Global Bond Markets

Introduction

The Bond Market (also known as the debt, credit or

fixed income market) is a financial market where
participants buy and sell debt securities, usually in the
form of bonds.
st

As of 31 December, 2010, the size of the worldwide

bond market (total debt outstanding) is an estimated $
95 trillion, of which the size of the outstanding U.S.
bond market debt was $ 37 trillion.

Nearly all of the $ 822 billion average daily

trading volume in the U.S. bond market takes place
between the broker-dealers and large institutions in
a decentralized, over-the-counter (OTC) market.
However, a small number of bonds, primarily
corporate, are listed on exchanges.

Structure of the Bond Market

Bond markets in most countries remain

decentralized and lack common exchanges like stock,
future and commodity markets. This has occurred, in
part, because no two bond issues are exactly alike,
and the variety of bond securities outstanding greatly
exceeds that of stocks.

However, the New York Stock Exchange (NYSE)

is the largest centralized bond market, representing
mostly corporate bonds. The NYSE migrated from the
Automated Bond System (ABS) to the NYSE Bonds
trading system in April 2007 and expects the number
of traded issues to increase from 1000 to 7500 till
December 2011.

Types of Bond Markets

Classification of the broader bond market into 5
specific bond markets is done by the
Securities Industry & Financial Markets
Association (SIFMA)

Corporate
Government & Agency

Municipal

Mortgage Backed, Asset Backed

and Collateralized Debt Obligation

Funding

Participants in Bond Markets

Bond Market participants are similar to

participants in most financial markets and are
essentially either buyers (debt issuer) of funds
or sellers (institution) of funds and often both.

Participants include:(1) Institutional Investors

(2) Governments
(3) Traders
(4) Individuals

Participants in Bond Markets

Because of the specificity of individual

bond issues and the lack of liquidity in
many smaller issues, the majority of
outstanding bonds are held by
institutions like pension funds, banks and
mutual funds. In the United States,
approximately 10% of the market is
currently held by private individuals.

Bond Market Size

Amounts outstanding on the global bond market increased by 5% in

2010 to a record $95 trillion. Domestic bonds accounted for 70% of
the total and international bonds for the remainder. The US was the
largest market with 39% of the total followed by Japan with 20%.
As a proportion of global GDP, the bond market increased to 130%
in 2010 from 119% in 2008 and 80% a decade earlier. The
considerable growth means that at the end of 2010 it was much
larger than the global equity market which had a market
capitalization of around $55 trillion.
Growth of the market since the start of the economic slowdown was
largely a result of an increase in issuance by governments, with
government bonds accounting for 43% of the value outstanding at
the end of 2010, up from 39% a year earlier.

The outstanding value of international bonds increased by 3% in

2010 to $28 trillion. The $1.5 trillion issued during the year was down
35% on the 2009 total. The first quarter of 2011 was off to a strong
start with issuance of nearly $500 billion. The US was the leading
centre in terms of value outstanding with 24% of the total followed by
the UK with 13%.

Bond Market Volatility

For market participants who own a bond, collect the coupon and hold it to
maturity, market volatility is irrelevant; principal and interest are received
according to a pre-determined schedule.

But participants who buy and sell bonds before maturity are exposed to
many risks, most importantly changes in interest rates. When interest
rates increase, the value of existing bonds fall, since new issues pay a
higher yield. Likewise, when interest rates decrease, the value of existing
bonds rise, since new issues pay a lower yield. This is the fundamental
concept of bond market volatility: changes in bond prices are inverse to
changes in interest rates. Fluctuating interest rates are part of a country's
monetary policy and bond market volatility is a response to expected
monetary policy and economic changes.

Economists' views of economic indicators versus actual released data

contribute to market volatility. A tight consensus is generally reflected in bond
prices and there is little price movement in the market after the release of "inline" data. If the economic release differs from the consensus view the
market usually undergoes rapid price movement as participants interpret the
data. Uncertainty (as measured by a wide consensus) generally brings more
volatility before and after an economic release. Economic releases vary in
importance and impact depending on where the economy is in the business
cycle.

Most Common Bond Indices

A number of bond indices exist for the

purposes of managing portfolios and
measuring performance, similar to the S&P
500 or DJIA for stocks.

The most common American benchmarks are

the Barclays Aggregate, Citigroup BIG and Merrill
Lynch Domestic Master.

Most indices are parts of families of

broader indices that can be used to
measure global bond portfolios or may be
further subdivided by maturity and/or sector
for managing specialized portfolios.

Types of Bonds

Domestic
Bonds

Euro Bonds

Foreign Bonds

Domestic Bonds

They are issued (and traded) locally

by a domestic borrower and are
denominated in the local currency.

