Markets for Corporate Debt Securities1/
Author: T. Todd Smith1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

This paper surveys markets for corporate debt securities in the major industrial countries and the international markets. The discussion includes a comparison of the sizes of the markets for various products, as well as the key operational, institutional, and legal features of primary and secondary markets. Although there are some signs that debt markets may be emphasized in the future by some countries, it remains true that North American debt markets are the most active and liquid in the world. The international debt markets are, however, growing in importance. The paper also investigates some of the reasons for the underdevelopment of domestic bond markets and the consequences of firms shifting their debt financing needs from banks to securities markets.

Abstract

This paper surveys markets for corporate debt securities in the major industrial countries and the international markets. The discussion includes a comparison of the sizes of the markets for various products, as well as the key operational, institutional, and legal features of primary and secondary markets. Although there are some signs that debt markets may be emphasized in the future by some countries, it remains true that North American debt markets are the most active and liquid in the world. The international debt markets are, however, growing in importance. The paper also investigates some of the reasons for the underdevelopment of domestic bond markets and the consequences of firms shifting their debt financing needs from banks to securities markets.

I. Introduction

Firms finance investment activities with internal and external funds. Whereas the source of internal funds is straightforward—retained earnings—there are a variety of methods available to raise funds externally—bonds, loans, equity. The decision as to which of these should be used by a particular firm presents some difficult issues because the options are generally not perfect substitutes and, indeed, may even be complementary. On the one hand, it is well-known in the academic literature that internal funds are generally less expensive than external funds owing to factors such as information asymmetries between borrowers and lenders, the direct costs of arranging financing, and so on. This therefore provides a coherent explanation for the fact that internal funds supply a large proportion of the financing needs of non-financial firms across a wide range of countries. On the other hand, while the existing literature does suggest factors that may make one type of external finance more favorable than another, the usage of bonds or equity or bank financing varies greatly across countries. Most striking in this respect is that some countries (e.g. Japan, Germany) have historically relied heavily on bank loans while others have instead turned to the bond market (e.g. the United States, Canada).

At the firm level, the costs and benefits of bank loans versus bond issues are most likely attributable to regulations, the degree of development of corporate bond markets (e.g. liquidity, infrastructure), and the legal implications of the instruments (e.g. corporate governance). This is so since the intrinsic properties of bank loans and bond issues are largely independent of geography or culture per se. For instance, in countries in which much external financing is facilitated by bank loans, the costs of issuing bonds may be relatively high due to an underdeveloped corporate bond market, withholding taxes on interest income, delays associated with requesting permission from regulators to issue bonds, and so on.

At the aggregate level, the costs and benefits associated with debt that is heavily tilted toward bank loans or to bonds can be quite different. For instance, with highly developed corporate bond markets, the loan book of banks is likely to be both thinner and more risky, and this has implications for the transmission mechanism of monetary policy. On the other side of the ledger, if banks ration credit at some phases of the business cycle, the consequences for the macroeconomy of banks tightening their loan books may be buffered if corporate debt securities markets are more developed.

This paper is divided into five sections. Sections 2-4 contain a detailed discussion of important features of domestic corporate debt markets in the major industrial countries and (less thoroughly) several other countries as well as the rapidly developing international market for corporate debt securities. Emphasized in this first main part of the paper is the influence of regulations on the nature of corporate debt across a range of countries, both from a historical perspective and in light of recent developments. Further, this part of the paper also emphasizes cross-country differences in the infrastructure of domestic (and international) corporate bond markets with the aim of providing some insight into the influences governing their evolution. The aim of section 5 of the paper is to propose and discuss some key problems with the operation of domestic and international corporate debt markets. The two key problems that are discussed are the reasons that underlie the almost ubiquitous illiquidity of secondary corporate bond markets and, second, the policy consequences of the shift by firms to raising funds in securities markets and increasingly, in international markets.

II. Overview of Corporate Debt Markets

1. The financing of business

Non-financial firms often have available a variety of methods to raise funds in order to finance the activities of the firm. One can first distinguish between internal funds and external funds. While internal funds are associated with retained earnings, external funds can be obtained in a number of distinct ways. For the purpose of this paper, it is useful to categorize them into two groups: debt and equity. It should be recognized that these categories may not be mutually exclusive because funds may be raised by issuing a security that has features of both.

Before turning to corporate debt markets in different countries, it is helpful to discuss briefly the role of alternative sources of finance for non-financial private businesses across a sample of countries. It is well known that inquiries of this type present a host of difficult questions about appropriate statistics and differences in accounting and reporting standards across countries. The brief discussion here is intended only to provide a general backdrop for the subsequent analysis of corporate debt markets.

Drawing on recent studies of the financing of business over the past two decades suggests some very general conclusions. 2/ First, on average over the 1970s and 1980s, internal funds are by far the most important source of funds for non-financial firms in the largest industrial countries. Specifically, measured by gross sources of funds, internal funds account for about 50-70 percent of total funds raised by firms in the United Kingdom, the United States, Germany, and Canada, and possibly somewhat less in Japan and France—about 40 percent in each. 3/ Second, over the past two decades bank financing accounted for the largest percentage of funds raised in Japan (about 40 percent over this period), about half as much (as a percentage) in the United Kingdom, Germany and France, and less in the United States and Canada. Third, over this period equity issues account for the largest source of funds in the United Kingdom, France and Canada (about 7-8 percent), about half as much or less in Japan, even less in Germany, with the least amount of funds raised through equity issues in the U.S. Fourth, over this period the United States by far accounts for the largest reliance on corporate bond issues (about 13 percent), followed by Canada (about 8 percent), Japan (about 3-4 percent), the United Kingdom and France (about 2 percent), and Germany (about 1 percent).

These numbers do indicate some distinct differences across countries in the methods used by firms to raise funds over the past two decades. However, since these generalizations are drawn from time-averaged data, they mask some important recent developments in the methods used by firms in some countries to raise funds externally. For instance, the widespread deregulation in the financial services industry and the privatization efforts in many countries are generally believed to have been important for the use of securities market financing in recent years. We shall study below the recent patterns in the financing of business for a number of industrial countries paying particular attention to the role of bond issuance. Next, however, we discuss some of the main corporate debt instruments available to firms to raise funds.

2. Corporate debt instruments

Although the types of debt finance that are available to firms differ to some degree across countries and across time, one can distinguish at least three general instruments that are used to varying degrees in domestic and international corporate debt markets: (1) short-term notes (including commercial paper (CP)) and medium-term notes (MTN), (2) bank loans, and (3) bonds.

CP is a short-term, unsecured, promissory note issued in the open market, usually in bearer form and usually at a discount from face value. 4/ Traditionally the issuance of CP by non-financial firms has been used as a close substitute for bank borrowing mainly by a relatively small number of large corporations with high credit ratings. 5/ In some countries (e.g. the United States and Japan), this is attributable to the regulatory framework rather than to an appetite for high-quality paper (as in the Euromarkets). The impact of regulation on issuance is studied in section 3 below. Euro commercial paper (ECP) differs from domestically issued CP only in that it is issued and placed outside the jurisdiction of the currency of denomination.

When a firm borrows by issuing short-term paper it runs the risk that it may not be able to sell future paper, especially if market conditions change. To eliminate this risk, a firm can establish a “note issuance facility” (NIF). A NIF is a contract between a borrower and a group of banks in which the banks underwrite the issuer’s notes which ensures that the borrower can issue notes over a designated future time period. NIF’s are typically associated with the Euro markets and are often referred to as “Euronotes”. 6/

Merrill Lynch pioneered the MTN market in 1981 to bridge the gap between CP and corporate bonds in the U.S. domestic corporate debt market. Most MTN’s are non-callable, unsecured, senior debt securities with fixed coupons and relatively high credit ratings. However, recently more exotic—called “structured”—MTN’s have been issued with increasing frequency. MTN’s are currently issued in many domestic debt markets and there is a very active Euro MTN (EMTN) market. MTN’s are usually continuously offered to investors over a period of time by an agent of the issuer acting as a dealer for the MTN “program”. From a given MTN program, investors can select issues from a variety of maturity bands from 9 months to 30 years or more, although most issues have maturities in the range of 1-10 years (Crabbe (1993)). That is, in contrast to most other debt securities, the characteristics of MTN’s are largely investor-driven. 7/ The interest rate on MTN’s may be either flexible or fixed. Typically, a firm will announce a MTN program which allows for the issue of notes over a specified period of time, which total at most the announced figure, and the choice of the maturity of the notes is made on an ongoing basis. Most issuers of MTN’s have a high credit rating, although (like CP) the market for MTN’s has recently opened to lower-quality issuers that attach letters of credit or collateral (“asset-backed”).

A second type of debt finance is bank loans. While a one-on-one bank loan to a firm is unambiguous, so-called “syndicated credits” have been a popular source of financing for many corporate customers. A syndicated credit is essentially a corporate loan from a group of banks. These debts typically are senior to bonds, notes, and paper in the event that a firm cannot meet all its obligations to creditors. The interest rate on a syndicated bank loan floats by periodically re-setting it to some base rate (such as LIBOR). The maturity of loans tends to be shorter than that of bonds. While bank loans are typically viewed as a non-traded asset, in some countries (principally the United States and to a lesser degree the United Kingdom) bank loans can be sold by either the “method of assignment”, in which all of the rights of the loan are transferred, or a “participation”, in which the rights are not transferred.

The third general type of corporate debt finance is a bond issue. Corporate bonds may be structured as either public issues or private issues. There are a number of important differences between these two structures (apart from regulatory differences which are discussed below), but loosely put private issues are often preferred by somewhat smaller corporations and also generally have a lower credit rating. Private issues in fact share many features with bank loans including an explicit credit evaluation and closer monitoring of the issuer by the lenders. 8/ Smith and Warner (1979) found that private placements of bonds had more restrictive covenants than public bond issues. The United States has a very large private issue market accounting for approximately 40 percent of all non-financial corporate bond issues in the past decade.

The promises of a corporate bond issuer and the rights of investors are often, but not always, detailed in contracts called “bond indentures”. Typically, a corporate trustee is brought in to handle the indenture and safeguard the interests of bondholders. A bond’s indenture sets out three important aspects: maturity, security, and provisions for retirement. Indentures and trustees are used widely in some countries (e.g. the United States and Japan) but are less common in other markets (e.g. the Euromarket). Most corporate bonds are “bullet bonds”—they run for a term of years and then become due and payable. Corporate bond issues generally have maturities ranging from 5 years out to thirty years, although they could be as short as a year. In practice, most bond issues are in the 3-10 year maturity range, although this often depends on both the country in which the bonds are issued as well as economic circumstances.

