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…

The Bond Issuers

Four basic types of entities issue bonds.

National governments

Bonds backed by the full faith and credit of national governments are called sovereigns. These are generally considered the most secure type of bond. A national government has strong incentives to pay on time in order to retain access to credit markets, and it has extraordinary powers, including the ability to print money and to take control of foreign currency reserves, that can be employed to make payments. The best-known sovereigns are those issued by the governments of large, wealthy countries. US Treasury bonds, known as Treasuries, are the most widely held securities in the world, with $4.5 trillion in private ownership in mid-2005. Other popular sovereigns include Japanese government bonds, called jgbs; the German government’s Bundesanleihen, or Bunds; the gilt-edged shares issued by the British government, known as gilts; and oats, the French government’s Obligations assimilables du trésor. Governments of so-called emerging economies, such as Brazil, Argentina and Russia, also issue large amounts of bonds. Another category of sovereigns includes bonds issued by entities, such as a province or an enterprise, for which a national government has agreed to take responsibility. Investors’ enthusiasm for such bondswill depend, among other things, on whether the government has made a legally binding commitment to repay or has only an unenforceable moral obligation. In many countries the amount of debt for which the national government is potentially responsible is extremely high. In the United States, for example, federally sponsored agencies had $2.7 trillion in bonds outstanding as of 2005. Although much of this does not represent legal obligations of the US government, the government would come under heavy pressure to pay if one of the issuing agencies were to default.

Lower levels of government

Bonds issued by a government at the subnational level, such as a city, a province or a state, are called semi-sovereigns. Semi-sovereigns are generally riskier than sovereigns because a city, unlike a national government, has no power to print money or to take control of foreign exchange. The best known semi-sovereigns are the municipal bonds issued by state and local governments in the United States, which are favoured by some investors because the interest is exempt from US federal income taxes and income taxes in the issuer’s state. About $2.1 trillion worth were outstanding in 2005. Canadian provincial bonds, Italian local government bonds and the bonds of Japanese regions and municipalities are also widely traded. Many countries, however, deliberately seek to keep subsovereign entities away from the bond markets. This serves to limit their indebtedness, but also has the less noble goal of providing a steady flow of loan business to banks. Germany’s states, or Länder, have emerged as significant issuers, with €170 billion of bonds outstanding at the end of 2004 – a leap from only €59 billion of bond indebtedness in 1999. German local governments, however, had almost no bonds outstanding.

There are many categories of semi-sovereigns, depending on the way in which repayment is assured. A general-obligation bond gives the bondholder a priority claim on the issuer’s tax revenue in the event of default. A revenue bond finances a particular project and gives bondholders a claim only on the revenue the project generates; in the case of a revenue bond issued to build a municipal car park, for example, bondholders cannot rely on the city government to make payments if the car park fails to generate sufficient revenue. Special-purpose bonds provide for repayment from a particular revenue source, such as a tax on hotel stays dedicated to service the bonds for a convention centre, but usually are not backed by the issuer’s general fund.

BOND MARKETS

Public-sector debt, including sovereign and semi-sovereign issues, accounts for about 60% of all domestic debt worldwide. The total amount of public-sector debt outstanding at June 2005 was almost $24 trillion, of which $22 trillion was issued by governments within their domestic bond markets and $1.4 trillion was issued internationally.

Corporations

Corporate bonds are issued by a business enterprise, whether owned by private investors or by a government. Large firms may have many debt issues outstanding at a given time. In issuing a secured obligation, the firm must pledge specific assets to bondholders. In the case of an electric utility that sells secured bonds to finance a generating plant, for example, the bondholders might be entitled to take possession of and sell the plant if the company defaults on its bonds, but they would have no claim on other generating plants or the revenue they earn. The holders of general-purpose debt have first claim on the company’s revenue and assets if the firm defaults, save those pledged to secured bondholders. The holders of subordinated debt have no claim on assets or income until all other bondholders have been paid. A big firm may have several classes of subordinated debt. Mezzanine debt is a bond issue that has less security than the issuer’s other bonds, but more than its shares.

Securitisation vehicles

An asset-backed security is a type of bond on which the required payments will be made out of the income generated by specific assets, such as mortgage loans or future sales. Some asset-backed securities are initiated by government agencies, others by private-sector entities. These sorts of securities are assembled by an investment bank, and often do not represent the obligations of a particular issuer. The distinctions among the various categories of bonds are often blurred. Government agencies, for example, frequently issue bonds to assist private companies, although investors may have no legal claim against the government if the issuer fails to pay. National governments may lend their moral support, but not necessarily their full faith and credit, to bond issues by state-owned enterprises or even by private enterprises. Corporations in one country may arrange for bonds to be issued by subsidiaries in other countries, eliminating the parent’s liability in the event of default but making payment dependent upon the policies of the foreign government.

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