They usually carry less risk as the

regulatory and taxation requirements
are usually known to the investors or at
least to their brokers and accountants.

Example of Domestic Bond

ABC Co. (incorporated & registered

in US) issues a bond in US for
placement in the US domestic market
(ie) only for the US resident investors.

The issue is underwritten by a

syndicate of American securities
houses.

The issue is denominated in the

currency of the target investors (ie) USD

Euro Bonds

Bonds issued or traded in a country using a

currency other than the one in which the bond is
denominated. This means that the bond uses a
certain currency, but operates outside the
jurisdiction of the central bank that issues that
currency.

Euro Bonds are generally issued by MNCs

and National Governments to raise capital in
international markets.

It is important to note that the term has nothing to do

with the currency EURO and that the prefix EURO" is
used more generally to refer to deposits outside the
jurisdiction of the domestic central bank.

Eurobonds are often bearer bonds.

Example of Euro Bond

ABC Co. (a foreign corporation incorporated &

registered in US) issues bonds to be placed

internationally (ie) say a British FMCG company

may issue a Euro Bond in Germany
denominating
it in USD or an Italian Automobile company might sell
Euro Bonds issued in USD to investors living in
European countries.

The issue is underwritten by an international syndicate of

securities houses.

The issue is denominated in any currency,

including even the currency of the borrowers
country of incorporation (ie) USD

Foreign Bonds

They are issued (and traded) on a

local market by a foreign borrower and
are denominated in the local currency.

Foreign bond issues and trading

are under the supervision of local
market authorities.

For example, a bond denominated in

US Dollars that is issued in the United
States by the Government of Canada is
a Foreign Bond.

Example of Foreign Bond

ABC Co. (a foreign corporation

registered & incorporated outside US)
issues bonds in US for placement in
the US market alone.

The issue is underwritten by a

syndicate of US securities houses.

The issue is denominated in the

currency of the target investors (ie) USD

Types of Bond Instruments

Straight or Fixed Income Bonds

Partly-paid Bonds
Zero-coupon Bonds
Floating Rate Notes (FRNs)
Perpetual FRNs
Convertible Bonds
Bonds with Warrants

Dual-Currency Bonds

Credit Rating

Credit is important because individuals and corporations with poor credit

will have difficulty finding financing and most likely will have to pay more
because of the risk of default.
Credit ratings are a tool used by lenders to determine the types of loans and rate
of interest that can be extended to a potential borrower.

A corporation's credit rating is an assessment of whether it will be able to

meet its obligations to bond holders and other investors. Credit rating
systems for corporations generally range from AAA or Aaa at the high end
to D (for default) at the low end.

Your credit rating is an independent statistical evaluation of your ability to repay debt
based on your borrowing and repayment history.

If you always pay your bills on time, you are more likely to have good credit
and therefore may receive favorable terms on a loan or credit card such as
relatively low finance charges.
If your credit rating is poor because you have paid bills late or have
defaulted on a loan, you may be offered less favorable terms or may be
denied credit altogether.

Credit Rating Agencies

A company that provides investors with

assessments of an investment's risk. The issuers of
investments, especially debt securities, pay credit
rating agencies to provide them with ratings.

A high rating indicates low risk and may therefore

encourage investors to buy a security. Additionally,
banks may only invest in securities with a high rating
from two or more credit rating agencies.

Fitch, S&P and Moody's are the three most

prominent global CRAs.

The ratings have letter designations (such as AAA, B,

CC) which represent the quality of a bond.

Bond ratings below BBB/Baa are called Junk Bonds.

Credit Rating Agencies

The ratings given by CRAs are only their

opinions.

Thus, they are not a recommendation to

buy, sell or hold a security and do not
address the suitability of an investment for
an investor.

Regulators have almost fully outsourced to

CRAs much of the responsibility for assessing
debt risk.

For investors, ratings are a screening tool

that influences the composition of their
portfolios as well as their investment
decisions.

Credit Ratings & Basel 2 Norms

The Basel 2 norms (ratings-based

regulations) are much common in USA than
across Europe.

Regulatory changes in banks capital

requirements under the Basel 2 norms have
resulted in a new role to credit ratings.

The major objective of Basel 2 is to revise

the rules of the 1988 Basel Capital Accord so
as to align banks regulatory capital more
closely with their risks, taking account of
progress in the measurement and
management of these risks and the
opportunities which these provide for
strengthened supervision.

Credit Ratings & Basel 2 Norms

Under Pillar 1 of Basel 2, regulatory capital

requirements for credit risk are calculated according
to 2 alternative approaches:(1) The Standardized Approach measurement of
credit risk is based on external credit assessments
provided by External Credit Assessment Institutions
such as credit rating agencies or export credit
agencies.
(2) The Internal Ratings-Based Approach subject to
the supervisory approval as to the satisfaction of
certain conditions, banks use their own rating
systems to measure some or all of the determinants
of credit risk.

