CHAPTER IV DEVELOPMENT OF CORPORATE BOND MARKETS IN EMERGING MARKET COUNTRIES
Author: International Monetary Fund. Monetary and Capital Markets Department
Language:
English
Keywords:
GFSR; corporate bond bond market; institutional investor; bond market; market correction; risk premium; fixed income; sovereign bond; secondary market; global bond; Corporate bonds; Securities markets; Bonds; Sovereign bonds; Emerging and frontier financial markets; Asia and Pacific; Africa; Europe
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Abstract

The macroeconomic and financial dislocations experienced following the crises in emerging markets (EMs) in the late 1990s have led to increased efforts in these countries to develop local bond markets as an alternative source of debt financing for corporates. A well-functioning bond market can strengthen corporate and bank restructuring and thus accelerate the resolution of a crisis. At the same time, local bond issues facilitate the reduction of currency and maturity mismatches on their balance sheets and thus reduce the vulnerability of the corporate sector. Recent work by the IMF on the use of the balance sheet approach to detect vulnerabilities in EMs has highlighted the importance of corporate sector vulnerabilities and their linkages to other sectors and markets. In this context, the April 2005 Global Financial Stability Report (GFSR) demonstrated the importance of having alternative sources of funding for the corporate sector, both to finance growth and to strengthen balance sheets. In this chapter, we continue this line of work and focus on ways to further develop corporate bond markets in EMs.

The macroeconomic and financial dislocations experienced following the crises in emerging markets (EMs) in the late 1990s have led to increased efforts in these countries to develop local bond markets as an alternative source of debt financing for corporates. A well-functioning bond market can strengthen corporate and bank restructuring and thus accelerate the resolution of a crisis. At the same time, local bond issues facilitate the reduction of currency and maturity mismatches on their balance sheets and thus reduce the vulnerability of the corporate sector. Recent work by the IMF on the use of the balance sheet approach to detect vulnerabilities in EMs has highlighted the importance of corporate sector vulnerabilities and their linkages to other sectors and markets. In this context, the April 2005 Global Financial Stability Report (GFSR) demonstrated the importance of having alternative sources of funding for the corporate sector, both to finance growth and to strengthen balance sheets. In this chapter, we continue this line of work and focus on ways to further develop corporate bond markets in EMs.

Well-functioning local corporate bond markets provide institutional investors with an instrument that satisfies their demand for fixed-income assets, especially of long maturities, as well as for yield pickup over government bonds. Thus, corporate bonds also help strengthen balance sheets of pension funds and life insurance companies. In many countries, assets under management of institutional investors have been growing faster than the supply of local instruments in which to invest. In addition to allowing institutional investors to invest internationally, a deep and liquid corporate bond market may help prevent the development of asset price bubbles and reduce this source of financial instability.

This chapter provides an overview of the factors and reform measures that contribute to and promote effective corporate bond markets. It highlights lessons from the experiences of mature markets (MMs), as well as from a small group of EMs that either have large corporate bond markets or have seen them grow rapidly in recent years.1 Many EMs have achieved a degree of macroeconomic stability—through fiscal consolidation and enhanced monetary policy credibility—and have made progress in the areas of banking supervision as well as in transparency and corporate governance. Some of these countries have been seeking to develop their corporate bond markets, but so far only the best corporates have been able to access these markets. Moreover, after a period of rapid growth in local corporate bond markets, issuance has slowed in the last two years, raising concerns that the initial growth was a purely cyclical phenomenon. In this chapter, we argue that a further broadening and deepening of these markets requires the removal of constraints mainly on the supply side, as well as improvements in market microstructure. Also, the lessons identified in this chapter could be relevant for other EMs that want to jump-start corporate bond markets.

Domestic corporate bonds may not, however, be a suitable instrument for all enterprises. Collateralized loan financing may be more accessible and appropriate for corporates that lack adequate credit information (IOSCO, 2004). In particular, small and medium-sized enterprises in many EMs are not able to access bond markets because of the inflexible structure of bond contracts, the high costs associated with issuance, and the need for large issuance size. At the other extreme, large corporates could find it more efficient to issue bonds in international or regional markets, although this may expose them to currency risks.

Moreover, despite the benefits associated with the provision of an alternative source of funding for corporates and a suitable instrument for local institutional investors, a rapid development of local corporate bond markets could be potentially risky. The development of these markets without minimum institutional support to deal with asymmetric information problems and other capital market imperfections—such as effective bankruptcy laws and transparencyc—could cause market turmoil and slow the development of such markets over the medium term.

Following a brief description of recent trends in global corporate bond markets, the next section focuses on demand and supply factors behind the development of corporate bond markets, as well as on the role played by financial intermediaries. Aspects of the microstructure of primary and secondary markets are discussed in the following section, after which a concluding section discusses the main challenges for and policy issues related to the development of these markets and their relation to financial stability.

Recent Trends in Local Corporate Bond Markets

This section looks at trends in corporate bond market development in emerging markets, focusing on some of the largest EMs over the past 10 years, with the pattern of development in the mature markets as background.2

The government and financial institutions remain the main issuers of local currency bonds, but corporate issuers are becoming important. As of end-2004, in mature markets, outstanding securities issued by the government, financial institutions, and corporates accounted for 66, 57, and 16 percent of GDP, respectively. In EMs, these figures were 25, 8, and 5 percent of GDP, respectively (Table 4.1.). The existence of a well-developed government bond market has been important in the development of the corporate bond markets,3 and cross-country analysis suggests that countries with larger outstanding government debt securities tend to have larger corporate bond markets (Figure 4.1).4 Also, while bank lending remains the main source of corporate finance in most mature and emerging markets (excluding retained earnings), corporate bond financing is increasing in relative terms.5

Table 4.1.

Outstanding Domestic Debt Securities, Stock Market Capitalization, and Bank Credit, 2004

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Sources: Bank for International Settlements (BIS); Bloomberg; Standard and Poor’s; and IMF staff estimates.

Euro area includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, and Spain, excluding Luxembourg.

The size of local corporate bond markets, as a percent of GDP, varies widely across countries. Among MMs, the United States has the largest (deepest) corporate bond market accounting for about 22 percent of GDP, followed by Japan at 16 percent of GDP, and the euro area countries at 10 percent of GDP. For most of the emerging markets countries, corporate bond markets remain small. However, the corporate bond markets in Malaysia and Korea are among the largest in the world in terms of GDP: 38 and 21 percent, respectively. Corporate bond markets in Thailand have been growing fast and reached about 12 percent of GDP by end-2004. In Latin America, Chile stands out; the outstanding volume of its corporate bonds amounts to 11 percent of GDP

Figure 4.1.
Figure 4.1.

Size and Composition of Local Bond Markets Outstanding, 2004

(In percent of GDP)

Sources: Bank for International Settlements (BIS); and IMF staff estimates.1Euro area includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, and Spain, excluding Luxembourg.2Indian corporate sector issues only cover commercial paper, as reported by the BIS. Under the more inclusive definition provided by JPMorgan & Chase Co., the outstanding volume of corporate securities would reach 5.4 percent of GDP.3The outstanding volume of government bonds for the Czech Republic includes issuance by the overall public sector, as reported by the BIS. This contrasts with the narrower definition of general government used to compute public debt under the IMF’s Government Finance Statistics methodology.

Global bond issuance expanded sharply in the 1990s. During 1999-2003, average annual corporate bond issuance in the United States was about $900 billion compared with $280 billion in 1994. In the euro area, it was about $550 billion, quadruple the 1994 level. (In Japan, it was government debt issuance that almost doubled, from $250 billion to about $450 billion.)6 Several EMs also experienced strong growth in corporate bond issuance since the mid-1990s. Cyclical factors, as well as diversification away from banks and the need for alternative sources of funding to reduce currency and maturity mismatches, have been important drivers of the growth in local corporate bond markets. While in Asia most of the growth took place in domestic bond markets, in Latin America corporates mainly accessed international bond markets until the emerging market crisis of 1998; since then, corporates have increased issuing in domestic bond markets.

