Bond market innovations and financial intermediation

Business Horizons, Nov-Dec, 1989 by Donald J. Smith, Robert A. Taggart, Jr.

Changes in the bond market in the past two decades have affected not only investing strategies, but also the nature of the financial industry

For many years the bond market was the realm of blue chip issuers and conservative investors. Its sedate pace suited those whose primary objectives were steady income and preservation of capital.

The upheaval began gradually. Increased market volatility in the late 1960s and 1970s led to growing awareness of interest rate and currency risk. This in turn sparked a demand for new types of market instruments, new strategies for managing risk, and new ways to exploit interest rate differentials across markets.

In the 1980s, the flow of innovation has become a flood. New instruments have proliferated in a bewildering variety. Financial engineering allows the uncoupling of investor demand from the instruments that issuers want to supply and has fundamentally altered the structure of financial intermediation. Bond markets have become truly global in scope, with trading occurring around the clock and around the world.

This article will describe the common characteristics of these bond market innovations and the underlying forces that have caused the recent wave of change. It first analyzes the general determinants of bond market demand and supply. It then describes some of the major innovations of the 1970s and 1980s, explaining how they represent a pattern of accelerating response to changing market conditions.

BOND MARKET DEMAND AND SUPPLY

A bond or any other financial instrument can be viewed as a package of characteristics such as return, risk, and liquidity. Investors, of course, prefer high returns, low risk and high liquidity, but issuers will not be able to produce that package at reasonable cost. Hence, tradeoffs will be determined by supply and demand.

On the demand side, these tradeoffs are influenced by the distribution of investable wealth, tax rules, regulatory restrictions, and perceptions of the relative importance of various risk categories. In the 1980s, for example, Japanese financial institutions have accumulated an increased share of the world's total investable wealth. It is not surprising, then, that the tax and regulatory rules facing these institutions have affected the form of bond market instruments.

Changing perceptions of risk have influenced investors' views of bonds in both the 1970s and 1980s. Credit risk was once thought to be the most important category of bond risk, but investors have now become more keenly aware of interest rate and currency risk. The corporate restructuring wave of the 1980s has also given rise to "event risk," that of a sudden decline in credit quality resulting from a takeover, divestiture, or recapitalization.

Increased sensitivity to these risks has in turn spurred a demand for securities with protective features. Examples include floating-rate notes, zero-coupon bonds, and put bonds. New investment strategies designed to tailor the overall risk of a portfolio more precisely, such as immunization and hedging strategies using futures and swaps, have also been developed. Finally, the market volatility generating these risks has increased the demand for liquidity, thus enhancing the appeal of public securities markets. Investors have discovered that risk-management strategies require a liquid portfolio.

On the supply side, bond issuers face a set of cost conditions for providing financial services. They will try to issue securities that minimize the cost of providing a given financial services package. These costs include both the explicit costs of executing transactions and the implicit costs of bearing financial risk, and they are affected by available technology, tax and regulatory rules, and the issuer's ability to offset various forms of risk.

For example, the relative costs of issuing debt in the public and private markets have been affected by Securities and Exchange Commission Rule 415, which makes it faster and easier for large companies to bring a public issue to market. Advances in communications and information processing technology have helped allow continuous and flexible access to debt markets.

Tax considerations have clear effects on the costs of servicing bond issues and can thus influence their design. A primary motivation for the introduction of zero-coupon and other original issue discount bonds in 1981 was the advantageous way that issuers could deduct the discount amortization from annual tax payments.

An issuer's ability to bear particular risks will influence the degree of risk protection offered to investors. Commercial banks have been frequent issuers of floating-rate notes, since their interest rate risk is hedged by the tendency of their revenues to vary directly with interest rates. Producers of commodities, such as silver or oil, have been natural issuers of commodity-backed bonds, whose ultimate payoff is indexed to a specified commodity price level.

The demand and supply sides of the bond market can be joined in two ways. They can meet directly when the issuers supply bonds with characteristics ultimate investors desire. This has been the traditional sphere of the public bond markets. Alternatively, they can meet indirectly through a financial intermediary. The intermediary purchases the issuer's debt security and in turn issues a claim on itself having characteristics that are more highly valued by the ultimate investors. This has been the traditional role of commercial banks, which purchase debt securities from businesses (make loans to them) and issue more liquid, less risky deposits to investors.