating rates for long maturities|
|All-in cost||Normally cheaper than bank loan financing, depending on market conditions; very cheap for opportunistic deals||Normally more expensive than bond financing|
|Credit analysis||Standardized rating by rating agencies||Proprietary credit analysis by a bank|
|Security||Normally unsecured||Normally secured|
|Use of proceeds||Normally not restricted||Normally restricted|
|Listing||Either listed or nonlisted||Nonlisted|
|Creditors||“Unspecific,” many investors, including individuals, corporations, banks, insurance companies, pension funds, mutual funds, etc.||A small number of banks and some other financial institutions|
|Transferability and liquidity||Readily transferable, and limited liquidity except for “major” issuers||Often not transferable and not liquid|
12.3 Overview of Corporate Bond Markets
12.3.1 Corporate Bond Markets in Developed Countries
When considering the development of private sector bond markets in developing countries, a review of bond markets in developed countries provides some perspective on the potential role of private sector bond markets in capital market development. Even in developed countries, there are few active private sector markets, and activity in private sector securities pales in comparison with that of government securities.
The United States has by far the largest corporate debt market, not just in terms of absolute volume, but also in terms of percentage of GDP. (See Table 12. 2.) Activity in corporate bond markets in developed countries is centered on the primary market. Except for a small number of major issuers, liquidity of secondary markets for corporate bonds in developed countries is generally thin.259 Institutional investors, rather than individual investors, dominate developed-country corporate bond markets. The majority of corporate bonds, once purchased by institutional investors, do not change hands until maturity. In the U.S. market, for example, more than 95 percent of corporate bond issues outstanding have no trades in the secondary market.
|Total debt securities||1,113.2||1,730.0||1,471.7||4,433.7||227.8||767.8||12,412.6||22,158.8|
|% of GDP||79.9||82.8||129.2||105.6||62.8||58.5||153.1||119.1|
|% of GDP||46.5||37.2||98.6||74.3||49.0||35.5||90.5||73.3|
|% of total debt securities||58.2||44.9||76.3||70.3||77.9||60.6||59.1||61.6|
|% of GDP||33.5||45.6||30.6||31.4||13.9||23.0||62.6||45.8|
|% of total debt securities||41.8||55.1||23.7||29.7||22.1||39.4||40.9||38.4|
The breakdown of corporate bond issuance varies greatly among developed countries. In Germany, corporate debt has been dominated by banks, with the nonfinancial sector totally absent from the bond market. In virtually all other developed markets, including Japan, the United Kingdom, and the United States, bond issuance by financial institutions has been greater than issuance by nonfinancial corporations. (See Table 12.3.)
Institutional investors, such as insurance companies, pension funds, and mutual funds, are the major buyers of corporate bonds issued in developed countries. Holdings of corporate bonds by households in Japan and the United States accounted for 12.2 percent of the total of corporate bonds outstanding at the end of 1998, and bonds of nonfinancial corporations amounted to only 6.9 and 1.5 percent, respectively.260 Households and corporations generally find a better risk/return trade-off for their investment through the intermediation of institutional investors that specialize in collecting and managing funds with specific characteristics.
12.3.2 Corporate Bond Markets in Developing Countries
Most corporate debt markets in developing countries are fledgling and small, even relative to their own low GDPs. Of the 10 developing countries from which the IFC has been able to collect reliable bond market statistics, only in the Republic of Korea and Malaysia do corporate bonds exceed 10 percent of GDP. In Korea, a majority of corporate bond issues had guarantees from commercial banks,261 although the issuers were reasonably diverse. Such Korean corporate bond issues might be regarded as a form of bank loans. Another example of commercial banks’ significant involvement in a corporate bond market is the Czech Republic, where bonds issued by commercial banks accounted for 77 percent of all corporate bonds issued between February 1997 and October 1999.
Table 12.4 presents data on the outstanding stock of equities, bank claims on the private sector, and government and corporate bonds for a select group of developed and developing countries. Even allowing for the limitations and inconsistencies in the data,262 it confirms a clear disparity between developed and developing countries for all categories of financing.
|Country||GDP||Total Equities||Bank Claims on|
|Developing||$ bln||$ bln||%||$ bln||%||$ bln||%||$ bln||%||$ bln||%|
|Rep. of Korea||321.0||114.59||35.7||264.67||82.5||277.78||86.5||178.46||55.6||99.32||30.9|
In order to understand the functions of private sector bond markets, especially in developing countries, it is helpful to distinguish between “major” and “minor” issuers of private sector bonds. Major private sector bond issuers are those issuers that provide investors with a regular, sizable and stable supply of bonds of high quality and uniform characteristics through public offerings. Minor private sector bond issuers comprise the rest. The latter may be of high quality in terms of creditworthiness, but they tap the bond market only irregularly. Their bond issues tend to be either small in size or opportunistic in timing, or both.
The distinction between these two categories of bond issuers should make it easier for policymakers in developing countries to lay out a development strategy for their debt market as a whole. The two categories of issuers and their bonds differ substantially. If the market is properly designed and maintained, bond issues by major issuers are likely to be traded on the secondary market. The trading volume of major issuers’ bonds on the secondary market may become large enough for their secondary market prices to form a benchmark yield curve. However, as noted above, even in developed countries, activity on the secondary market for corporate issues is limited.
Major private sector bond issuers issue their bonds on an almost regular basis—say, every quarter—so that investors can reasonably anticipate when bonds will be available for sale. Infrastructure and utility companies, housing finance companies, and development finance companies have become major issuers of private sector bonds in developing countries in recent years.263 Under normal circumstances, the issue size of the major issuers is relatively stable and large enough to meet the demand for the bonds across the market. Major bond issuers typically are financially strong and competently manage their business operations, and investors thus have confidence in their ability to pay interest and principal in a timely manner. The high quality is conveniently expressed with a rating symbol such as “AAA” or “Aaa.”
Minor private sector bond issuers tend to be opportunistic. Opportunistic issuers tap the bond market only when a very attractive financing window opens to meet the specific, short-lived investment needs of a specific type of investor. Their bonds are likely to be diverse and unlikely to be traded (frequently) on the secondary market after they are initially placed on the primary market. Despite the inherent illiquidity of minor private sector bond issues, the primary market of minor issuers has contributed significantly in supplying long-term funds to a country’s private sector.
12.4 Changes in Public Policy and New Financial Technology and Development of Private Sector Bond Markets
Changes in public policy and new financial technology have broadened the scope for private sector debt securities. This is allowing the private sector bond market to satisfy the growing borrowing demand generated by the increase in private sector initiatives. The changes in public policy include the decentralization of public finance, privatization, and deregulation. These developments are reflected most directly in private financing demands for infrastructure and housing. Securitization is an increasingly popular new financial technology applicable to infrastructure financing and housing financing.
12.4.1 Infrastructure Financing
An increasing pace of infrastructure building and a shift of the leading role of economic development from the public sector to the private sector have stimulated policymakers in developing countries to develop a private sector bond market.
Social infrastructure building has been critical to economic development and is heavily dependent on long-term financing because of large capital investments and long gestation periods. Traditionally, most social infrastructure was built, owned, and operated by the public sector. Even after completion, governments often subsidized the operation of social infrastructure projects. The pursuit of economic efficiency has shifted the driving force of economic development from the public to the private sector. The shift has been realized by the privatization of state-owned enterprises (SOEs) and by the deregulation of infrastructure activities. The majority of privatized SOEs have been in the utility sectors, telecommunications, energy, transportation, water, and sanitation.
There has been a marked increase in the number of privatization transactions in developing countries. (See Figure 12.1.) Private participation in infrastructure projects in developing countries increased at an average annual rate of 34 percent in real terms from 1990 to 1997. Even after a downturn of infrastructure investment in 1998, a result of the Asian financial crisis in 1997, the real growth rate was over 25 percent over the period from 1990 to 1998.264 These high rates of demand growth compare with an average real GDP growth rate of 6.4 percent for developing countries over the 1990–97 period.265 (See Table 12.5.) It is estimated that 10–20 percent of these infrastructure project costs was locally financed by debt instruments issued in developing countries.266
Figure 12.1.Privatization Transactions in Developing Countries
|Water and sanitation||0.0||0.1||1.8||7.3||0.8||1.4||2.0||8.4||1.5||23.3||—||—|
|East Asia and the Pacific||2.3||4.0||8.7||15.9||17.3||20.4||31.5||37.6||9.5||147.2||49.1||19.4|
|Europe and Central Asia||0.1||0.3||0.5||1.5||3.9||8.4||10.7||15.3||11.3||52.0||105.2||80.6|
|Latin America and the Caribbean||12.9||12.3||17.1||18.0||18.4||19.0||27.4||45.1||66.3||236.5||19.6||22.7|
|Middle East and North Africa||0.0||0.0||0.0||3.3||0.3||0.1||0.3||5.2||3.6||12.8||—||—|
|Real GDP growth (in percent) (GDP vol. measure)||4.3||4.2||5.7||8.0||7.2||6.9||7.0||6.0||6.42|
Growth rates are calculated on compounded basis.
Growth rates are calculated on compounded basis.
The burden of infrastructure project financing is thus passing from the public to the private sector. Debt securities financing for infrastructure projects can be arranged normally through one of three routes: (i) long-term loans extended by development banks or development finance companies that are funded through issuance of their own bonds, (ii) bond issuance by project sponsors, (iii) non- or limited-recourse financing, such as build-operate-transfer (BOT) or build-own-operate-transfer (BOOT), which are innovative and increasingly popular.
Although many infrastructure projects are financed through syndicated loans of commercial banks, given the large investment sizes and long gestation periods of these projects, their financing through bond issuance in the private capital market would be appropriate. The shift from public to private financing of these infrastructure projects has therefore led policymakers to assess, plan, and implement the development of an efficient private sector bond market.
12.4.2 Housing Finance
The development of fixed-income securities markets would benefit housing finance. Housing represents the largest class of real assets in most emerging markets and is a major socioeconomic priority as well as an engine of growth. Affordable housing finance (with long-maturity loans at low spreads) requires a comprehensive housing policy and long-term mortgage markets that are well integrated with the financial markets. The size of residential mortgage markets often varies greatly among developed countries, and even more so between developed and emerging-market countries. In several high-income OECD countries, the value of outstanding residential mortgage loans exceeds 50 percent of GDP, while the average for Europe is 28 percent of GDP. In many emerging countries, mortgage markets represent less than 5 percent of GDP, although in Chile they approach 20 percent, and they are above that level in Colombia and Malaysia.
22.214.171.124 Types of Mortgage Securities and Mortgage Debt Issuers
A variety of securities can be issued by primary mortgage lenders, by special purpose vehicles often called “conduits,” or by secondary mortgage companies purchasing mortgage loans with or without recourse from originators. For a housing finance industry in its infancy, a centralized liquidity facility issuing conventional bonds or enhancing mortgage securities appears fitting for many developing countries. Given an appropriate legal and regulatory environment, universal or specialized banks can also issue simple mortgage bonds as shown by the U.S. and European experience. Box 12.1. summarizes the range and variety of mortgage-backed securities in different regions of the world.
Debt issuers for housing finance can be grouped into three main types. First, there are bank and housing finance companies that originate housing loans. They can finance these loans by issuing long-term bonds rather than relying exclusively on short-term deposits and other short-term funding. Second, a centralized liquidity facility can purchase housing loans with recourse from the originators of these loans and finance the purchase by issuing general obligation bonds. Third, housing loan originators, or more typically a mortgage finance company, can buy housing loans from originators, securitize these mortgage loans, and sell mortgage-backed securities to institutional investors interested in quality paper that offer better yields than Treasury securities.
Box 12.1.Significance of Mortgage Debt Markets
The dynamics of mortgage bond markets and the growth of mortgage-backed securities varies considerably across regions of the world, and from country to country. The dynamics reflect the history and financial infrastructure of each market. In some OECD countries, mortgage-related securities have reached high levels of liquidity, performance, and market efficiency in relation to government bonds. A variety of debt products includes pass-through securities, collateralized mortgage obligations, mortgage bonds, uncollateralized bonds. Mortgage bonds proper provide no capital relief to lenders but reduce their liquidity, interest rate, and prepayment risks. Mortgage bonds are secured by a given pool or by the overall portfolio of mortgage loans, with seniority creditor status in the event of bankruptcy.
In Europe, mortgage bonds funded an average of 19 percent of residential mortgage loans in 1998, with much higher proportions in Denmark, Germany, and Sweden. In these three countries, property mortgage bonds fund more than housing and can also be collateralized with commercial property assets. In Denmark, for instance, corporations rely extensively on mortgage bonds, and this explains the small size of corporate debt in that market. In Germany, three-fourths of the Pfandbriefe are not property bonds (“mortgage” Pfandbriefe); they are debt obligations issued by state and local governments issued under a separate law (“Public” Pfandbriefe). The birth of the Euro and the growth of global markets favor the issuance of larger debt issues and more liquid debt securities.
In Latin America, inflation-indexed letras hipotecarias purchased by pension funds have financed the impressive growth of mortgage markets in Chile from less than 7 percent of GDP in the early 1980s to over 17 percent of GDP in 2000. These letras fund about two-thirds of the mortgage needs of the housing market.
In Asia, the National Mortgage Corporation of Malaysia (Cagamas) has catalyzed the growth of mortgage markets by funding the purchase with recourse to eligible mortgage loans through bonds and notes. Cagamas securities represented about 13 percent of the total fixed-income market in 1998 and about 40 percent of the funding of residential mortgages. Institutions comparable to Cagamas now operate or are being created in about a dozen of other emerging countries.
Measured in terms of outstanding debt, residential mortgages comprise the largest single sector of U.S. financial markets. Mortgage securitization has become a dominant component of mortgage debt markets. In contrast, mortgage securitization in Europe still represents less than 1 percent of total mortgage debt funding. U.S. mortgage-related securities are mostly issued or guaranteed by government sponsored enterprises (GSE) operating as private corporations with implicit government backing. The overall size of the mortgage-backed securities (MBS) market is now comparable to that of U.S. Treasuries. The annual issuance of MBS fluctuates over the business cycle, but MBS now fund about 50 percent of U.S. residential mortgage needs.
126.96.36.199 Development Path of Mortgage Markets
Mortgage markets usually evolve gradually toward the more advanced securitization stage. Securitization refers to the pooling of normally illiquid assets and the issuing of new securities backed by cash flows from those assets. Such securities can take the form of bonds, shares, and unit trust certificates. Bonds are the most popular form, which is exemplified by the increasing popularity of mortgage-backed securities in developed countries. Of particular interest to governments is that securitization facilitates development of a secondary mortgage market through mortgage-backed securities issuance and at the same time helps improve the capital adequacy ratios of banks through the sale of otherwise illiquid mortgage loan portfolios. This assists and encourages banks to manage their balance sheets in a more sound and efficient manner.
Securitization helps to further reduce intermediation costs in a more competitive mortgage industry, allows for better management of balance sheets, and improves capital adequacy through the sale of otherwise illiquid portfolios. Reaching this advanced stage of market evolution, however, is demanding and requires having the appropriate legal and regulatory infrastructure prerequisites in place. The potential benefits of mortgage securitization, however, also carry the financial costs of new technology and information systems.
Mortgage debt markets benefit from the development of the market infrastructure built up for government securities, but they have their specific legal and regulatory needs. A sound retail (or primary) mortgage market is the cornerstone of housing finance. Basic requisites for mortgage markets include a land registry system, an effective bankruptcy law, efficient foreclosure procedures, reliable property valuation, proper mortgage loan underwriting, and modern technology in loan processing and servicing. Well-rated mortgage-related securities also require a comprehensive regulatory treatment for banks and institutional investors (pension funds, mutual funds, and insurance companies).
The development of government and mortgage securities markets is interlinked. As fixed-income securities markets expand in general, the supply of mortgage-related securities of various forms grows to represent one of the largest fixed-income markets. They offer quality securities with low spreads over Treasuries. As countries run sound fiscal policies with balanced budgets or budget surpluses, they will experience a relative shortage of government securities, making it more difficult to maintain bond benchmarks. (See Chapter 4, Developing Benchmark Issues.) In certain circumstances, mortgage bonds could assume this function. (See Section 188.8.131.52 below.)
12.4.3 Privatization and Deregulation
A major reason for increased private sector debt issuance is the greater involvement of the private sector in the economy as a result of privatization and deregulation. Some of the larger SOEs, with a correspondingly great need for debt financing, have been privatized and their industry sectors deregulated. The leading SOEs that have been privatized or deregulated have been the utility companies, such as telecommunications, electricity, and power. A motivation for privatizing these vital service providers could be their need for large amounts of investment and debt financing that are no longer available on the market or from banks unless their operations and balance sheets are radically rationalized through a private sector approach. In many developing countries, these privatized companies are becoming the most prominent issuers of private sector bonds.
12.5 Issues in Developing Private Sector Bond Markets
The government and private sector securities markets interact through many channels. Government actions can also hinder the development of the private sector securities market. Excessive government borrowing can “crowd out” the private sector, and transaction taxes can discourage trade in private securities. There are also other factors influencing private sector market development that are less directly in the hands of the government, such as sufficient supply of bonds by private sector issuers and demand for private sector issues by investors that are needed for deep and active markets. Capital markets need a critical mass of securities, investors, and funds for their efficient functioning. However, the size of the economy in which a private sector bond market is able to function appears to be more critical for the development of a private sector bond market than for the development of a government bond market. Therefore, a private sector bond market may be more difficult to develop in a small economy.
12.5.1 Linkages Between Private Sector and Government Bond Markets
A well-functioning government bond market often is the forerunner of a private sector bond market, and provides the institutional and operational infrastructure for the private sector market. The role of government benchmark issues, the experience of the dealer community, and the investor base for security purchases and trading all are valuable features of securities markets that could be drawn upon in the development of an effective private sector securities market. The government bond market also serves as a means of educating authorities, financial and nonfinancial institutions, and a wide portion of the populace about debt market operations. This will create a knowledge base about bonds that will be valuable when developing the private sector bond market.
184.108.40.206 Government as Benchmark Issuer
The government is by far the most likely issuer of debt securities that could serve as benchmarks. (See Chapter 4, Developing Benchmark Issues.) The benchmark yield curve is a basic benchmark for pricing other government or nongovernment bond issues of comparable maturities across the yield curve on the primary market as well as the secondary market. Other debt securities are priced by taking the corresponding maturity on the yield curve and adjusting for the (greater) credit risk of the nongovernment issuer. The government benchmark is an important tool for price discovery in other fixed-income securities markets, including the private sector debt market. Without that benchmark, it is difficult to price fixed-income securities, including private sector debt securities, in a rational manner.
The short end of the yield curve is important in the development of efficient money markets. The short end of the yield curve is a linkage to interest rates under the banking system. It is also where the monetary authorities can influence the general interest level of the economy through open market operations. The short end of the yield curve is, thus, the anchor to the entire yield curve. (See Chapter 2, Money Markets and Monetary Policy Operations.)
While government bonds work well as benchmark issues, countries with a small or no fiscal deficit, and those running budget surpluses after having run deficits in the past face, difficulties in supplying the government issues needed to constitute a benchmark yield curve.267 (See Chapter 4, Developing Benchmark Issues.) If government securities are not able to serve as a benchmark, it may sometimes be possible to use other bonds from major issuers, such as development banks, subnationals, or the major private sector issuers (such as mortgage bond issuers) as de facto benchmark issues. (See Chapter 11, Development of Subnational Bond Markets.)
With mortgage markets growing faster than government securities markets, consideration could be given to substitute mortgage debt benchmarks for government bond benchmarks. (See Section 220.127.116.11 above.) However, mortgage-backed securities other than bonds are not sufficiently homogeneous and free from various embedded risks for that purpose. In addition, the emergence of mortgage securities as benchmarks is difficult without a high degree of financial intermediation through a mortgage bank or a secondary market agency.
18.104.22.168 Dealer Community and Investor Base for Government and Private Sector Bonds
An efficient government bond market encourages, and even requires, the development of highly skilled fixed-income securities intermediaries. These intermediaries, in turn, can support the development of the private sector bond market. The government bond market can provide the experience needed to build skills in the fixed-income business, because it is more liquid than the private sector bond market and involves more issuance and trading—both of which also provide a strong profit base. Dealers need these skills and profits to support private sector bond transactions, which are riskier than government bonds because of the greater credit risk of private sector issuers and the lower liquidity of private sector issues (market risk). Two types of intermediaries where the government role is especially important are market makers and interdealer brokers (IDBs). (See Chapter 7, Developing Secondary Market Structures for Government Securities.)