Corporate bond markets in most mature markets were almost nonexistent in the early 1980s, except in the United States, where historically the local bond market has been an important source of funding for the corporate sector. The traditional importance of bank lending in financing large and medium-sized corporates in most MMs began to erode in the second half of the 1990s both in the euro area and, to a lesser extent, in Japan. In the United States, the economic boom of the 1990s led to a strong increase in corporate debt issues. Although private sector issues declined in 1999–2000, following the Long-Term Capital Management and Russian debt crises, issuance picked up again after 2000. In Japan, the corporate bond market was heavily regulated until 1985. The relaxation of market eligibility standards, the establishment of rating agencies, and the start of bond futures trading followed by the liberalization of financial transactions (the “Big-Bang” reforms in the mid-1990s) contributed to the development of securities markets. The relevant measures taken included abolishing the securities transaction tax, deregulating brokerage commission, preparing the legal framework for securitization, allowing banks to issue straight (unsecured) bonds, and introducing a registration system for securities companies. Local corporate bond markets in mature markets grew from about 5 percent of GDP in the early 1980s to an average of 16 percent of GDP during 2000–04. (See Table 4.2. and Figure 4.2 for recent developments.)

Table 4.2.

Corporate Issuers: Outstanding Domestic Debt Securities

(In percent of GDP)

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Sources: BIS; Cbonds; MICEX; and IMF staff estimates.

Euro area includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, and Spain, excluding Luxembourg.

Figure 4.2.
Figure 4.2.

Local Corporate Bonds Outstanding

(In percent of GDP)

Sources: Bank for International Settlements (BIS); and IMF staff estimates.

Most European corporate bond markets, except for Germany, were relatively small until the introduction of the euro. Pagano and von Thadden (2004) show that it was the corporate sector of the euro area bond market that grew the most in the wake of European Monetary Union, and transformed the euro into a leading currency of denomination for international bond issues. During 2000–04, euro area corporate bond markets increased from about 4 percent to 10 percent of GDP.

Corporate bond issuance in the major EMs has also grown rapidly since the mid-1990s. In Asia, corporate bond markets increased from 4.3 percent of GDP to 8.4 percent, with large variance across countries. Malaysia and Korea’s bond markets reached their largest sizes in 2001 (at 48 percent of GDP) and 2002 (at 30 percent of GDP), respectively. The stock of outstanding corporate bonds also doubled in Thailand, reaching 13.5 percent of GDP in 2003. In Latin America, corporate bond markets also more than doubled in size between 1997 and 2003, with Chile’s bond markets reaching 11 percent of GDP in 2003. The growth of these markets in Central and Eastern Europe has been much less impressive, because of the abundance of bank credit. One exception is the Czech Republic, where the delayed reform of the banking system—which stabilized in 2002 following the completion of privatization and the reduction of impaired assets to below 15 percent of total loans—combined with a sharp fall in local interest rates may have helped spur the growth of the corporate bond market (Figure 4.3).7 Unlike the pattern observed in the region, increasing bank lending rates in the Czech Republic during 1993-97 may have prompted corporates to look for alternative sources of finance. Likewise, an environment of declining interest rates after 1997 may have skewed investors’ choices toward more sophisticated market-based instruments.

Figure 4.3.
Figure 4.3.

Corporate Bond Market and Money Market Interest Rates in the Czech Republic

Sources: Bank for International Settlements (BIS); and IMF, International Financial Statistics.

The growth of local corporate bond markets did, however, slow in 2004, as the interest rate cycle began to turn, the financing needs of local firms diminished, and the constraints facing new entrants into the bond market became apparent. Most companies are either cash rich and/or are able to access cheap bank funding, as banks are now pursuing aggressive lending strategies following the postcrisis restructuring. Market participants have noted that, despite important structural progress, the takeoff of several EM corporate bond markets has a strong cyclical component. Whether the previous growth spurt in corporate bond issuance is sustainable is subject to debate.

Both cyclical and structural factors have been important drivers of the rapid development of the domestic corporate bond markets in several emerging market countries. The financing needs of local corporates in the aftermath of financial crises have been a key cause of the domestic corporate bond market development, especially in Asia and Mexico. The easing of inflationary pressures, increased global liquidity, and the sharp decline in domestic interest rates also contributed to the increased issuance of corporate bonds (Figure 4.4). These trends also coincided with corporates’ restructuring in EMs (especially in Asia and Latin America), allowing corporates to refinance expensive external debt with local funding. The shift away from international issuance was also supported by the strong growth in assets under the management of such local institutional investors as pension funds, insurance companies, and asset management companies.8

Figure 4.4.
Figure 4.4.

Domestic Government Bond and Money Market Rates1

(In percent)

Source: Bloomberg L.P.1For Asia, the rates were for a five-year government bond. For Latin America, one-year money market rates were used.

The authorities also implemented significant and targeted reforms to facilitate the development of the corporate bond markets. These included establishing rating agencies and benchmark yield curves, permitting issuance of unsecured bonds, and liberalizing market eligibility standards. Reforms and policy initiatives to improve bond market infrastructure have strengthened trading platforms, clearing and settlement systems, and the regulatory environment. In many countries, benchmark yield curves were established through the issuance of government bonds both to fund financial restructuring and infrastructure projects as well as to absorb excess liquidity attributable to the buildup of foreign reserves. However, as discussed later, gaps remain regarding the development of hedging products and derivatives markets, and strengthening the disclosure standards and the framework for creditor rights and investor protection.

Since the binding constraint often appears to be on the availability of sound credits, some issuers and arrangers have resorted to credit enhancements and structured products to enhance credit quality and appeal to a wider investor base (Table 4.3.). In Latin America, structured finance transactions in local markets have continued to grow steadily; in 2004, they surpassed for the first time the volume of cross-border structured finance issuance. In Korea, the asset-backed securities market—which spurred the development of the corporate bond market following the Asian crisis—declined following the problems with credit card companies in 2003. Meanwhile, after a decline in 2002–03, the structured finance market in Malaysia continued to develop in 2004. That said, conditions have proved challenging for the securitization market. Banks have little incentive to securitize their assets, given the abundance of liquidity in the banking system and strong capital adequacy ratios within the industry.

Table 4.3.

Securitization: Selected Emerging Markets

(In millions of U.S. dollars)

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Sources: Dealogic; and IMF staff estimates.

To analyze the main drivers of these recent trends, and the obstacles to further development of the corporate bond markets, the remainder of this chapter focuses on two groups of issues:

  • the main causes of the growth of the demand for and supply of corporate bonds, as well as the role played by intermediaries; and

  • aspects of the microstructure of the primary and secondary markets, as well as regulatory issues that help promote the growth of corporate bond markets.

Demand and Supply Factors Driving Corporate Bond Markets

The engines of growth of corporate bond markets have varied across countries. The growth of institutional investors’ assets under management has been a major reason for the growth of some corporate bond markets, while the collapse of other sources of funding has been the main cause of the growth in the supply of corporate bonds in other markets. To identify the main obstacles to a deeper and broader market, we need to focus on whether the main driving force of growth has been on the demand or supply side of the market.

The exponential growth of corporate bond markets in the euro area over the last decade illustrates the forces underlying the growth of these markets. Monetary unification, globalization, and efforts to develop government bond markets gave the initial push to bond markets in the euro area that resulted in a sharp increase in corporate bond issuance (Pagano and von Thadden, 2004). These initial triggers operated through changes in the behavior of investors and issuers alike, as well as through ongoing changes in the banking industry. On the demand side, duration and diversification needs of institutional investors were a major force behind the growth in the market, supported by the elimination of currency risks. Asset managers in the euro area countries moved rapidly to reap the diversification gains of cross-border investing, and pension funds’ and insurance companies’ moves toward diversification were also aided by the relaxation of a number of regulatory restrictions on the matching of their assets and liabilities. The changes in the investment strategies of institutional investors resulted in a net increase in the demand for corporate bonds in (previously) local markets.9 Issuers that saw this large pool of investors increased their issuance and took advantage of the opportunity to diversify their sources of funding away from local banks. At the same time, banks faced with increasing disintermediation and the need to strengthen balance sheets and business lines supported the process by competing in the primary market and lowering underwriting costs, and by providing increasingly homogeneous secondary market trading facilities. These forces have also been at play in some emerging market countries.

Demand Factors

The rapid growth of assets under the management of local institutional investors has been one of the key factors behind the rapid development of domestic corporate bond markets in Latin America and, to a lesser extent, in emerging Asia. Institutional investors’ assets under management are growing rapidly in EMs as a result of pension reforms, the low levels of insurance penetration, and the growing popularity of mutual funds. Although these factors have largely benefited government bond markets, in some countries they have also boosted corporate bond markets. Corporate bonds constitute an attractive instrument for institutional investors that need to match assets and liabilities; these investors are also attracted by the pickup in yield provided by some exposure to credit risk. In some Asian EMs, state-run pension funds are increasingly farming out the management of assets to private managers: analysts note that an increasingly commercial orientation may lead to further demand for corporate bonds.

Local institutional investors in Chile, Mexico, and Peru, for instance, hold around 70–90 percent of outstanding corporate bonds, while banks and retail investors hold the largest share in Thailand (Table 4.4). The growth in corporate bonds outstanding in the Latin American countries was associated with the growth of pension fund assets under management(Figure 4.5). In Asia, the growth of insurance companies has been an important source of demand for corporate bonds.

Table 4.4.

Local Institutional Investor Base for Corporate Bonds

(In billions of U.S. dollars, unless indicated otherwise)

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Sources: Thai Bond Dealing Center; and IMF staff estimates.Note: AUM = assets under management.

Not including the banking sector.

Includes securitizations.

Includes banks and retail investors.

Figure 4.5.
Figure 4.5.

Pension Fund Assets Under Management and Corporate Bonds Outstanding

(In percent of GDP)

Sources: IMF staff estimates based on FIAP; BIS; and IMF, International Financial Statistics.

From a similar level of 14 percent of GDP in 1998, insurance companies’ assets under management at end-2003 had grown to 25 percent of GDP in Korea and to 19 percent in Malaysia (Table 4.5). Insurance penetration in Latin America is much lower, with assets under management exceeding 9 percent of GDP only in Chile. In most cases, however, the aggregate exposures of institutional investors to corporate debt are relatively low (see Table 4.6 for a sample of EMs pension funds) and below regulatory limits. This suggests that the potential demand for private debt instruments is significant.

Table 4.5.

Assets Under Management by Insurance Companies

(In percent of GDP)

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Sources: National regulators; and IMF staff estimates.
Table 4.6.

Pension Fund Investment in Corporate Fixed-Income Instruments

(In percent of total investment)

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Source: International Federation of Pension Funds Administrators (FIAP).

However, the rapid growth in mutual fund assets under management did not have an important impact on corporate bond markets, as these vehicles focus mostly on such liquid assets as money market instruments, government bills and bonds, and equities. Brazil and South Africa have seen mutual fund assets under management (as a percent of GDP) almost triple since 1997 (Table 4.7), while the ratio of corporate bonds outstanding relative to GDP has been stable-albeit at a higherlevel in South Africa.10 Similarly, the rapid growth of mutual funds in Poland, Turkey, and Thailand has been associated with the growth of government rather than corporate bond markets.

Table 4.7.

Emerging Market Mutual Funds: Total Net Assets1

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Sources: Bloomberg; Federation of Malaysian Unit Trust Managers; Investment Company Institute; Monetary Authority of Singapore; Security and Exchange Commission of Thailand; Superintendencia de Bancaria and Superintendencia de Valores, Colombia.

Funds of funds are not included; home-domiciled funds except for Hong Kong, Korea, New Zealand, and Singapore, which include home- and foreign-domiciled funds.

Participation by foreign investors in local corporate bond markets remains very low relative to participation in equity and government bond markets. For instance, foreign investors hold a large share of long duration government bonds in Malaysia, Mexico, and South Africa, but they rarely invest in local corporate bonds.11 In Korea, the share of foreign investors in equity markets is about 40 percent, but foreign participation in both corporate and government bond market is very small, as foreign investors see much more upside in equity markets. The general lack of interest from foreign investors in the EM local corporate bond markets has also been attributed to the tightness of spreads, general unfamiliarity with these markets, and the lack of hedging instruments.

Supply Factors

Corporates consider several factors in deciding whether to use bank funding or bond funding. These include cost considerations, access to long-term funding, disclosure requirements, and the desire to diversify funding sources. In some EMs, corporates have found strong incentives to issue bonds when faced with increasing costs of bank lending or when they were rationed out of the loan market-as a result of banking distress. However, even when bond issuance was advantageous-including in terms of maturities and covenants-some corporates were reluctant to issue bonds to avoid the disclosure implicit in securing market funding.

The growth in Asian corporate bond markets has been driven mainly by corporates’ need for alternative sources of funding in the face of a collapse in bank lending.12 Korea and Malaysia had already developed corporate bond markets in the mid-1990s, but both markets more than doubled, relative to GDP, between 1997 and 1999. In Korea, the issuance of nonguaranteed corporate bonds increased sharply after the financial crisis of 1997, aided by the fact that conglomerates owned the investment trust companies (ITCs) that bought the new bonds. However, the mid-1999 collapse of Daewoo Group, the third largest conglomerate, triggered a sharp withdrawal of funds and liquidity problems in the ITCs, which were the main holders of the bonds issued by the group. The Korean experience also demonstrates the potential problems associated with increased issuance of corporate bonds during a period of intensive corporate restructuring, as well as how poor credit risk management by investment trust companies contributed to and further magnified the turmoil in the corporate bond market.13

Another clear example of supply-driven growth in corporate bonds is the Russian experience. Ruble-denominated corporate bonds grew from less than 1 percent of GDP in the year 2000 to 2.8 percent in 2004, as a result of the large financing needs of the corporate sector and the inability of the banking system to recover from the crisis of 1998–99. Interestingly, the local corporate bond market in Russia took off despite the absence of a well-developed benchmark yield curve, a strong institutional investor base, or a “credit culture” (Box 4.1). Also, it is one of the few EMs where foreign investors participate on a meaningful scale in the local corporate bond market

Imbalances Between Demand and Supply of Corporate Bonds

As noted in the April 2004 GFSR, the inability of the local supply of securities to respond to the rapid growth of the demand (derived from the growth in assets under management) may lead to mispricing and eventually to asset price bubbles. This has become an issue in some EMs, both in the sovereign and corporate bond markets, as well as in some equity markets. For instance, in Peru, local corporates have been able to issue local bonds denominated in U.S. dollars at lower costs than the sovereign or similarly rated companies that borrow in international markets. Similarly, some analysts believe that the strong run-up in the Santiago stock exchange is due in part to the shift of pension fund investors toward more aggressive funds that are allowed larger allocations to equities.14 Also, in Malaysia and Thailand, five-year domestic government bonds were trading at sub-Libor levels in April 2005, compared with Libor plus 20–30 basis points for the five-year offshore bonds.15

Moreover, herding behavior and excessive concentration in a few market participants could magnify the asset price effects of portfolio relocations, especially in smaller markets. The experience of several Latin American countries’ pension fund industries demonstrates that concentration of demand in a few players can lead to pricing distortions at issuance and limited trading in secondary markets. Regulatory limits on exposures to an individual issuer may become binding when a large pension fund faces the option to invest in a bond issued by a relatively small company.

Corporate Bond Market in Russia

The corporate bond market in Russia, which came into existence in 1999, experienced rapid growth in the past five years. The total value of all outstanding corporate bonds rose from 39 billion rubles ($1.4 billion) at end-2000 to 267 billion rubles ($9.6 billion) at end-2004 (see first figure below). During 1999–2004, Russia experienced a positive term-of-trade shock (rising oil prices), which resulted in strong capital inflows and higher liquidity in the domestic financial system. The concurrent expansion of the aggregate demand led to an increase in the financing needs of local firms. However, given a slow recovery of Russian banks from the 1998 crisis, the bank lending channel could not serve as an efficient mechanism for reallocating financial resources to meet the funding needs of firms outside the energy sector. At the same time, the “veksel” market (an “informal” commercial paper market) was available only to the largest corporates and banks. Against this background, the corporate bond market emerged as a natural alternative mechanism to channel excess liquidity into the broader nonfinancial sector.

Compared to collateralized domestic bank loans, corporate bonds offered several advantages: a possibility of noncollateralized borrowing, larger size (because of the larger number of creditors), longer tenors (achieved, at least initially, through embedding put options into the longer-term corporate bonds), and often lower borrowing costs. For medium-sized firms, ruble bonds represented an opportunity to build public credit history and to diversify funding sources away from bank loans. For private domestic banks, many of which had access only to short-term funding and had been investing primarily in government bonds before the 1998 crisis, corporate bonds represented an opportunity to have an exposure to credit risk through traded instruments rather than through nontraded loans. Thus, banks were initially the main investors in ruble corporate bonds.

What makes the Russian case interesting is that the local corporate bond market took off despite the absence of certain institutional features that are generally seen as “preconditions” for the existence of a well-functioning corporate bond market. Although there is no general agreement on which conditions are “necessary,” multiple studies document that a country with a well-functioning corporate bond market typically has (1) a reliable regulatory framework; (2) a developed market infrastructure; (3) adequate corporate governance and reporting standards; (4) a well-functioning government bond market that provides corporate issuers with a stable and liquid benchmark curve in local currency; (5) a developed “credit culture;” (6) a sound and well-regulated banking system; (7) a broad investor base; and (8) a well-functioning market for derivative instruments for hedging interest rate and credit risks. Many examples, however, show that a subset of these conditions (arguably (1)–(5)) may be sufficient for the emergence of the corporate bond market. However, in the case of Russia, despite significant progress in the development of a legal framework for and infrastructure of the securities markets, some key elements of an institutional framework, such as a risk-free benchmark, a broad investor base, and a developed credit culture, are still missing.

uch04bx01fig01

Domestic Bond Markets in Russia: Amounts Outstanding

(In billions of dollars)

Sources: Ministry of Finance; MICEX; and Cbonds.

Benchmark Yield Curve

The collapse of the government bond market following the 1998 sovereign default left local corporates without a risk-free local currency benchmark. Despite the recent increase in the sovereign ruble bond issuance, secondary market liquidity remains low, in part due to the dominant position of the state-owned Sberbank. Because of low liquidity and pricing inefficiencies, local borrowers prefer not to use the sovereign curve as a benchmark. Instead, they use the synthetic zero-coupon yield curve derived from the yields on bonds issued by the City of Moscow. The latter is viewed as a natural substitute benchmark provider because of its quasi-sovereign status and its well-developed yield curve (10 issues ranging from 6 months to 6 years). However, yields on the Moscow bonds do contain a quasi-sovereign risk premium and, therefore, are not the ideal risk-free local currency benchmark.

In addition, given that the average size of the City of Moscow bonds is comparable to the average size of bonds issued by the “blue chip” corporates, the Moscow benchmark bonds may not be liquid enough to absorb large negative shocks without transmitting volatility to the rest of the ruble bond market. One example of such a negative shock is a potential unexpected change in the foreign investors’ appetite for ruble bonds. Indeed, foreign purchases of ruble bonds rose substantially in recent years and were largely driven by the continued nominal appreciation of the ruble, with foreigners focusing mainly on the City of Moscow bonds. According to market sources, foreign investors currently dominate the short segment of the City of Moscow curve and own a significant amount of paper in the long segment.1 Thus, turnaround of the ruble-dollar rate could trigger capital outflows, which would affect the Moscow benchmark bonds and the rest of the ruble corporate bond market. In contrast, with a deeper and more liquid government bond market, the impact of such shocks on broader markets is likely to be less severe.

Credit Culture

In contrast with many other countries, credit rating agencies do not play a major role in the Russian corporate bond market. Although all three major international credit rating agencies are present in Russia, public credit ratings were so far awarded to about 40 nonfinancial firms out of 200 local bond issuers. Most Russian companies do not have incentives to seek credit ratings, because the regulatory investment restrictions for local institutional investors are not linked to credit ratings. Instead, investment restrictions typically refer to the “quotation lists” of the Moscow stock exchange (MICEX).2 The majority of rated firms are active participants in the international capital markets, where spreads are closely related to credit quality (as reflected in credit ratings) and maturity of bonds. In contrast, in the ruble bond market, there is no clear relationship between credit ratings and bond prices, although the second figure seems to suggest that higher-rated firms are able to borrow in longer tenors.

Because the pricing is not always aligned with credit fundamentals, and current yields are at historic lows, analysts believe that any major (not necessarily systemically important) credit event can trigger a “re-pricing” of risks across the entire credit spectrum. The reduction in corporate bond yields during 2003–05 was indeed dramatic, with the average yield on the top-tier corporate bonds falling from 14 percent in January 2003 to around 7 percent in April 2005. This decline was mainly driven by high liquidity in the banking sector and by the continued nominal appreciation of the ruble. Also, during 2003–04, many medium-sized and smaller firms (mostly unrated and often not very transparent) entered the bond market, creating the “junk” bond segment at the short-end (see third figure).

uch04bx01fig02

Russian Corporate Eurobond and Credit-Linked Note Spreads

(In basis points over the relevant benchmark, June 2005)

Source: TRUST Investment Bank.

Investor Base

While the investor base for Russian corporate bonds is gradually becoming more diverse, local demand is still mainly driven by banks and remains very sensitive to changes in commodity prices. Local banks and brokerage houses currently account for around 50–60 percent of the market (compared with 70–80 percent in 2003); local institutional investors, 20–30 percent; and foreign investors, 10–25 percent. The majority of private banks in Russia have to rely primarily on short-term corporate deposits, rather than on longer-term retail funds. Thus, their liquidity is heavily dependent on corporate flows and, as a result, is highly sensitive to changes in commodity prices. In addition, a large part of funds managed by asset management companies comes from wealthy individuals, who often tend to have a short-term opportunistic approach toward investing in local markets. At the same time, the asset base of the traditional long-term investors, such as pension funds and insurance companies, remains fairly narrow. Lack of long-term money in the corporate bond market implies higher volatility and lower pricing efficiency.

Thus, it can be argued that, in the case of Russia, it was the funding needs of local firms rather than the demand of domestic institutional investors (as was the case in Latin America) that provided a strong impetus for the development of the domestic corporate bond market. Although the corporate bond market in Russia experienced rapid growth in the absence of a well-developed government bond market, a long-term institutional investor base, or a developed credit culture, these elements are needed to ensure its stability and efficiency going forward, and will have to be gradually established as the market continues to mature.

uch04bx01fig03

Corporate Ruble Bond Spreads

(In basis points over the relevant benchmark)

Source: TRUST Investment Bank.
1 The unremunerated reserve requirement on foreign purchases of subsovereign bonds is 2 percent, compared with 15 percent for the sovereign bonds, which makes the subsovereign and municipal bonds, for example, the City of Moscow bonds, more attractive for foreigners than the sovereign bonds.2 The inclusion in the “quotation lists” is based on the fulfillment of certain formal requirements (with regard to the firm’s financial performance, quality of information disclosure, total amount of issue, and market liquidity), rather than on the analysis of credit risk.

Thus, while the growth in institutional investors’ assets under management is contributing to the deepening of the corporate bond markets, the lack of reasonable credits to invest in may lead to distortions and potential financial instability. The preference of institutional investors in these markets to hold high-grade paper has limited the investible universe of corporates to large firms with strong credit fundamentals. Even in countries where institutional investors are not tightly regulated, self-imposed credit-based restrictions by individual companies constrain holdings of subinvestment- grade debt. However, this is not an EMspecific issue (Figure 4.6): in the Group of Seven (G-7) countries, more than 90 percent of corporate bond issuance is in investment-grade categories (Box 4.2).16

Figure 4.6.
Figure 4.6.

G-7 Corporate Bond Issuance by S&P Rating

(In percent of total bond issuance per region, 1997–2004)

Sources: Dealogic; and IMF staff estimates.

Given these constraints, pension funds and insurance regulators in some countries are studying how to change the regulatory regimes to allow more freedom to invest, including in corporate bonds. There is a general trend to try to move toward a risk-based rather than an investment-limit-by-instrument regulatory regime. However, regulators are finding it difficult to define a regime that incorporates the many risks-market, credit, operational, and longevity-involved in pension fund management. In the meantime, and recognizing the limitations of the local markets, both the Chilean and Mexican authorities have increased the limits to investments in foreign assets to 30 and 20 percent, respectively, while Peru’s limit remains at 10.5 percent. Similarly, the Korean authorities have increased the investment limit of insurance companies in foreign assets from 20 to 30 percent, to circumvent the shortage of appropriate instruments in local markets. In Malaysia, there is a 5 percent limit on foreign investment by life insurance companies, while investment-linked funds are subject to a 30 percent limit. Where limits on foreign investment are binding, as in Peru, market participants have developed new domestic instruments to provide foreign exposure to circumvent them.

High-Yield Bonds

A number of theoretical and empirical studies have established the existence of a causal link between financial development and economic growth.1 Corporate bonds are particularly important in this regard, as borrowing proceeds generally flow directly into investment in the real economy. High-yield bonds potentially have an important role to play as a subset of the corporate bond market, as they can be a vehicle for financing new, or small, enterprises or funding the expansion of weak credits that might otherwise lack a substitute source of funds. In this way, the high-yield market may promote incremental economic growth by providing financing that might not otherwise be available from alternate sources.2

The potential contribution of the high-yield market is not inconsequential. In the United States, high-yield bonds peaked as a percentage of the market in the 1980s, before dropping back to sustainable levels of around 6 percent of the market. In Europe, including the United Kingdom, high-yield issuance has been growing rapidly, particularly after the EMU, helped in part by the transfer of knowledge of U.S. investment banks, and investment banks’ ability to replicate concepts pioneered in the development of the U.S. high-yield market. However, the high-yield debt market share still remains below that in the United States. In Japan, the abolition of issue standards in 1996 made possible the issuance of high-yield debt. However, relatively few corporations have taken advantage of this type of financing.

High-yield bonds have specific characteristics that differentiate them from other sources of finance. First, high-yield bonds generally have more liberal financial covenants and a wider range of investment conditions than are available in bank loans, and thus provide issuers with a greater degree of financial and operational flexibility. Second, high-yield bonds funnel investment funds into high-growth companies that have outperformed the average for companies in industrial countries in terms of employment growth, productivity, and capital investment.3

The question of why high-yield bond markets have failed to develop in emerging markets is puzzling when two of the necessary conditions for their existence-fast-growing corporations and companies with weak credit quality-are present. Information relevant to resolving this apparent contradiction is contained in a recent paper that identifies five macroeconomic variables that determine the structure of the highyield bond market.4 These include the following:

  • A positive correlation between leveraged buyouts and high-yield bond issuance.

  • A negative correlation between mergers and acquisitions (M&A) activity and high-yield bond issuance.

  • Industrial production has opposing effects on the financing activities of high-yield borrowers, depending on their type. With many growing faster than the rest of the economy, high-yield borrowers have increased funding needs to finance working capital and investment.5 Alternatively, declining industrial production is conducive to credit rating downgrades and expansion of the “Fallen Angels,” or companies that were formerly investment grade and have been downgraded to highyield status.

  • Equity price movements are positively correlated with the high-yield bond market. Higher stock prices imply increasing corporate values (enhancing bond collateral), plus increasing investor confidence in the path of the economy, both of which encourage a movement of funds into higher-risk investments.

  • The high-yield bond market expansion is correlated with the spread between yields on speculative grade paper and debt issued by investment-grade-rated corporates (or the risk-free rate on government securities).

Viewed through this perspective, analysis of the high-yield corporate bond market in the United States and EU provides valuable input that helps explain the arrested development of high-yield bond markets in emerging market countries. For example, it is relevant that the origins of the high-yield corporate bond market can be traced to the “Fallen Angel” phenomena, and not new issues sold to raise cash.6 The highyield market only emerged as a source of finance in the 1980s when it was transformed into a source of finance for highly leveraged (or start-up) companies that were unable to raise funds from banks or raise bank funding on a basis that allowed them sufficient operational flexibility.

A contributing factor in the failure of high-yield bond markets to take hold in emerging markets may relate to patterns of corporate development in these countries. In the United States, growth of the high-yield market was fostered by corporate restructurings, particularly leveraged buyouts. In most of the emerging market economies, there has been little in the way of leveraged buyouts, large-scale acquisitions, and other types of corporate reorganizations potentially requiring large amounts of debt financing-except following large-scale, systemic financial crises. The contrast is important, in that much of high-yield financing completed in the United States has been done in connection with business combinations involving large, low-rated corporations.

Industrial production, economic growth, and financing cost variables (e.g., stock market returns and the spread between the yield on speculative-grade bonds and the risk-free rate) also have an important impact on high-yield bond markets with implications for the development of high-yield financing activity,7 particularly in the emerging markets. For example, many of the large companies in emerging market countries are solidly profitable, possessing strong balance sheets and open to a wide range of financing alternatives. As a result, there are relatively few “Fallen Angels” with the need to execute high-yield financing transactions.8 Moreover, as local bond rating scales are adjusted for the credit rating of the sovereign, companies that would not qualify for investment-grade credit ratings in developed economies do qualify as investment grade in emerging market economies. Meanwhile, many companies that would be rated at subinvestment-grade levels according to local scales are privately held or insufficiently large to qualify for public debt financing or to have sufficient needs to justify the expense of a public offering. Given the substantial presence of family-run companies (especially in Latin America) and other factors limiting reorganizations and changes in corporate control, the number of leveraged buyouts and other transactions that could potentially give rise to substantial transactions involving a preponderance of debt securities is very limited.

Finally, given strong returns in the emerging equity markets over the last few years, there has been little incentive for institutional investors to “reach” for the additional return offered through high-yield bond holdings while assuming the accompanying risk. Equity market returns (in excess of the risk-free rate) have been sufficient so that investors have not seen the need to diversify into high-yield credits.9

1Herring and Chatusripitak (2001).2 High-yield bonds can play this role, particularly when the banking sector is reluctant to increase its risk assets (e.g., the late 1990s in Japan).3Rajan and Zingales (1998).4 De Bondt and Marqués-Ibáñez (2004).5Yago and Trimbath (2003).6Taggart (1988).7De Bondt and Marqués-Ibáñez (2004).8 Recent downgrades of Ford Motor Company and General Motors to junk status according to international credit rating scales may alter this situation, as both have local subsidiaries that are large-scale issuers in the Mexican corporate bond market. However, to date, local ratings for their subsidiaries have remained at investment-grade levels.9 In Korea, there are a lot of investors, including overseas investors, participating in equity markets, while far fewer invest in high-yield corporate bonds.

Role of Financial Intermediaries

Banks and other financial intermediaries in general have played an important role in the development of corporate bond markets, but they have at times been reluctant to support the emergence or growth of corporate bond markets. In several countries, banks and other intermediaries have been important bond issuers-mainly of subordinated debt-as well as buyers of bonds (especially in Russia and some Asian countries). However, their main role is to provide underwriting capabilities to corporates and making secondary markets work adequately (Hawkins, 2002). In some cases, banks have preferred to keep their lending relationships with corporates, rather than provide corporates with alternative instruments such as corporate bonds-especially when bank lending spreads are high. Increasing competition is likely to force banks to change this behavior.

Some analysts have suggested that, in several European countries and in Japan, the market power of banks actually impeded the development of securities markets until the late 1980s. Banks can do this by controlling access to the payment system or distribution networks, or by encouraging regulations that increase the cost of issuance and underwriting of securities.17

The last two decades, however, have witnessed an expansion of securities markets everywhere (Rajan and Zingales, 2003). Moreover, the recent growth of corporate bond markets in the European Union and Canada demonstrate that banks and markets can grow in tandem and actually support and complement each other, in particular through investment banking activities. The growth in the EU was aided by the introduction of the euro and a substantial decrease in underwriting fees. In Canada, corporations became increasingly dependent on market-based financing during the 1980s and 1990s as banking legislation changes allowed banks to become more involved in such financial market activities as underwriting and brokerage services.18

Reflecting in part some of the obstacles behind the demand and supply of corporate bonds, the level of investment banking activity in many emerging markets is seen as one constraint on local firms’ financing via capital markets. Issuing corporate securities typically involves the services of an investment bank (rather than a commercial bank or a securities broker). These services usually include advising the issuers on the terms and timing of the offer and on terms of underwriting the issue (see next section). Investment banking expertise is difficult and slow to develop within a country on its own and is typically costly to purchase from abroad. This may be changing, however, given the increasing role of foreign banks in EMs, together with the increasing move toward universal banking.19

In sum, the growth of corporate bond markets has been supported by both demand and supply factors. Further expansion of the local corporate bond markets, however, depends critically on access of new, medium-sized companies to the market. As discussed earlier, although institutional investors’ assets under management are growing rapidly, these investors generally invest in investment-grade bonds, which in most EMs limits the universe of corporate names that can issue bonds to about 20–30 large firms with strong credit fundamentals. Similarly, foreign investors would have to move further down the credit spectrum to obtain sufficiently attractive yields commensurate with the risk exposure. They are not prepared to do so, however, because of the nonexistence or illiquidity of suitable corporates in these countries. Thus, to satisfy institutional investors’ demand, potential issuers will have to improve their credit fundamentals. This, in turn, requires an improvement in the legal and regulatory framework for these markets and their participants, and it involves, among other things, improvements in corporate governance and transparency (IMF, 2005).

As discussed in earlier issues of the GFSR, the existence of a regulatory framework that ensures investor protection, market integrity, and contains systemic risks is essential for the development of securities markets in general and the corporate bond market in particular. 20 Unlike banks, individual bondholders typically have much smaller stakes in private firms and less bargaining power in the event of default or debt restructuring. Therefore, bankruptcy laws-which clearly define creditors’ rights and borrowers’ responsibilities, as well as the required enforcement mechanisms- are essential for establishing the legitimacy and credibility of corporate bond instruments. Adequate corporate governance practices and a timely and accurate public disclosure of financial information are important for maintaining credibility and stability of the corporate bond market.

Both market participants and the authorities in EMs with relatively large corporate bond markets are aware of the constraints to further development of the markets and are working to overcome the main obstacles. The Mexican Congress is about to finalize approval of a new capital markets law that aims to change corporate structures and governance to make them more investor friendly, and the pension fund regulatory agency is studying ways to make fund managers less risk averse. In Chile, a new law that creates a modern framework for the development of a venture capital industry is about to be approved. In Peru, pension fund regulators and the securities commission are trying to remove constraints to the emergence of new instruments, allowing pension funds to invest, among others, in private equity and bonds. In Brazil, a new bankruptcy regime that was approved in December 2004 is expected to speed up restructurings, improve investor’s collection rights, and boost corporate bond markets. In Korea, in an effort to strengthen corporate governance, the Bankruptcy Law has been strengthened by the integration of all existing “sporadic” laws, with the aim of removing confusion and promoting greater consistency in implementation. The new law is also expected to revitalize the repo market. In Malaysia, several developmental initiatives and reforms, including recommendations from the National Bond Market Committee, Capital Market Masterplan, Finance Committee Report on Corporate Governance, and Corporate Law Reform Committee, have been implemented to improve various aspects of the legal, regulatory, and institutional frame works for the development of the corporate bond market.

Market Structure and Obstacles to Growth of Corporate Bond Markets

We now turn to those elements of microstructure that are critical for broadening and deepening corporate bond markets. In addition to demand and supply constraints, and the legal and regulatory framework, elements of the microstructure of primary and secondary markets-such as auctions, trading mechanisms, dissemination of transaction information, and the role of intermediaries-are important for market development. This section focuses on the main determinants of the cost of bond issuance and secondary market liquidity by examining the experiences of the EMs with large corporate bond markets and relevant mature markets.

Primary Markets and Issuance Costs

Key features of the corporate bond issuance process are the structuring, pricing, and distribution of bond issues to end-investors. The cost of issuance also depends on the type of instruments and the nature of bond contracts used in different jurisdictions. Furthermore, these market factors interact with credit ratings, registration, and other regulatory requirements to determine the all-in cost of financing.

Types of Instruments and Bond Contracts

The types of instruments issued by EM corporates vary, reflecting regional trends, and inflation and devaluation experiences. Most corporate debt securities in the largest Asian EMs are plain vanilla fixed coupon bonds. Maturities range from short-term (less than one year) commercial paper sold on a discount basis to 3–10 year corporate bonds, with the majority under five years. Convertible bonds were popular before the bursting of the technology bubble. In contrast, several different structures are used in Latin America, including floating rate notes (paying interest at a spread over the applicable government instrument), bonds with interest and principal indexed to U.S. dollars, and inflation-indexed bonds with adjustable coupons and principal payments. Latin American corporates issue coupon bonds for maturities extending to 30 years, which, in some cases, is longer than the maximum tenor of local government securities. Latin America’s comparative success in selling long-term corporate bonds is a result of the widespread use of indexation or capital preservation mechanisms, a consequence in part of a history of high inflation and repeated currency devaluations.

Bond contracts show substantial homogeneity across the major EMs. While no overriding body of law, or regulations, force standardization of bond contracts, this may be the result of concentration in the securities industries similar to the standardization in the unregulated Eurobond market. However, in contrast with the generalized trend toward structuring bonds as “promissory notes” (i.e., in essence “promises to pay” with a minimum of covenants), EM corporate bonds feature terms and conditions that include covenants on leverage, interest coverage, liquidity, negative pledge, cross default, and minimum levels of shareholders’ equity.

Mexico’s experience clearly illustrates the importance of a standard and flexible instrument that accommodates issuers and investors’ needs. The corporate bond market in Mexico was marginal until the introduction of a new instrument—Certificados Bursatiles (CBs)–in the 2001 securities law. The CBs contributed to the takeoff of the market for corporate bonds and has become the dominant debt instrument for corporates–accounting for about 99 percent of 2004 issuance. The CBs combined the attractive features of earlier debt instruments (medium-term notes (MTNs) and debentures).21 They offer the speed and ease of issuance characteristic of MTNs and the flexible amortization schedules and covenants of debentures.

In some countries, credit enhancements and securitization have broadened investor appeal. Credit guarantees have enabled low-credit- quality borrowers to issue corporate bonds, especially in some Asian EMs.22 Several EM local markets have increased issuance of securitized and/or structured products, such as asset-backed securities (ABS) and collateralized bond obligations.23 Owing to the credit enhancements, these instruments normally receive better credit ratings than nonstructured transactions (usually by one or two notches), allowing regulated pension funds to invest in bonds from weaker credits. Structured transactions are also used to circumvent investment limits.24 However, investors in EMs are not always familiar with the risks associated with these products. In Chile, for instance, the rapid decline in local interest rates during 2004 led to a sharp increase in mortgage prepayments, and several mortgage-backed securities (MBS) were downgraded and some of them defaulted on their obligations. In Korea, investment trust companies suffered losses after March 2003 as the liquidity problems of the credit card companies and the SK Corporation accounting scandal triggered large withdrawals.

In other markets, new instruments are used to attract new investors and broaden the investor base. The recent growth of Islamic bonds in Malaysia has been spurred by the successful establishment of a government yield curve and their popularity among issuers who want to tap a wider investor base in local and regional markets. The issuance of Islamic bonds outstripped that of conventional bonds in Malaysia in 2002, and currently the outstanding stock of Islamic bonds amounts to almost 30 percent of GDP (Box 4.3).

Issuance Process and Costs

The issuance process and associated costs constitute an important determinant of the decision of a corporate to access the local corporate bond market. Low issuance costs are likely to facilitate the development of local corporate bond markets, with positive implications for small enterprise creation (indirectly), large corporation development, and overall economic growth.25 A reduction in these costs could contribute to increased access for lowertier credits and further deepen and broaden the corporate bond market.

Issuance costs can be classified into five main categories. Some of these costs are directly linked to issuance methods and other institutional arrangements.

Management Fees

Management fees are paid for advice in structuring the transaction, preparing disclosure documentation for credit rating agencies, issuing registration and other offering documents, as well as in underwriting costs. Such fees are typically the largest single cost of a corporate bond issue; however, highly competitive underwriting business environments in both Asia and Latin America, combined with the structural undersupply of corporate bonds, have resulted in a dramatic compression in the fees that lead managers charge issuers.

Islamic Bonds in Malaysia

Islamic bonds have played an increasingly important role in Malaysia’s financial market. Over the past 10 years, the issuance of Islamic bonds in Malaysia has been growing at a compounded rate of 31 percent, outgrowing the issuance of bonds in total, which were growing at the rate of 13 percent over the same period. Islamic bonds issued in 2004 amounted to 9.1 billion Malaysian ringgit ($2.4 billion), accounting for 32 percent of the total bonds issued (see first figure below). The total Islamic bonds outstanding is approximately 107 billion Malaysian ringgit ($28 billion) or about one quarter of the size of the total bond market in Malaysia. It is estimated that about 85 percent of Islamic bonds issued were issued by Malaysia, making Malaysia one of the world’s largest Islamic bond markets.1

The issuers of Islamic bonds in Malaysia range from the government, government agencies, and private corporation to international development organizations. The government has played an important role in the development of the Islamic bond market by issuing Islamic bonds to use as a benchmark. Currently, Islamic private debt securities are the largest segment of the Malaysian Islamic bond market, accounting for about 70 percent of the market. Recently, Malaysia has allowed multilateral development banks and multinational corporations to issue ringgit denominated bonds in Malaysia. Since then, the International Bank for Reconstruction and Development (IBRD) and the International Finance Corporation (IFC) have issued Islamic bonds in Malaysia.

Despite the impressive growth of new Islamic bond issuance in Malaysia, there is a still a large demand for Islamic instruments. It is estimated that $39 billion worth of assets of Malaysian Muslims are not invested in the Islamic financial system.2 Together with the much larger amount of Muslim funds from overseas, the largely untapped demand for Islamic financial products presents potential opportunities for Malaysia to develop itself as a center for an Islamic bond market.

Islamic bonds (Sukuk) must comply to the Shariah principles. The Shariah principles are Islamic laws and rules that govern religious, cultural, social, political, and (see first figure economic aspects of Islamic societies. An important financial aspect of Shariah principles is the prohibition of interest (riba) on borrowing. Therefore, a fixed or predetermined rate of return is prohibited, whereas the earning of profits or returns from underlying assets is encouraged. Moreover, exchanging money for debt is also prohibited under Islamic finance. To issue an Islamic bond, there must be underlying transactions backed by existing or future assets. In addition, the proceedings from Islamic bonds can only be invested in activities not prohibited by Shariah.

Common types of Shariah principles used in Islamic bonds in Malaysia can be classified into debt-based, asset-based, and equity-based instruments. Murabahah (cost-plus sale), bai bithaman ajil (BBA; deferred payment sale), and istisna (project finance) bonds can be considered as debt-based bonds because they are issued in exchange for debt created by the repurchase of an underlying asset. These principles effectively limit debt creation to the issuer’s (current or future) assets. Ijarah (leasing) bonds are backed by an asset under a leasing contract. Mudharabah and musharakah are profit-sharing contracts between the issuer and investors.

uch04bx03fig01

Malaysia: Total Bond Issuance

(In billions of Malaysian ringgit)

Source: Bank Negara Malaysia.Note: Excluding Cagamas bonds.

The majority of Islamic bonds in Malaysia are debt-based instruments. As shown in the second figure, about 90 percent of Islamic bonds issued in 2004 were based on Murabahah, BBA, and istisna principles. These debt-based bonds involve the purchase of an asset by investors (lenders) and the simultaneous sale of the asset back to the issuer with a markup (i.e., a profit margin) agreed upon by both parties. The title to the asset is transferred back to the issuer who, as a result of the transactions, is indebted to the investors. The issuer’s obligation is securitized via the issuance of debt certificates, which can be traded in the secondary market.3 Murabahah and BBA are similar except that BBA bonds are used for longer-term financing and the seller is not required to disclose the profit margin in the selling price.4 Similarly, an issuer can also use a working project as an asset to issue Islamic bonds if the project is undertaken with the istisna principle.5 Once the issuer enters into the istisna contract with a contractor to undertake the project, the issuer can use the project as an asset in the sell-and-buyback transactions (similar to what is described above) to issue istisna bonds even though the project has not yet been completed.

Islamic bonds can also be backed by an asset. Under the Ijarah principle, an issuer sells an asset (e.g., plants, equipments, machines, and vehicles) to investors. The investors will then lease them back to the issuer via the Ijarah contract. The title of the asset will remain with the investors throughout the tenure of the contract. Upon the completion of the contract, the title will be returned to the issuer, unless it is agreed otherwise. Ijarah bonds are in effect bonds backed by the receipts from the leasing contract.

uch04bx03fig02

Malaysia: Issuance of Islamic Bonds in 2004, by Shariah Principle

Source: Islamic Finance Information Services.