Credit Ratings & Basel 2 Norms

Under the Foundation Version (FV), banks

calculate the Probability of Default (PD) on the
basis of their own ratings but rely on their
supervisors for the measures of the other
determinants of credit risk.

Under the Advanced Version (AV), banks

also estimate their own measures of all the
determinants of credit risk including the Loss
Given Default (LGD) and Exposure at Default
(EAD).

Procedures & Methods of CRAs

The processes and methods used to establish credit

ratings vary widely among CRAs.

Traditionally, CRAs have relied on a process based

on a qualitative and quantitative assessment reviewed
and finalized by a rating committee.

Recently, there has been increased reliance

on quantitative statistical models based on
publicly available data.

The key measure in credit risk models is the

measure of the Probability of Default (PD) but
exposure is also determined by the expected timing of
default and by the Recovery Rate (RE) after the
default has occurred.

Procedures & Methods of CRAs

Standard & Poors ratings seek to capture only the

forward-looking probability of the occurrence of
default. They provide no assessment of the expected
time of default or mode of default resolution and
recovery values.

Moodys ratings focus on the Expected Loss (EL) which

is a function of both PD and RE.

Fitchs ratings also focus on both PD and RE. They

have a more explicitly hybrid character in that analysts
are also reminded to be forward-looking and to be alert
to possible discontinuities between past track records
and future trends.

The credit ratings of Moodys and Standard & Poors

are assigned by rating committees and not by individual
analysts.

International Regulations on
CRAs

International Organization of Securities Commission (IOSCO) has formulated a

Code of Conduct Fundamentals for the working of CRAs.

The Code Fundamentals are designed to apply to any CRA and any person
employed by a CRA in either in full-time or part-time capacity.

It focuses on transparency and disclosure in relation to CRA

methodologies, conflicts of interest, use of information, performance and
duties to the issuers and public, the role of CRA in structured finance
transactions, etc.

It does not dictate business models or governance but rather seeks to

provide the market with information to judge and assess the CRA activities,
performance and reliability.

The IOSCO Code of Conduct broadly covers the following 4 areas:(1)Quality and integrity of the rating process
(2)CRAs independence and avoidance of conflicts of interest
(3)CRAs responsibilities towards the investing public and issuers
(4)Disclosure

of the Code of Conduct and communication with the

market participants

Investment Grades of Bonds

A bond is considered investment grade or IG if its

credit rating is BBB- or higher by Standard & Poor or
Baa3 or higher by Moody's.

Generally they are bonds that are judged by the rating

agency as likely enough to meet payment obligations that
banks are allowed to invest in them.

Ratings play a critical role in determining how

much companies and other entities that issue debt,
including sovereign governments, have to pay to
access credit markets, i.e., the amount of interest they
pay on their issued debt.

The threshold between investment-grade and

speculative-grade ratings has important market
implications for issuers' borrowing costs.

Investment Grades of Bonds

Bonds that are not rated as investment-grade bonds

are known as high yield bonds or more commonly as
junk bonds.

The risks associated with investment-grade bonds

(or investment-grade corporate debt) are considered
noticeably higher than in the case of first-class
government bonds.

The difference between rates for first-class

government bonds and investment-grade bonds is
called investment-grade spread.

It is an indicator for the market's belief in the stability

of the economy. The higher these investment-grade
spreads (or risk premiums) are, the weaker the economy
is considered and vice-versa.

Criticism on Credit Rating Agencies

Until the early 1970s, bond credit rating agencies were paid for their work by
investors who wanted impartial information on the credit worthiness of
securities issuers and their particular offerings.

Starting in the early 1970s, the "Big Three" ratings agencies (S&P,
Moody's & Fitch) began to receive payment for their work by the
securities issuers for whom they issue those ratings, which has led to
charges that these ratings agencies can no longer always be impartial
when issuing ratings for those securities issuers.

Securities issuers have been accused of "shopping" for the best ratings from
these three ratings agencies, in order to attract investors, until at least one of
the agencies delivers favorable ratings.

This arrangement has been cited as one of the primary causes of the
sub-prime mortgage crisis (which began in 2007), when some securities,
particularly mortgage backed securities (MBSs) and collateralized debt
obligations (CDOs) rated highly by the credit ratings agencies, and thus
heavily invested in by many organizations and individuals, were rapidly
and vastly devalued due to defaults, and fear of defaults, on some of the
individual components of those securities, such as home loans and
credit card accounts.