Either real property (using a mortgage) or personal property may be pledged as security beyond the general credit standing of the issuer. A “debenture bond” is not secured by a specific pledge of property although it may have a claim just due to general bondholder privileges. Subordinated debentures have junior claim. Most corporate issues have a call provision allowing the issuer an option to buy back all or part of the issue prior to maturity. Finally, corporate bonds are either “straights” or “equity-linked”. The former provide only interest payments between their issue date and maturity date, while the latter also contain the option to convert the bonds into some other security (typically debt or equity). The two kinds of equity-linked bonds are convertibles and bonds with warrants attached. If the bond pays coupons (i.e. it is not a “zero-coupon bond”), these coupon payments may be either fixed or set periodically as a function of some reference variable, such as LIBOR. Bonds with fluctuating coupon payments are called floating rate notes (FRN).

There are at least two factors that may make it difficult to distinguish between a bond issue and a syndicated loan. First, if a small number of investors purchase all of the bond issue with no intention of selling prior to maturity, the issue is effectively a loan. For example, the underwriting syndicate for a bond issue may (and sometimes does) simply park the issue on their books. 9/ Second, the fact that a secondary market for loans exists in some countries (notably the United States and, to a significantly lesser degree, the United Kingdom) further blurs the line distinguishing these two types of financing.

For a firm located in any country, three corporate debt markets can be identified, although some of these may not be developed or accessible (either due to regulation or to credit standing) to all firms in all countries. These three markets are the domestic, foreign, and international (Euro and dragon) debt markets. 10/ The domestic corporate debt market includes loans from domestic banks, and notes and bonds issued in the domestic market and purchased largely by domestic investors. The foreign corporate debt markets include loans from a bank in a foreign country and the issue of notes and bonds in a foreign country. Euro debt markets include loans from an international syndicate of banks and issues of bonds or notes arranged by an international syndicate of securities firms and marketed internationally. Dragon debt is similar except that it is marketed (and in the case of bonds, listed on local stock exchanges) in a set of southeast Asian countries.

Although the distinctions between these three types of debt markets have become increasingly blurred in recent years (see Chester (1991), Benzie (1992), Clarke (1990)), Eurobonds and Euronotes have some distinguishing features. Key features of the Eurobond markets are that: (1) they are underwritten by an international syndicate 11/, (2) at issuance they are offered to investors in many countries, (3) they are issued outside of the jurisdiction of any single country, (4) they are almost always in unregistered (or bearer) form, and (5) interest payments are not subject to withholding tax. 12/ Eurobonds are also typically unsecured, but they do generally contain a “negative pledge” (i.e. a statement that the issuer will not subsequently issue senior debt) and may contain credit enhancements such as guarantees (see Clarke (1990)). Although they are typically registered on a national stock exchange (usually Luxembourg or London) the bulk of all secondary trading is in the over-the-counter (OTC) market. The reason they are listed at all is because some investors (e.g. pension funds in some countries) are restricted to hold only listed securities. These bonds may also be denominated in a wide variety of currencies, although the U.S. dollar, Japanese yen, and German deutsche mark are the principal currencies (see Chester (1991), Benzie (1992), Clarke (1990)).

3. The size of corporate debt markets

In the United States, it is well known that firms have relied extensively on securities issues to raise funds, and this is in part responsible for the well-developed domestic markets for both equity and bonds. Gross issues of equity fell in the 1980s due in large part to significant equity repurchases, but equity issuance has rebounded in recent years (Table 1). The issuance of bonds on the domestic market by U.S. firms has been considerably larger than equity issuance. The growth rate of bond issuance is however smaller than that of equity issuance. International bond issuance has been much smaller than domestic issuance. Notice also the large magnitude of offshore syndicated credits obtained by U.S. firms in recent years. 13/

Table 1.

United States: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: Federal Reserve Board, Flow of Funds Accounts : OECD, Financial Statistics Monthly: the Bank for International Settlements; Crabbe (1993); IMF, International Financial Statistics: staff estimates.Note: … means not available or not yet available.

Amounts outstanding.

Announced syndicated credits.

As discussed more fully below, in 1990 the Securities and Exchange Commission (SEC) implemented Rule 144A which effectively opened the U.S. market to the issuance of securities without having to satisfy SEC registration requirements. The only drawback was that the securities could only be held and traded amongst “qualified institutional investors”, which in practice are institutional investors. It is interesting to gauge the size of the public bond markets versus the 144A market. From April 1990 through December 1993, foreign firms have issued $18.06 billion in the 144A market and U.S. firms have issued $58.58 billion (Securities and Exchange Commission (1994)). Convertible bond issuance in the 144A market accounts for 32.7 percent of all convertible bond issuance in the United States, but only 4.84 percent of straight bonds. By comparison, 144A issues of common equity account for 1.91 percent of total common equity issuance in the United States.

The CP market in the U.S. is the oldest and the largest in the world. However, its share of the world market has fallen significantly in recent years, owing to the development of many other domestic CP markets as well as the ECP market. 14/ These data (Table 1) are outstanding amounts of CP; gross issues would be several times larger than this because the average maturity of U.S. CP is less than two months. For instance, with an average maturity at issue of 45 days, gross issues would be roughly eight times CP outstanding. Further, the “size” of the entire CP market is much larger than Table 1 shows because financial corporations (not included in the tables) issue roughly three to four times the quantity of paper that is issued by non-financial firms. In recent years, issuance in the U.S. CP market by foreign entities has accelerated and in 1992 accounted for 15 percent of the total outstanding stock of CP. To put this in perspective, the foreign component of the U.S. CP market is about the same size as the entire ECP market, and not much smaller than the domestic CP market in Japan or all the domestic markets in Europe put together.

The MTN market in the United States has become increasingly important. The domestic MTN market in the United States had outstanding issues in 1992 of $223 billion, of which $67.6 billion was issued by non-financial firms (Crabbe (1993)). To put this in perspective, the EMTN market had outstanding issues of $50 billion (for all issuers) in the same year, and all foreign domestic markets had outstanding issues of $10 billion. Clearly, the U.S. market is by far the largest MTN market in the world, although MTN markets in other countries (e.g. France) have been reported to have increased significantly in importance in recent years.

It is interesting to study the dynamics of the balance sheets of non-financial corporations (Table 2). Equity has fallen continuously as a percentage of total liabilities, whereas bonds have increased continuously. The proportion of liabilities accounted for by bank loans has also increased throughout the period, although less dramatically than bonds. The explanation for this is probably the important role of banks in so-called “highly-leveraged transactions”. For example, banks provided around $100 billion of funds for leveraged buyouts alone in the 1980s (see Borio (1990b)).

Table 2.

United States: Liabilities of Non-Financial Enterprises 1/

(In billions of U.S. dollars)

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Source: OECD, Financial Statistics (Part III).

The item “Bonds” includes short-term bills and bonds plus long-term bonds. The item “Loans” includes short- and long-term bank loans.

In the United Kingdom, gross equity issues have been erratic, due in large part to privatization programs (Table 3). Although there is clearly some trend growth in gross equity issuance by U.K. companies, there were large issues in the mid 1980s as well as more recently. The U.K. CP market is also fairly active, although care must be taken because the figures refer to gross issues. The domestic bond market has become increasingly less important in the United Kingdom, and U.K. firms have instead chosen to issue bonds in international markets. Indeed, the offshore bond issues and loans obtained by U.K. firms are substantial, each being larger than equity issues in most recent years. In light of the advantages of Eurobonds over domestic sterling issues (discussed below), the domestic market has essentially merged with the Euromarket. 15/

Table 3.

United Kingdom: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly, the Bank for International Settlements; IMF, International Financial Statistics: staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Studying the aggregate balance sheet for U.K. non-financial firms reveals that equity has been almost constant as a percentage of total liabilities (Table 4). In contrast, bonds increased primarily in the mid 1980s and have grown only slowly since then. Also, loans fell dramatically in the mid 1980s, mirroring the increase in bonds, but have regained some ground since then.

Table 4.

United Kingdom: Liabilities of Non-Financial Enterprises1/

(In billions of D&Id sterlinq)

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Source: OECD, Financial Statistics (Part III).

The item “Bonds” includes short-term bills and bonds plus long-term bonds. The item “Loans” includes short- and long-term bank loans.

In Germany, issuing equity has been an important source of funds, with the largest amount of issuance occurring in the 1990s (Table 5). The activity in the CP market is impressive in light of the fact that it opened in the early 1990s. This sharp trend might be expected to continue in light of the fact that money market mutual funds have recently been introduced in Germany. The international and domestic bond markets have been unimportant for German firms. The aggregate balance sheet reveals similar patterns (Table 6). Notable here is that equity financing has increased somewhat as a percentage of liabilities, as has “other liabilities”, which may be attributable to a decrease in the importance of loans for German firms. It should be noted, however, that any displacement of bank loans was not due to an increase in bond issuance.

Table 5.

Germany: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: Deutsche Bundesbank, Kapital Markt Statistik: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics: staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 6.

Germany: Liabilities of Non-Financial Enterprises1/

(In billions of deutsche marks)

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Source: OECD, Financial Statistics (Part III); Deutsche Bundesbank, Kapital Markt Statistik.

The item “Bonds” includes short-term bills and bonds plus long-term bonds. The item “Other Liabilities” includes bank loans.

In France, equity issues have taken off especially since the mid 1980s, although again privatization is an important factor in these numbers (Table 7). Bond issues too have shown some increase and it is interesting to note that offshore markets have been more important than the domestic bond market in recent years. International bank credit has also been tapped as an important source of funds for French firms in recent years. The share of total liabilities accounted for by equity has increased dramatically since the mid 1980s, with the contraction in loans mirroring this (Table 8). The proportion of liabilities accounted for by bonds is still very small in France.

Table 7.

France: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics; Banque de France, Bulletin de la Banque de France: Supplement Satistiques. First Quarter 1994; staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 8.

France: Liabilities of Non-Financial Enterprises

(In billions of French francs)

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Source: OECD, Financial Statistics (Part III).

Includes only long-term bonds.

In Japan, there were significant equity issues in the late 1980s, and an equally dramatic decrease in recent years (Table 9 and Table 10). The CP market in Japan is the second largest in the world, an impressive size given that it opened only recently. 16/ The issuance of bonds in Japan has been phenomenal, especially since 1987 or so: in several years it exceeded that in the United States on a per-capita (or relative to GDP) basis. Expressed as a percentage of GDP, the outstanding amount of Japanese corporate bonds is roughly comparable to the United States. However, it should be recognized that a significant portion of these bonds are issued offshore—in recent years offshore issuance has been about half as large as domestic issuance. Moreover, about half of the bond issues in the latter half of the 1980s were equity-linked bonds (Horiuchi (1994)). Since 1990, the issue of straight bonds has increased steadily accounting for about 80 percent of issuance in 1993 (Horiuchi (1994)). 17/ Further, a very substantial proportion of bond issues in the 1980s is associated with electric utilities and NTT. Japanese firms have obtained virtually no loans offshore.

Table 9.

Japan: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics: staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 10.

