Bonding with bonds
View(s):In the recent past Sri Lankans have become aware of the term “bonds” and, have been pretty much concerned about them too. Until then, many of us not even knew that there is something called bonds.
Today I decided to talk about bonds not necessarily to answer the questions like “what is a bond” and “how does it work”, but its relation to the global financial issue that I discussed in this column last week: i.e. the world is heading towards a man-made financial crash.
By answering the above questions too, I thought of elaborating “the bondage of the financial market to the issue of bonds” which also plays crucial role in the global financial problem.
Debt instrument
A bond is a “debt instrument” that can be issued by those who need to borrow money. The bond-issuing agencies are governments and private corporations.
The governments (including local governments), issue bonds when they are faced with cash shortages to finance budget deficits or to finance projects. For private companies, issuing bonds is an alternative method of raising capital apart from borrowing from commercial banks and listing in the stock exchange. For them, there are advantages of issuing bonds rather than borrowing from banks or issuing company shares, which I don’t intend to discuss today.
A bond is a “saving or investment instrument” that can be bought by those who have excess money. Instead of depositing excess money in a savings or fixed deposit or buying company shares in the stock exchange, someone can buy bonds.
Bonds have a period of maturity, which might be different from days or months to years and perpetual time. However, most of the long-term bonds rarely go beyond 30 years of maturity period.
Throughout the period until maturity, a bond yields a periodic interest income and at maturity the return of its capital as indicated in its face value.
Primary and secondary markets
There are two markets for bonds as primary and secondary markets. The initial offer takes place at the primary market where only designated buyers – primary dealers -, bid for bulk quantities. This is where the issuers raise the capital that it needs to borrow.
Then the primary dealers place the bonds in the secondary market for retail sales. This is where the public, including all types of financial institutions and various private or government funds can buy bonds. Depending on the demand-supply conditions, the market price of the bond (which could be different from its face value) is determined.
If the price is high (in response to high demand), then the interest income of the bond (which is also now different from its coupon rate) will be lower. If the price is low (in response to low demand), then the interest income of the bond will be higher.
If you think of Sri Lanka, which is not our focus today, its bond market is overwhelmingly dominated by the bonds issued by the government – Treasury Bills and Treasury Bonds. While our local governments don’t issue bonds, the corporate sector bond issuance is still small. By global standards, Sri Lanka has a tiny bond market where foreign participation is restricted by both regulation and the smallness of the market.
While the world is heading towards a man-made financial crisis, global warming and climate change mean agriculture plots like this (in the picture) would be confronted with severe drought, flash floods or intensive heat.
Apart from the Treasury bills and bonds which are rupee-denominated, the government has also started issuing US$-denominated sovereign bonds since 2007. With these bonds, the government has stepped into increased commercial borrowing in foreign currency.
Global corporate bonds
The global picture of the bond market is a different one, because it is dominated by corporate bonds. The biggest bond market in the world is in the US, while the second biggest is in Europe. In Asia both China and Japan also account for a significant share of the world’s corporate bond market.
Here is the problem: According to an OECD report, which is also confirmed by the reports of the rating agencies, corporate bond issuance in the world in general and in advanced countries in particular, has grown significantly over the past 10 years.
Before the global financial crisis, total outstanding amount of corporate bonds issued by non-financial companies have increased from $6.5 trillion in 2008 to $13 trillion in 2018. This unprecedented increase in corporate bonds in the world has been contributed mostly by firstly the US, secondly the EU and, finally China.
The annual bond issuance by non-financial companies in advance was around the value of $900 billion; it has doubled over the years reaching above $1,800 billion in the past few years. Together with that, emerging economies in which China plays a major role have also increased the value of bond issuance significantly.
The number of companies issuing bonds which was around 1000 in 2008 has doubled by 2016 exceeding 2000 in advanced countries. In the same way, the number of such companies in emerging economies which was about 400 has increased four-times to around 1600 by 2016.
What’s the problem?
As the profits were wiped out by the global financial crisis, there is no doubt that the corporate sector was in need of capital. It coincided with easy monetary policies in advanced countries and emerging market economies; they started injecting massive amounts of money through reduction in policy rates, quantitative easing, and direct lending. Part of the easy money flowed into corporate bond markets, enabling the companies to raise easy capital.
So what’s the problem? A closer look at the changes in the global corporate bond markets shows that there is a problem in this whole scenario. It would feed into a potential “debt crash” as part of the financial collapse, as revealed in last week’s column.
Let’s examine the symptoms of the problem; it’s all about credit quality. Credit quality is measured and presented with credit rating grades by credit rating agencies – Moody’s, Standard and Poor’s, and Fitch. Credit rating grades show the “credit worthiness” or the potential ability of the bond-issuing companies to pay back their debt.
Credit worthiness
The “lower” risk is denoted by A grades, with the highest credit worthiness attributed to AAA grading. The lower risk credit worthiness ends with BBB rating, generally other B grading and C grading carry higher risk of the ability to pay back the debt.
Understandably, the companies that are falling under “investment category” are from AAA to BBB grading levels so that their bond prices are higher (due to higher demand) and interest gain is lower; but holding their bonds is less-risky.
In contrast, the bonds issued by companies with grading lower than BBB carry high risk. Their prices are lower (due to less demand), but interest gain is higher with an added “risk premium” to compensate for less demand. These bonds fall under “speculative category” because those who buy such bonds do not expect to hold them for longer periods; they look for higher returns in shorter time periods.
Falling credit quality
The global corporate bond market has experienced falling credit worthiness along with an unprecedented increase in the world’s bond volume.
The increase in the number of leveraged companies has already put the world’s financial markets in trouble with a high risk of default.
According to a report by Moody’s about 60 per cent of global non-financial companies are now rated under speculative grade, while the majority of them too as high as 40 per cent fall under high-risk categories.
In an overall assessment, it is clear now, the world’s corporate credit worthiness has deteriorated along with the increase in the money stock in the world. The world economy is moving towards a “high risk” zone.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk).