The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

Bond futures

Futures contracts on interest rates are traded on exchanges in many countries. These contracts allow investors to receive payment if an interest rate is above or below a specified level on the contract’s expiration date. Large investors use such contracts as an integral part of their bond investment
strategies.

The biggest national markets

Corporate bonds and some asset-backed securities are the main components of the private-sector debt market. This market has been growing rapidly overall, although in a few countries, notably Japan and France, the value of outstanding bonds has diminished . A disproportionate share of the world’s private-sector debt securities is issued in the United States. This is largely the result of deliberate efforts to retard the development of bond markets in many other countries. In Japan, the Bond Issue Arrangement Committee, a bankers’ group encouraged by the government, controlled costs and the timing of issuance until 1987, and a bankers’ cartel kept fees high. In Germany, regulations up to 1984 prohibited companies from selling bonds with terms of less than five years and required  approval from the finance ministry for each issue. France barred corporate issues with terms of less than seven years before 1992, required Treasury approval of the details of each issue and required a committee of bankers and public officials to approve the timing so that private-sector issues would not interfere with the government’s borrowing plans. Such restrictions encouraged the use of bank financing rather than bonds. The European corporate-bond market has grown rapidly since the introduction of a single currency in 12 eu countries created a large pool of investors who could purchase a bond denominated in euros without exposing themselves to the risk of exchange-rate changes.

Bond markets in many countries expanded rapidly in 2002–04. This was partly the result of low interest rates around the world, and partly the consequence of a more stable macroeconomic environment, which gave investors increased confidence in owning long-term obligations.

Issuing bonds

National regulations detail the steps required to issue bonds. Each issue is preceded by a lengthy legal document, variously called the offer document, prospectus or official statement, which lays out in detail the financial condition of the issuer; the purposes for which the debt is being sold; the schedule for the interest and principal payments required to service the debt; and the security offered to bondholders in the event the debt is not serviced as required. Investors scrutinise such documents carefully, because details specific to the issue have a great impact on the probability of timely payment. In some cases, regulators must review the offer document to determine whether the disclosures are sufficient, and may block the bond issue until additional information is provided. Issuers in the United States may file a shelf registration to obtain advance approval for a large volume of bonds, which can be sold in pieces, or tranches, whenever market conditions appear favourable. Most other countries have not adopted this innovation.

Underwriters and dealers

Issuers sell their bonds to the public with the help of underwriters and dealers. An issue may be underwritten by a single investment banking firm or by a group of them, referred to as a syndicate. Many syndicates include investment banks from different countries, the better to sell the bonds internationally. The issuer normally chooses one or two firms to be the lead underwriters. They are responsible for arranging the syndicate and for allocating a proportion of the bonds to each of the member firms. Formerly, dozens of firms competed in the underwriting business. However, mergers and acquisitions among banks have led to the creation of a handful of huge investment banks, most of them based in the United States, that dominate bond underwriting throughout the world.

The underwriters may receive a fee from the issuer in return for arranging the issue and marketing it to potential investors. Alternatively, they may purchase the bonds from the issuer at a discount and resell them to the public at a higher price, profiting from the mark-up. If the investment bankers underwrite the issue on a firm commitment basis, they guarantee the price the issuer will receive and take the risk of loss if purchasers do not come forward at that price. They may instead underwrite the bonds with only their best efforts, in which case the issuer receives whatever price investors will pay and the underwriter takes no risk if the bonds fail to sell at a particular price. The underwriters may sell bonds at a discount to dealers, who take no underwriting risk but handle sales to smaller investors. National governments often distribute their bonds through primary dealers without the assistance of underwriters. Primary dealers have the obligation, and often the exclusive right, to participate in the government’s bond sales, and then resell the bonds to investors.

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