Japan: Liabilities of Non-Financial Enterprises 1/

(In billions of yen)

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Source: OECD, Financial Statistics (Part III).

Includes only long-term bonds.

Announced syndicated credits or bond issues.

Comparing the use of the international markets versus the domestic markets for bonds in the G-5 countries reveals that the Japanese have relied on the international market much more extensively than other countries, with Japanese firms’ offshore issuance accounting for about half as much as domestic issues. 18/ They have issued well over twice the amount of bonds internationally as U.S. firms. Firms in France and the United Kingdom have accessed the international market to a considerable extent especially when measured relative to GDP. Interestingly, German firms have virtually no activity in the international bond market. But with the exception of Germany, being an exception, the use of the international debt market by other G5 countries as a source of funds has grown continuously. 19/

Consider some smaller industrial countries—Spain, Denmark, Belgium, the Netherlands, and Canada. Roughly put, equity has increased both in terms of gross issues and in terms of the percentage of total liabilities (Tables 11-20). This fact is of course much more pronounced (and lumpy) in those countries that have engaged in large-scale privatization programs. For this set of smaller industrial countries, Canada has the most active corporate bond market. Indeed, it ranks among the largest corporate bond markets in the world. In the Netherlands and, to a lesser extent, Spain and Belgium, bond issuance has been an important source of funds even compared to some of the larger countries discussed above. However, bond issuance by Dutch firms appears to have been largely in the international markets up to 1992, and equity issuance appears to have displaced bonds to some degree in Belgium. 20/ In Denmark, it appears that equity and banks provide much corporate finance.

Table 11.

Spain: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics: staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 12.

Spain: Liabilities of Non-Financial Enterprises 1/

(In billions of pesetas)

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Source: OECD, Financial Statistics (Part III).

The item “Bonds” includes short-term bills and bonds plus long-term bonds. The item “Loans” includes short- and long-term bank loans.

Table 13.

Denmark: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics; and staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 14.

Denmark: Liabilities of Non-Financial Enterprises 1/

(In billions of kroner)

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Source: OECD, Financial Statistics (Part III).

The item “Other Liabilities” includes all non-equity Habilites.

Table 15.

Belgium: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics: and staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 16.

Belgium: Liabilities of Non-Financial Enterprises 1/

(In billions of Belgian francs)

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Source: OECD, Financial Statistics (Part III).

The item “Bonds” includes short-term bills and bonds plus long-term bonds. The item “Loans” includes short- and long-term bank loans.

Table 17.

Netherlands: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: OECD, Financial Statistics Monthly: the Bank for International Settlements; IMF, International Financial Statistics: and staff estimates.Note: … means not available or not yet available.

Announced syndicated credits or bond issues.

Table 18.

Netherlands: Liabilities of Non-Financial Enterprises

(In billions of guilders)

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Source: OECD, Financial Statistics (Part III).

Includes only long-term bonds.

Table 19.

Canada: Gross Bond Issues

(In billions of U.S. dollars)

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Sources: Bank of Canada Review (Spring 1994); OECD, Financial Statistics Monthly : the Bank for International Settlements; IMF, International Financial Statistics: and staff estimates.Note: … means not available or not yet available.

Amounts outstanding.

Announced syndicated credits or bond issues.

Table 20.

Canada: Liabilities of Non-Financial Enterprises 1/

(In billions of Canadian dollars)

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Source: OECD, Financial Statistics (Part III).

The item “Bonds” includes short-term bills and bonds plus long-term bonds. The item “Loans” includes short- and long-term bank loans.

4. Issuers and purchasers of corporate debt securities

As a general rule of thumb, the bond, CP, and MTN markets have increasingly become dominated on the demand side by institutional investors—i.e. insurance companies, pension funds, mutual funds, foundations and endowments, trusts, etc. However, there is also considerable cross-country variation in the importance of institutions and retail investors. At one end of the spectrum, the U.S. and Canadian corporate debt securities markets are dominated by institutions. The importance of banks and near banks has been on the decline in North America for some time, but they have been important players in Western Europe, Japan, and the newer markets in Latin America and Southeast Asia.

In the United Kingdom and Germany the major investors in domestically issued corporate bonds are domestic insurance companies and pension funds and, in the case of Germany, banks too are key players (European Bond Commission (1993)). However, in both cases the domestic markets are very small, with much of the issuance by domestic firms taking place in the Euromarket and to a lesser extent in the U.S. domestic market. Investment in the U.K. and German domestic corporate bond markets has been limited by the unattractiveness (relative to Eurobonds) of the withholding tax on coupon payments (see section III below). A withholding tax is also unappealing for issuers, not only because it potentially reduces the investor base, but also because it is regarded by issuers as a nuisance.

Individuals have been an important source of demand in the French and (more recently) the German bond markets, although the relative importance of the retail investor base has started to decline as mutual funds and pension funds have institutionalized retail market activity. For instance, in the French corporate bond market, 56.8 percent of outstanding bonds in 1980 were held by individuals and this had fallen to 37.9 percent in 1991 (European Bond Commission (1993)). At the same time the importance of institutional investors has virtually mirrored this behavior, rising from 32.8 percent to 49.6 percent over the same period, reflecting the institutionalization of portfolio management.

As in the German case, Japanese banks and near banks have been an important source of funds for the corporate bond market. However, the share of bonds held by banks has fallen considerably in Japan as well. 21/ In 1984, banks purchased almost 20 percent of new issues of corporate straight bonds. This share fell to a low of 2.1 percent in 1991, but rebounded somewhat in 1993 to 6.3 percent. It is interesting to note that the share of convertibles bought by banks has remained relatively constant over the past decade, and currently about 10 percent of new issues are purchased by banks. Non-bank financial institutions have also held a fairly constant share of convertibles, but in contrast to banks the share of straights purchased by non-bank financial institutions has increased five-fold over the past decade and in 1993 29 percent of primary market issues were purchased by non-bank financial institutions. The change in purchases of new issues of corporate straight bonds by individuals has shown the most dramatic change dropping from 57.5 percent in 1984 to 7.3 percent in 1993. However, like banks this decreasing share of total demand has not been reflected in convertibles.

In the U.S. corporate bond market, mutual funds and foreigners have increased significantly their holdings while direct holdings by households and pension fund holdings have decreased. In 1993, households held 3.7 percent of the outstanding amount of corporate bonds, insurance companies 37.8 percent, pension funds 22.7 percent, mutual funds 8.5 percent, and foreigners 12.6 percent. 22/ Holdings by mutual funds have increased five-fold since 1980, while foreign holdings have almost doubled over the same period. Household direct ownership has decreased by almost 50 percent over this period.

With regard to the types of issuers in corporate debt markets, it is true that these markets are not easily accessible to lesser-known names. The reason for this is well known: measuring creditworthiness (and thus determining a reasonable borrowing rate) as well as monitoring the actions of borrowers may be more difficult and costly with a diffuse pool of borrowers, and thus bank lending might be preferred for lesser-known names or firms with low credit ratings. However, in the United States the market for sub-investment grade bonds is very well developed and this increases accessibility to corporate debt markets because it provides an alternative to bank financing for all but very small firms. 23/

The importance of junk bonds to the financing of a particular class of firms has been very significant in the United States. 24/ The General Accounting Office (1988) reports that from 1982 to 1987 there were 920 publicly traded, non-convertible, (financial and non-financial) corporate issues (by 622 firms) and 586 convertible issues (by 581 firms) with a speculative rating. The dollar value of total issuance during this period was $108.2 billion of non-convertible issues and $28.1 billion of convertibles. The following two years saw and additional $57.5 billion of issuance activity. 25/ At least 80 percent of the issuers over this period were non-financial corporations.

Junk bond issuance faded in 1990 with only $2.7 billion in gross issues, but the market took off again beginning in 1991. In 1991, junk bond issuance increased to $14.6 billion, more than tripled to a record-setting $46.18 in 1992, and reached a staggering $77.91 billion in 1993 (Securities and Exchange Commission (1994)).

The importance of the high-yield bond market as a substitute for bank financing is reflected in the fact that as the U.S. domestic market grew, the average credit rating fell. In effect, the size of the market attracted additional issuers of low credit rating. Moreover, the widely-held belief that junk bonds are used largely for acquisition finance is erroneous. The General Accounting Office (1988) found that barely a quarter of the total amount raised with junk bonds in the 1980s was used for acquisition purposes. The most important use of funds was “general corporate purposes”.

The reason that markets for low-rated corporate paper do not exist in other countries is attributable to a combination of regulation—they are prohibited in Japan for example and frowned upon in many European markets—the underdeveloped state of many domestic corporate bond markets, and a general disinterest on the part of investors in low-grade bonds. In Europe, for instance, there is a general view that if investors wish to establish a risky position in a firm, the equity market is the appropriate conduit. As discussed below, while the Eurobond markets are highly developed and have at times seen issues of junk bonds from U.S. entities, investors in the Euromarkets typically prefer fairly low-risk securities relative to investors in the United States corporate bond market. It follows that, outside of the United States, firms with lower credit ratings and that are not well known outside their own country, have not had the option of raising funds through bond issues. However, some recent innovations in structuring bond issues have opened some bond markets to a wider range of firms, although the underdeveloped state of many domestic markets remains a hindrance to accessibility to all but a few firms.

The Rule 144A market in the United States provides an avenue for firms to issue debt securities (albeit only to institutional investors) without having to comply with the registration requirements of U.S. securities law. This market is discussed in more detail in section III below, but some characteristics of it are of interest here. First, the 144A market has increasingly been an important source of funds for non-investment grade bond issuers as well as for unrated firms, both domestic and foreign (Securities and Exchange Commission (1994)). In fact, since the market opened in April 1990, Rule 144A placements of investment-grade bonds have totalled $36.23 billion. Junk bond placements by domestic firms have totalled $18.28 billion, and foreign firms have issued $3.16 billion of junk bonds in the 144A markets, and there was a further $8 billion of unrated debt issued by foreign firms and U.S. firms, split equally. Relative to the public junk bond market, 144A junk bond issues in 1993 were roughly one quarter as large as public issues of junk bonds in the United States. The second key feature of the 144A market is that purchasers of 144A debt securities are restricted to be “qualified institutional buyers” (see section III below). In practice, investment companies and insurance companies are by far the key players in the 144A market (Securities and Exchange Commission (1994)), just as they are in other bond markets.

Successful issuance in the Eurobond and Euronote markets has been limited to corporate issuers with well-known names and usually (but not always) with high credit ratings. In fact, successful issuance in these markets requires foremost that the firm be well known; the credit rating is secondary, although this does not mean it is unimportant (see Euromoney (1994b)). Issues backed by strong credit but have a low public image have in the past encountered a poor reception and performed poorly in the secondary Euromarket (Clarke (1990)). On the other hand, “household names” have been able to obtain more favorable rates at times in the Euromarkets than in domestic markets (notably the U.S. market). An important exception to the importance of the issuer’s name is an asset-backed issue, which relies almost entirely on the credit rating rather than on public image. One other notable feature of the Euromarkets is that the investor base is largely retail-based. 26/ This stands in.sharp contrast to most domestic markets which are dominated by institutional investors.

Alworth and Borio (1993) and Corporate Finance (1991, 1993) document the types of investors that hold CP in all the large CP markets as well as several others. However, it is not possible to distinguish between investors in CP issued by financial and non-financial firms, although because CP markets are dominated by highly creditworthy issuers it is unlikely that this distinction would have any effect on the investor base. In the ECP market, about half of the outstanding paper is held by institutional investors (trusts, funds, insurance companies), 15-25 percent by non-financial companies, 10 percent by financial institutions, and much of the remaining held by supranationals and central banks. In the U.S. domestic market, about 60 percent of CP is held by institutional investors, about 10 percent by non-financial companies, about 6 percent by banks, and about 20 percent by individuals. 27/ The relatively large holdings by institutional investors in the United States include about 30 percent by money market mutual funds, up from 0.8 percent in 1975. Over the same period, holdings by non-financial companies have fallen from almost 30 percent to just over 9 percent. In France, most of the CP is held by institutional investors and banks, and the importance of institutional investors has also accelerated while holdings of non-financial companies has dwindled. In the United Kingdom, institutional investors and non-financial companies hold almost 90 percent of the CP. In Japan, non-financial companies are estimated to hold over half of the CP, 16 percent is held by institutional investors, and about 10 percent by banks.

5. Innovations and developments in corporate debt financing

Prior to 1970 the vast majority of bonds issued by corporates, financials, and the public sector were straight bonds possibly with a call feature. Bonds and notes have become increasingly sophisticated and currently include features such as: convertibility and exchangeability options, attachments (such as warrants), enhancements (such as letters of credit, claims on pools of assets, third-party guarantees, and back-up facilities), and contingent payment features (such as floating-rate coupons, partly-paid bonds, junk bonds, and others). At the same time, fundamental changes in the role and activities of financial intermediaries have blurred the distinction between bank loans on the one hand and bonds and notes on the other hand.

There are currently active markets for many variants of straight bonds issued in the United States and the international bond markets. Some of these variations allow for convertibility into the issuer’s debt or equity, exchangeability into the securities of some other firm, periodic (“sinking fund”) or delayed repayment of a portion of the principal (“partly paid bonds”), or an indexed coupon rate (FRN’s). FRN’s are very popular in periods when interest rates are quite volatile and this explains much of the surge in issuance during 1994 of these securities (see e.g. Bank for International Settlements (p.11-12, 1994)). In practice, the coupon yield on FRN’s (which is paid, say, every six months) is reset every 3 or 6 months to some base rate plus or minus a premium reflecting the creditworthiness of the issuer. 28/ Variations on the baseline FRN—”structured FRN’s”—include changing the structure to a fixed-income base (FRN convertibles and drop-lock FRN’s), resetting the coupon yield more frequently but not the payment period (mismatch FRN’s and variable floating rate notes—VRN’s), and combinations of FRN’s and derivatives such as capped FRN’s (contains an interest rate cap) and minimax FRN’s (includes a collar).

The combination of the international investor clientele in the Euromarkets and its “offshore” status, have meant that the Eurobond markets are highly innovative markets. Although the preponderance of issues are straights issued by generally high-quality entities on an unsecured basis, the market is also home to zero-coupon issues, deferred-coupon issues, step-up issues, and dual-currency issues (which pay coupons in one currency and principal in another). Nonetheless, it is true that the United States corporate bond market is the largest and the most innovative in the world. Many standard structures in Euromarkets and elsewhere were originated in the U.S.

Securitization is a recent innovation pioneered in the U.S. debt markets. The word “securitization” has broad meaning and includes, on the one hand, “asset-backed securities” (ABS) and “mortgage-backed securities” (MBS), and on the other hand, the packaging of historically non-tradeable assets into securitized claims. 29/ Both types of securitization have had profound effects on corporate finance. For example, the securitization of bank loans has eliminated the difference between bank financing and some types of bond issues. Specifically, as commercial and industrial loans in the United States are at present not marketed publicly but can (and are) traded among banks, they are very similar to private placements of bonds. 30/ Sales of non-financial corporate loans in the United States have grown from $50 billion per quarter in 1986 to almost $300 billion per quarter in the late 1980s, but have subsequently declined to $100 billion in the early 1990s (see Demsetz (1993)). While loan selling is much more widespread in America than in Western Europe or the Pacific Rim countries, it is beginning to take hold in many countries including developing countries. 31/ Development of markets for distressed (or “junk”) loans has proven to be especially beneficial for initiating quickly changes in balance sheets of financial firms in the United States and the United Kingdom, but have not developed in other countries largely because of legal or accounting impediments. 32/

Public issues of notes and bonds have historically only been possible for large corporations. This reflects a number of factors, including costs of public issuance, credit rating, and how well-known the issuer is. However, securitization through issuance of ABS’s or through other innovations has expanded the range of firms (both in terms of size and financial standing) that can access bond and note markets. Specifically, backing an issue with assets or future cash flow effectively “pumps up” the credit rating of an issue and has enabled a new class of firms to access domestic and international note markets. 33/ The securitization of corporate receivables and asset pools has led to a new form of secured bond and paper issuance that has very different effects on a firm’s balance sheet (see Corporate Finance (1994)). Most of the industrial countries now permit some form of these types of securitization, although many restrict activities and often to a considerable extent. 34/

III. Primary Bond Markets: Institutional Features and Regulatory Cons iderations

1. General issuance techniques

While the process associated with a bank loan is relatively straightforward, the issuance of debt securities is more complicated. Although there are circumstances in which some corporate issuers do not require outside assistance with a debt issue (some examples are provided below), issuing corporate securities typically involves investment banks in one or both of the following activities: (1) advising the issuer on the terms and timing of the offering and (2) underwriting the issue either on a “firm commitment basis”—the price is guaranteed by the underwriter—or a “best efforts” arrangement—roughly put, the price is that which the market will bear.