Some Islamic bonds are based on profit sharing schemes. Mudharabah is an agreement between an investor who provides 100 percent of the capital required to complete a project and an entrepreneur who solely manages the project. Profits from the project will be distributed according to a predetermined ratio between the capital provider and the entrepreneur. Any loss will be borne solely by the investor, unless the loss is due to negligence of the entrepreneur. Under musharakah, both the entrepreneur and the investors contribute resources to the project, either in the form of capital or in kind. Any profits will be shared at an agreed-upon ratio, but a loss will be shared on the basis of equity participation.

Many market participants in Malaysia perceive Islamic bonds as being similar to conventional bonds in terms of underlying risks. Islamic bonds are widely traded by Islamic investors and are viewed as a perfect substitute for conventional bonds by non-Islamic investors. Because of the relatively small supply of Islamic bonds relative to the larger investor base, Islamic bonds are often traded at higher prices compared with conventional bonds.

However, investor protection mechanisms of Islamic bonds have not yet been tested. In principle, Islamic bonds share the same criteria as (unsecured) conventional bonds in the matter of late payments or default proceedings. However, because there have not been many default cases for Islamic debt securities in Malaysia, the bankruptcy process and dispute resolution mechanism for Islamic securities are largely untested. Its functionality remains to be seen.

1 Other countries that have been issuing Islamic bonds include Saudi Arabia, United Arab Emirates, Bahrain, and Indonesia. Recently, Pakistan was successful in issuing its first sovereign Islamic bond of $600 in January 2005.2Nik Jaafar (2005).3 While Shariah scholars and the Securities Commission in Malaysia have approved the trading of these debt-based bonds in the secondary market, these bonds are not traded in the secondary market in many other countries. Because it is not permissible to sell a deferred debt at the price below its par value as it would result in riba (interest), some Islamic jurists prohibit the trading of Murabahah and similar credit transactions in the secondary market. In Malaysia, Islamic bonds are commonly traded in the secondary market. The annual trading volume of Islamic debt securities (government and PDS) exceeds 126 billion Malaysian ringgit in 2004.4 The government of Malaysia has issued Islamic bonds based on these principles. These bonds are considered benchmarks for Islamic bonds.5Istisna is a purchase contract of an asset to be constructed in the future. The buyer requires a seller or contractor to construct the asset that will be complete in the future according to the specifications given in the contract.

The use of underwriting and auctions for corporate bond issues differ by region. Bond issues in Asia are underwritten and distributed by an investment bank or a syndicate of brokerage houses, similar to the traditional process used in the U.S. domestic and Eurobond markets.26 Historically, the issuance process was similar in Latin America, but has now migrated to an auction-based system, patterned after government bond auctions. Under this procedure, corporations choose a lead manager (placement agent) for the offering, and institutional investors make direct bids for specific amounts of bonds at various prices. Under a “Dutch auction” mechanism, all bonds are awarded to bidders at a single cut-off price that gives the borrower its desired volume of issuance. Under these auction-based systems, there is no need to form syndicates to spread underwriting risk or to assist the lead manager in the selling effort. Lead managers have been forced to accept this issuance methodology by a concentrated, powerful group of institutional investors who want to ensure that corporate bond offerings are executed in a fair, open, and transparent manner.

Registration, Listing, and Legal Fees

Registration, listing, and other legal mechanisms provide issuers and investors common standards (e.g., business description, financial statements, terms and conditions, public disclosure) both to assess the investment merits of bonds and to provide market and legal safeguards.

In most EMs, shelf registration can be used to increase issuer flexibility, reduce issuance cost, and improve market timing. Corporate bonds can be registered either as a single issue or under a program umbrella, structured along the lines of shelf registration rules in the United States. Shelf registration allows corporations to prepare their bond offering documentation on a regular basis, reducing the workload surrounding preparation of an issue for market, and allowing the spreading of fixed issuance costs over a larger number of instruments.

Most corporate debt issues are either registered with the local securities and exchange commission (SEC) or a similar body (based on the U.S. model), or may also be listed on a stock exchange (as is customary in the Eurobond market).27 The practice in Latin America is for both SEC-style registration and stock exchange listing; however, regulators and stock exchanges have largely come to “gentlemen’s agreements” on a division of oversight duties to avoid duplication of effort. There are, however, subtle differences in how the registration process works in practice across countries that affect the cost of issuance.28

A corporate bond offering will also entail other fees, including those of trustees or fiscal agents. Typically a trustee or fiscal agent is needed to make interest and principal payments and is compensated through a flat “upfront” fee and additional charges for each payment made on behalf of the issuer. The fiscal agency structure is common in U.S. domestic and Eurobond markets because of its low cost and the fiscal agents’ subordinate role (where a fiscal agent acts as the agent of the issuer). Bonds issued under trust deeds are common in most EMs. Because of the trustee’s authority to initiate legal proceedings on behalf of bondholders, the trustee can help resolve disputes between issuers and bondholders.29

Legal fees are not typically calculated according to the value of the note. Instead, they tend to be calculated on the basis of time-based professional costs, and they tend to be higher for an initial issue and lower thereafter. These costs are relatively low in most EMs. Legal costs connected with an initial corporate debt offering are substantially higher (as much as five times greater) than an update of existing documents for corporates that are frequent issuers. The initial high legal costs can act as a powerful disincentive for potential new corporate debt issuers.

Credit Ratings

Obtaining a credit rating can be an additional expense of a corporate bond transaction. The cost of a credit rating is based on several factors; the most relevant is the issue amount. However, a credit rating is valuable to an issuer and a high credit rating can lower the interest costs on its corporate bond. Ratings, like legal fees, are an area in which frequent issuers have cost advantages. For example, most rating agencies charge an “upfront” fee to recover the incremental costs of preparing the initial credit ratings for a corporation about to issue its first public bond. While the authorities in some jurisdictions do not require any ratings for public bond issues (or alternatively, require only one), market practice is to have two ratings (three is becoming more common).30

Marketing Costs

Marketing costs depend on the location of the investor base, regulatory requirements, investors’ needs, and frequency of issuance. Issue documentation, particularly the prospectus/offering circular, must be distributed to all bond purchasers. Unless the borrower is well known or has recently issued, there may also be the need for investor presentations in key financial cities, including group presentations and individual meetings with significant institutional investors. These costs are far less for domestic transactions.

Taxes

Taxes are also a major cost of issuance and influence the structure of corporate bond markets in many ways. A certain minimum level of taxation is acceptable to all parties in corporate debt transactions. However, largescale levies against corporate borrowers do much to discourage borrowing or move it to tax-free jurisdictions such as the Euromarkets. A powerful example is Chile’s stamp tax, which is levied on all loans and debt instruments.31 A change in the Chilean regulations in 2002, which spread the cost of the tax through several issues, led to a recovery of the commercial paper market in Chile.

In sum, issuance processes and costs vary significantly across countries, and high costs have been one of the obstacles that reduced issuance by corporates (Box 4.4), in particular by smaller and lower-rated companies. Zervos (2004) shows that for a standard size ($100 million) bond, issuance costs in Mexico are roughly half of those in Brazil and Chile (Table 4.8). The higher costs are related to higher disclosure costs in Brazil and the stamp tax in Chile, which makes issuance in local markets costlier than issuance in international markets. The study also shows the importance of issue size: the costs of issuing a $10–$20 million bond is double the cost of issuing a $100 million bond-reaching, in the cases of Brazil and Chile, a 4.6 percent level. Although some countries have seen issuance sizes under $10 million (e.g., Peru where about one-third of corporate bonds are under $10 million), it is unclear whether these smaller sizes would be reasonable for issuers and investors alike. Indeed, the fraction of issues under $10 million is much lower in Malaysia, Mexico, and Thailand (Figure 4.7). High issuance costs may explain the reluctance of smaller companies to issue bonds in some local markets.

Table 4.8.

Cost of Domestic and International Bond Issues

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Source: Zervos (2004).

Average of $10 and $20 million bonds.