Government securities also provide dealers with mechanisms to hedge their private sector securities market exposures. This could be done through repurchase agreements that are typically based on government securities, through government securities themselves that are lower risk and more liquid than private sector debt securities, or through interest rate derivatives that are often based on government securities.
12.5.2 Distinctive Characteristics of Private Sector Bond Markets
While government securities markets provide many elements needed for a private sector securities market to function, there are several components that a private sector debt securities market requires, and, if absent, could impede its development, regardless of how well developed the government securities market is. The most important components are attractive issuers, a disclosure and information system, a credit-rating system, and bankruptcy laws that are particular to nongovernment bond markets.
22.214.171.124 Disclosure System and Information
In order to attract and maintain investor interest, all bond issuers—whether government, subnational, or private sector—need to disclose objective, relevant, and timely information about themselves and about the securities being offered to the public. Disclosure issues relating to private sector bond development have some special aspects.
In contrast to a disclosure system, which depends on building investor awareness, regulators in developing countries sometimes use a merit system to oversee and guide private sector capital market issues. A merit system is one in which the regulatory authorities review the substantive merits of a proposed capital market issue in order to ensure that investors are protected and that the issue is compatible with national development objectives. Pursuant to laws, decrees, or directives, the authorities determine the participants that may enter the market and the terms of their involvement, including but not limited to the type of instrument that may be used and the substantive terms of the instrument (e.g., timing and pricing of the issuance). This gives regulators the ability to exercise considerable power over market outcomes.268
A merit system does not make regulators accountable for their decisions and can induce moral hazard among market participants and investors. A merit system will protract and even crush the development of a sustainable and efficient market mechanism. In private sector bond markets in developing countries, a merit system is exemplified by a queuing system, a coupon-rate control, eligibility criteria for issuers, restrictions on bond term, and the like. Use of a merit system is understandable in developing countries with major shortcomings in such essential market infrastructures as law enforcement and court systems, sophistication of investors, strong intermediaries, adequate credit-rating systems, proper accounting standards and auditing systems, and effective corporate governance. Even under such conditions, the use of a merit system should be considered as a temporary expedient, and it should be discontinued as soon as the market infrastructure is sufficiently strong to allow the private sector market to rely on conventional disclosure system procedures.
The extent of regulatory disclosure requirements for private sector debt instruments may vary by the issuing history of the issuer and the scope of targeted investors. The existence of an equity market is practically a prerequisite for private sector bond market development, as it often sets an example for disclosure practice. International accounting standards are a good model to follow to avoid accounting ambiguities in financial statement disclosure. Disclosure on private sector bonds should focus on the issuer’s creditworthiness and the issuer’s product information.
In addition to meeting regulatory disclosure requirements, the development of private sector bond markets could be aided by voluntary disclosure. Policymakers in developing countries should be aware of the important role that voluntary disclosure activities play in the functioning of developed-country capital markets, and should promote and facilitate proactive information dissemination by private sector entities. If not already mandatory, the voluntary public release of a credit-rating agency’s rating of a private sector bond issuer could form an important element of a voluntary disclosure system. Voluntary disclosure is also achieved by improvements in corporate governance that focus on transparency of the issuer’s activities and management,269 public relations through the media, and investor relations.
126.96.36.199 Credit-Rating System
Credit-rating agencies perform a catalytic role in developing capital markets. The purpose of credit ratings is to provide objective and independent summary opinions of relative credit risk. Ratings give an indication of relative risk for a bond issuer’s ability and willingness to make full and timely payments of principal and interest over the lifetime of the rated instrument.270 Investors will demand a higher interest rate to compensate for investing in bond issues with a lower rating, which reflects higher credit risk. The differentiation of interest rates on the basis of risk has two beneficial effects—the efficient allocation of resources by investors and encouragement of companies to improve their financial structure and operations. Regulators can also use credit ratings when assessing fulfillment of capital adequacy requirements, with debt of a higher credit rating carrying more weight. More generally, credit-rating agencies encourage greater transparency, increased information flow, and improved accounting and auditing. For credit-rating agencies to be successful, they must be seen to be independent, and investors must understand and value the role of ratings.
While credit-rating agencies help in the development of capital markets, they also need a minimal degree of capital market development in order to be commercially sustainable. It is doubtful whether most developing countries have the minimal degree of capital market development to sustain a credit-rating agency under normal conditions. One alternative has been for credit-rating agencies to expand into other business lines such as providing general financial information services.
Some rating agencies have dropped the link between ratings and specific issues of debt. Instead, they have rated institutions that issue the debt. In the Philippines and Turkey, for example, domestic banks obtain ratings in order to establish relationships with foreign banks and even to raise funding on international markets.