There may be up to three layers between the issuer and the final investors. The first layer is the managing group, comprised of a syndicate of firms with one (or more) being the lead manager (the “bookrunner”). The second layer is the underwriters, who perform an insurance function to the managing group by agreeing to buy the issues at a set price if they cannot be sold for a higher price in the market at the time of issue. The third layer is the selling group who market the securities. Often the same firms perform more than one of these three functions. The price is only fixed at the end of the selling period, which generates some uncertainty for the issuer.

The above so-called “traditional syndication” can be contrasted with some variations of it that are used to varying degrees in different markets. One variation is the so-called “bought deal”. The bought deal was first introduced in the Eurobond market in 1981 when the investment bank CS First Boston bought from GMAC a $100 million issue without having lined up a syndicate. Bought deals are now the principal method of issuing corporate debt in the Euromarkets (Davis (1992)). In the case of a bought deal, the underwriter either has pre-sold the issue or “shops” it to other investment banks after purchase. The advantage of the bought deal to the issuer is that it transfers selling price risk from the issuer to the intermediary. A further advantage is that it can facilitate quick issuance of securities, such as in the United States where it can be used in conjunction with the shelf registration rule (discussed below). The drawbacks are that the capital required to purchase an entire issue may be substantial and that the risk of re-selling the issue may not be shared.

In the case of both the traditional syndication and the bought deal there can be a lack of discipline over the price at which members of the syndicate sell the issue. As Davis (p.116,1992) points out, “As a result of intense competition, bonds are often sold at a discount to attract investors (the “reallowance”) or else banks would sell their bonds in the grey market (a market for bonds on which the issue price or syndicate allocations has not been determined, where quotes are set in relation to the unknown final price), which may oblige the lead manager to buy the bonds back in order to support the price.” Because of this unpleasant possibility (from the bookrunner’s perspective), the U.S. corporate bond market has long used the so-called “fixed price reoffer” technique. This “technique” is effectively a collusion device that prevents sellers in the primary market from undercutting each other: banks in the syndicate have a contractual obligation not to sell for less than an agreed-upon price until issuance is complete. Because of the appeal of this technique from the perspective of the investment banks, it has been adopted in the corporate bond markets in France (in 1991), it is now widely used in the Euromarkets, and has very recently been introduced (by American investment banks) in the Japanese domestic corporate bond market.

A second, much less-widely used method of issuing debt securities, is to auction them. In this case, the issuer announces the terms of the issue and interested parties submit bids for the entire issue or for specified amounts (a Dutch Auction). The advantage of an auction is that it eliminates the costs of underwriting, but on the other side of the ledger there is no obligation by some investment banks to make a secondary market in the issue. Moreover, this form of issuing securities is likely only practical for issuers that issue frequently and in large amounts—hence its widespread use for the issuance of government debt obligations.

Rather than structuring an issue as a “public” sale, one can alternatively directly (or “privately”) place corporate debt securities, again typically with the aid of an investment bank. Private offerings typically have less stringent issuance requirements than do public issues, but the set of possible investors can be much smaller (usually restricted to institutional investors) which tends to raise the cost of funds.

The issuance of shorter term debt securities may be accomplished differently than by the methods above. Notably, CP is typically placed either directly (“direct paper”) or via a dealer (“dealer-placed paper”). In the former case the issuer also performs the role of the intermediary by lining up investors. The vast majority of direct paper is placed by financial corporations, and is widely used only in the United States. 35/ Only Japan (of the major industrial countries) prohibits direct placements of CP. Dealer-placed paper is generally underwritten on a best-efforts basis. Additional variations are the note issuance facility (NIF) and the revolving underwriting facility (RUF). Both of these are mechanisms to issue bonds continuously rather than discretely. Wit the exception of Japan, CP is issued in the major industrial countries primarily through a “CP program”. Since CP issues are often “rolled over”, to protect the issuer from risk of not being able to roll over its CP, in many countries CP issues are backed by implicit (e.g. Germany) or explicit (e.g. Canada and the United States) bank credit lines in exchange for a commitment fee. In fact, in Canada and the United States almost all CP is backed by bank credit lines and this is being done increasingly in the Euro markets as well as the domestic CP markets in Europe.

2. Supervision, regulation, and issuance

In the United States surveillance and regulation of securities issued in the country is the responsibility of the Securities and Exchange Commission with a mandate provided by the Securities Act of 1933. Issuance of corporate bonds in the United States is facilitated by the aid of investment banks as well as by other financial institutions that provide investment banking services. The Glass-Steagall Act substantially restricts the underwriting activities of commercial banks. However, investment banking services can be provided by commercial banks through a so-called “Section 20 subsidiary”, which is a separately capitalized unit authorized by the Federal Reserve (beginning in 1986) to conduct the underwriting and distribution of corporate bonds.