Another, and more controversial, method to make credit-rating agencies willing to rate entities in developing countries has been to aid these agencies by public policy actions. In most developing countries with credit rating agencies, mandatory ratings by accredited credit-rating agencies have been introduced, and, often, a system is set up to license approved rating agencies. Mandatory ratings usually require private sector bond issues to be rated, and certain institutional investors may be restricted to purchase securities that have received a certain rating classification. For example, pension funds may be required to purchase only rated securities.
International credit-rating agencies, such as Standard & Poor’s and Moody’s, have advantages over domestic agencies in their greater expertise and credibility. They at times may lack, however, the qualitative understanding of local conditions, which is particularly important in developing countries where access to, and availability of, quantitative data is often lacking. A common approach has been for a domestic credit agency to form a joint venture with an international rating agency, with the latter providing technical assistance to the domestic rating agency. Fitch-IBCA Duff & Phelps,271 a leading international credit-rating agency, has expanded its activities to lesser-developed capital markets through joint ventures. Often this has been with the International Finance Corporation of the World Bank Group helping to establish the new rating agency and taking a small equity share. Most of these projects are yet to be completed, and it is too early to assess the success of the local joint venture rating agencies that have begun operations. Their supposed catalytic impact on capital market development is far from demonstrated, especially as they almost all rely upon mandatory ratings.
Another issue is the optimal number of credit-rating agencies in a market. Too much competition in an undeveloped market may cause an inflation of ratings or lower quality of the rating process in an attempt to cut costs. Too little competition, on the other hand, raises concerns about slackening of standards and performance.
188.8.131.52 Bankruptcy Laws
Bankruptcy laws are another essential element for developing private sector securities markets. Nongovernment bonds, typically private sector bonds, may default, whereas government bonds denominated in the local currency do not default, at least in theory.
The issuer’s obligation to pay interest and repay the principal in a timely manner should not be a matter for issuer discretion. The investor is able to assess meaningfully the risk of investing in bonds only if the limit of the investor’s legal ability to force the bankrupt issuer to service its obligations and the procedures for going to that limit are clearly defined. Bankruptcy laws define the limit and the procedures. A mechanism for efficient reorganization is vital to a smooth functioning of private sector bond markets in that it establishes the investor’s right to recover investments and establishes the priority (seniority) or subordination of one investor’s right to that of other creditors.272
The investor’s ability to force a bankrupt issuer to repay its obligations under bankruptcy laws can be generally classified into three classes according to its security type—secured or collateralized bonds, senior bonds, and subordinated bonds.
12.5.3 Impediments to Private Sector Bond Market Development
The absence, deficiency, or ineffectiveness of the essential elements needed to develop and maintain an effective government or subnational bond sector discussed in other chapters of the handbook may impede market development and/or substantially impair the functioning of the market. While these considerations apply to the development of the private sector bond market, there are two specific government actions—crowding out and statutory restrictions—that can impair the development of private sector bond markets.
184.108.40.206 Crowding Out by Public Sector Borrowing
Given the credit standing of government bonds, such securities, especially if priced competitively, will be the preferred investment choice for many market participants. Persistent large government budget deficits, financed by issuance of new government bonds, could absorb national savings, thereby crowding out the private sector from the bond market. Under such circumstances, the private sector will find it impossible to obtain investors for its bonds or will do so only at prohibitively high interest rates.
There are other ways in which the government may be crowding out the private sector. The government may be tempted to finance its fiscal deficit at the lowest possible cost before any nongovernment issuers tap the market. This could be achieved by offering special-issue bonds with a low yield but with other attractive features (e.g., tax exemptions, backing by proceeds of gold or oil, distinctive maturities) that other issuers are not able to provide. A variant is for the government to require financial institutions to purchase government securities to meet regulatory requirements (captive sources of government funding). (See Chapter 6, Developing the Investor Base for Government Securities.) There is not much that the private sector can do to contend with such government actions except to engage government officials and enlighten them of the undesirable consequences of their conduct and policies.
220.127.116.11 Statutory Restrictions
The primary private sector bond market is more subject to governmental interference than the secondary market because it is the entry point of securities into the market and thus the very first checkpoint for investor protection. Statutory restrictions are usually imposed around either the market participants’ eligibility or product features, or both. Such government interference often ends up with a merit system. (See Section 18.104.22.168.)
Table 12.6 summarizes typical restrictions that the government in a developing country often imposes on the primary market for private sector bonds, possible motives behind the restrictions, and possible negative impacts of the restrictions on private sector bond market development. These statutory restrictions usually have plausible but ostensible policy objectives that often disguise their true intentions and/or negative effects. Possible motives behind those statutory restrictions can be categorized as:
|Restrictive Areas||Restrictions and Requirements||Possible Motives||Possible Negative Impacts on Debt Market Development|
|Product features||No short term||To avoid conflicts with banking products||No reliable anchor for yield curve; will distort yield curve|
|Cap on coupon rates||To keep general level of interest rates artificially low||Will hamper formation of yield curve; will dampen supply of, and demand for, long-term bonds|
|No floating rate||To limit competition with bank deposits||Will limit hedging tools against interest-rate risks|
|No/restrictive unsecured bonds||Unsecured bonds may undermine banks’ demand for collateral to their loans||Will be disadvantageous to new, fast growing companies and noncapital-intensive companies|
|Bank guarantee||To keep bond issuance under a bank’s control||Will limit free risk/return trade-off|
|No forex-linked bonds||Capital control||Will limit hedging tools against currency risks|
|Issuer’s eligibility||Credit-rating-linked eligibility for bond issuance||To avoid conflict with banks in lucrative mid-market||Will limit free risk/return trade-off; disadvantageous to low-rated companies|
|Cap on debt issue amount||To keep bond issuance supplementary to bank loans||Will limit free risk/return trade-off|
|Queuing system||To keep room for government bond issuance||Will dysfunction demand/supply relationship|
|Underwriter’s eligibility||Strict requirements or no license for new entrants||To protect vested interests of existing underwriters||Will limit competition and innovation|
|Taxation||Withholding tax and stamp duties||To compensate for weak tax collection system||Will fragment market and limit liquidity|
|Other||Ban on swap Ban on futures and options||Bureaucratic investor protection in absence of financial expertise and well-organized risk management systems at regulatory and corporate levels||Will limit hedging tools against interest rate risks; will limit arbitrage activities|
|Vetting period of securities registration||Cumbersome and time-consuming; bureaucratic inefficiency. Banks may benefit from this inefficiency||Will reduce optimal financing opportunities; may raise financing costs to issuers|
Protection of vested interests of market participants
Preservation of the existing tax base
The development of private sector bond markets may erode some part of the business activity of commercial banks. Banks may feel threatened by an emerging securities industry, and often will attempt to use their political influence to foil or curb the development of such private sector markets.
Opposition to the development of a primary market for private sector bonds may also be found in a country’s securities industry itself. Existing intermediaries, such as investment banks and brokerage houses, may have built up significant vested interests through a banking/brokerage business and may resist changes to existing market structures and environments. Pressure from these firms at times has effectively barred new entrants such as commercial banks and foreign investment banks from posing strong competition to them. In the process, the development of the private sector bond market is impaired.
As discussed in Chapter 10 (Development of Government Securities Market and Tax Policy), taxes on securities transactions and fees (stamp duties) are common impediments to the development of government securities markets. The same considerations apply to the development of the private sector bond market. Such taxes and fees reduce market turnover and thereby market liquidity in the secondary market for private sector bonds, and in this manner inhibit the development of the market.
Lengthy vetting of filed securities registration statements is in all likelihood not an intended restriction. It is a by-product of a statutory action to implement disclosure requirements. Nonetheless, cumbersome and excessive filing requirements can become a de facto statutory restriction in that it actually prohibits issuers from expeditiously availing themselves of timely financing opportunities.
In addition to making vetting operations at the regulatory authority efficient by periodic review of existing requirements and by staff training, a shelf-registration system may be helpful in this regard. A shelf-registration system allows for the sale of securities on a delayed or continuous basis. Once a prospective issuer registers for an amount that may reasonably be expected to be sold for a predetermined period (say, two years) after the initial date of registration, the issuer and its underwriters are allowed the flexibility to sell the registered securities when they think market conditions are most favorable during that period. The major security markets, including those in Japan, the United Kingdom, and the United States, have shelf-registration arrangements.
The issuance of fixed-income securities by private sector entities will contribute to economic development through more efficient allocation of capital to the private sector. New trends in public policy and financial technology broaden the application of private sector debt securities. They create new borrowers that arise from the growth of private sector initiatives, typically in housing finance and infrastructure building. Unlike government bonds, only a small number of private sector bond issues are likely to be liquid. A private sector bond market needs, among other things, a credit-rating system, a disclosure system including securities registration, and effective bankruptcy laws.
Development of a well-functioning government bond market in developing countries will often precede and facilitate development of a private sector bond market. A well-functioning government securities market provides the institutional and operational infrastructure for the private sector market. The government securities bond benchmark is an important tool for price discovery in the private sector fixed-income securities market. The experience of the dealer community and the investor base for security purchases and trading are valuable features of securities markets that could be drawn upon in the development of an effective private sector securities market. The government securities market also serves as a means of educating authorities, financial and nonfinancial institutions, and a wide portion of the populace about debt market operations. This will create a base of knowledge about bonds that will be valuable when developing the private sector securities market.
AylwardAnthony and JackGlen. 1999. “Primary Securities Markets: Cross Country Findings.”Discussion Paper Number 39. International Finance CorporationWashington, D.C.
BIS (Bank for International Settlements). 1999. Quarterly Review: International Banking and Financial Market Developments. November. Basel, Switzerland. Available at www.bis.org/publ/index.htm.
CarterLawrence W. and GaryBond.1996. IFC Lessons of Experience 4: Financing Private Infrastructure. International Finance CorporationWashington, D.C.
DarcheBenjamin.2000. Local Capital Markets and Private Infrastructure Development: Global Best Practice Review. World BankWashington, D.C.
EndoTadashi.2000. “Corporate Bond Market Development.”IFC Working Paper. International Finance CorporationWashington, D.C.
Federal Reserve Board. 1999. Flow of Funds Accounts of the United States 1998. Board of Governors of the Federal Reserve SystemWashington, D.C.
HakanssonNils H.1999. “The Role of a Corporate Bond Market in an Economy—and in Avoiding Crises.”Working Papers RPF—287. Institute of Business and Economic Research (IBER)University of California at Berkeley.
HarwoodAlison.2000. “Building Local Bond Markets: Some Issues and Actions.” In Building Local Bond Markets: An Asian Perspective. International Finance CorporationWashington, D.C. Available at www.ifc.org/publications/pubs/bond.html.
IMF (International Monetary Fund). 1998. International Financial Statistical Yearbook 1998. Washington, D.C.
LeeEsmond K. Y.1999. “Debt Market Development in Hong Kong.”Presentation to the World Bank Group.
OECD (Organization for Economic Cooperation and Development). 1999. Principles of Corporate Governance. Paris, France. Available at www.oecd.org//daf/governance/principles.pdf.
PettisMichael.2000. “The Risk Management Benefits of Bonds.” In Building Local Bond Markets: An Asian Perspective. International Finance CorporationWashington D.C. Available at www.ifc.org/publications/pubs/bond.html.
PinkesKenneth.1997. The Function of Ratings in Capital Markets. Global Credit Research, Moody’s Investors ServiceNew York.
Rhee S. Ghon. 1998. “Institutional Impediments to the Development of Fixed-Income Securities Markets: An Asian Perspective.”OECD/World Bank Workshop on the Development of Fixed-Income Securities Markets in Emerging Market Economies. Paris, France. December.
RogerNeil.1999. “Recent Trends in Private Participation in Infrastructure.” Private Sector/Viewpoint. Note No. 196. World BankWashington, D.C.
SchinasiGarry J. and R. ToddSmith.1998. “Fixed-Income Markets in the United States, Europe, and Japan: Some Lessons for Emerging Markets.”IMF Working Paper 98/173.International Monetary FundWashington, D.C. Available at www.imf.org.
In order to meet particular needs, investment banks have been developing a wide range of debt instruments in addition to fine-tuning parameters of individual instruments for specific clientele. These include commercial paper, certificates of deposit, floating rate notes, zero-coupon bonds, deep-discount bonds, perpetual bonds, secured or unsecured bonds, convertible bonds, bonds with equity warrants, mortgage-backed securities, asset-backed securities, index-linked bonds, medium-term notes, dual-currency bonds, reverse dual-currency bonds, and catastrophe bonds. Terminology varies among jurisdictions, with the precise definitions of commercial paper, notes, and bonds carrying different meanings. In this chapter, “debt securities” is used as a genetic term, while “bonds” is used to describe debt securities with maturities of at least a year.
Even in the large U.S. capital market, only 4 percent of about 400,000 corporate issues outstanding in 1996 traded even once that year (see New York Times, June 27, 1999).
See Bank of Japan (1998) and Federal Reserve Board 1999. The corporate bonds in Japan are “industrial securities” (straight bonds, convertible bonds, and bonds with equity warrants) and bank debentures.
In 1996 and 1997, 93 percent and 87 percent of Korean corporate bonds were guaranteed, with the remainder nonguaranteed. In 1998, these proportions had altered drastically, with 33 percent guaranteed and 67 percent nonguaranteed (Bank of Korea and Korea Securities Dealers Association).
Though corporate bond markets already exist in one way or another in many developing countries, it is difficult to gather reliable statistical data on them. More surprisingly, reasonably consistent data for corporate bond markets in developed countries are also not available (see notes to Table 12.4). BIS data do not include domestic debt securities in some developing countries (for example, Indonesia, Philippines, the Slovak Republic, and Thailand), and show amounts different from IFC data for the other developing countries. There are apparently differences in definition between the two sources.
Major corporate bond issuers in developing countries include ICICI in India, KDB in Korea, and Industrial Finance Corporation in Thailand. (All three are development finance institutions, i.e., quasi-statal development banks, and perhaps fall in a/the subnational category.) A true corporate issuer in a developing country is EGAT, an electricity company in Thailand.
See Roger 1999.
See IMF 1998.
According to the data on the 115 IFC-financed private infrastructure projects during 1967 to 1996, the financial structure of the projects was as follows: debt: equity = 58 percent:42 percent; local: foreign =33 percent:67 percent. If the debt and equity shares were the same in the foreign and local shares, the local debt share would be 19.4 percent (58 percent x 33 percent). The actual shares of local debt (local commercial banks) and local equity in 1996 were 10 percent and 26 percent, respectively. The range of 10–20 percent was estimated from the 19.4 percent and 10 percent figures (see Carter and Bond 1996).
The United States is facing the prospect of this situation, and this was also an issue in Australia in the 1990s.
See Wong 1996.
In 1999, the OECD published, Principles of Corporate Governance. The five basic principles recommended for corporate governance are: (i) The Rights of Shareholders: The corporate governance framework should protect shareholders’ rights. (ii) The Equitable Treatment of Shareholders: The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. (iii) The Role of Stakeholders in Corporate Governance: The corporate governance framework should recognize the rights of stakeholders as established by law and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. (iv) Disclosure and Transparency: The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. (v) The Responsibilities of the Board: The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of the management by the board, and the board’s accountability to the company and the shareholders. (See OECD 1999.)
See Pinkes 1997.
Fitch-IBCA und Duff Phelps Credit Rating (DCR) merged in March 2000.
See Hakansson 1999.