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GLOBAL AND LOCAL BOND MARKETS: A FINANCIAL STABILITY PERSPECTIVE
Remarks by William Witherell,
Director of the Directorate for Financial, Fiscal and Enterprise Affairs
OECD
Fifth Annual OECD-World Bank Bond Market Forum
June 2-3, 2003
H Auditorium, World Bank Headquarters, Washington, DC
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Mr Chairman, Ladies and Gentlemen, it is my pleasure to address this joint OECD/World
Bank Forum on bond market development (already the fifth in this series and a measure of its
usefulness). As on previous occasions, this workshop is being held under the aegis of the OECD
Working Party on Public Debt Management, which is a subsidiary of our Committee on Financial
Markets and thus is able to draw upon the market analysis of that body.
As first speaker in the morning session on “Trends and Developments in Bond Markets”,
I will look at the overall global setting for bond markets and consider some financial stability
issues. This stability perspective is being pursued in much of our work at the OECD and was an
underlying theme at our most recent annual Ministerial meeting. Naturally, it is at the heart of the
activities of the Financial Stability Forum in which both we and the Bank participate – literally
side-by-side.
Significant downside risks in the macro picture
In recent discussions at the OECD and also the Financial Stability Forum, we reviewed
the international financial system by examining various underlying sources of economic and
financial strengths and weakness. Near term prospects have weakened in recent months, with
geopolitical risks playing a key role. The conclusion of organised fighting in Iraq has been a
positive development. The acute risk of an oil crisis has now greatly receded. But unfortunately,
this has been off-set to an unknown degree by the negative but uncertain impact of SARS on the
global economy and the various regions, in particular Asia, and increased concerns about
terrorism. And there continue to be concerns about governance in our markets. On balance, we
are cautiously optimistic about the outlook, with the risks being skewed to the downside. We
anticipate a few quarters of slow, below trend, growth in the OECD group of countries in 2003,
followed by good - slightly above potential - growth next year. Combined with falling oil prices,
such an environment of weak demand would prove to be relatively disinflationary, with inflation
significantly below 2% in the Euro area and the United States and persistent deflation in Japan.
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Mature financial markets under stress
In the present environment, it will be critical that financial markets, both domestic and
international, continue to operate effectively and play their role in supporting recovery. Recent
experience have demonstrated that when financial systems perform badly, they can both hold
back recovery and depress longer-term economic performance.
It is important to recognise that the global financial system has remained resilient, absorbing a
series of major shocks which have seriously undermined investor confidence: 9/11, the Argentina
crisis and default, the bursting of the equity market bubble, and a number of scandals due to
governance failures and in some cases corporate or financial crimes. In addition to the loss of
confidence resulting from the dramatic falls in equity prices, the governance failures that occurred
during the downturn have created in their wake a legacy of mistrust in the underpinnings of the
financial system.
Serious questions are being asked whether major market participants can be relied upon to act in
the interests of investors. In the corporate sector we have seen flaws in governance systems of
companies in the most advanced of our own members. In the financial sector, some of the more
serious problems that have lessened trust are:

The provision of biased investment research and advice by investment banks in order to
promote the offerings of clients who were the source of underwriting fees. In the United
States abuses have led to a “global settlement” that provides for compensation and
major structural reforms.

Rating agencies are accused of being slow to identify credit problems, often following
market developments rather than highlighting future difficulties.

Questions have been raised about whether the governance systems of institutional
investors (pension funds, insurance companies and collective investments) adequately
align the incentives of the institution with those of final beneficiaries.

Doubts have also surfaced about whether institutional investors have been effective in
using their ownership rights in companies in the interest of their beneficiaries.
Such problems have impaired confidence to a significant degree. Stock markets have been
weighed down by this atmosphere of mistrust. Weak stock prices have meant a virtual drying up
of the market for initial public offerings and are impeding funding for new innovative firms. Most
recently, equity markets have broadly firmed, suggesting that governance concerns may be
receding somewhat. Corporate results are looking better and earnings expectations are
improving.
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Some parts of the financial sector have weathered the recent storms quite well. Outside
of Japan and Germany, commercial banks have generally come through this period in relatively
good shape. Capital had been built up during the previous boom. Their good performance has
also been due to lessons learned from previous periods of difficulty. In particular, these
institutions have developed much more robust in-house risk management systems.
Recently
commercial banks and investment banks have experienced some strains, to be sure. Their
profitability cushions and surplus capital in the financial sector probably have eroded to some
extent. As problems have continued to accumulate, some institutions may have come closer to
critical thresholds, especially for institutions for which the problems have affected several sources
of earnings at the same time. Trading losses due to stock market drops, a general decline in
revenues from capital market activities, deteriorating loan portfolios and record numbers of
corporate defaults all added to pressures on profitability and capital during the past year. As a
result, fees earned through equity underwriting, mergers and acquisitions and syndicated lending
have fallen substantially, while bad debt provisions have increased.
As well, while banks in a
number of countries adjusted deposit rates more quickly than loan rates as official rates fell, there
will be fewer, opportunities to do so going forward.
The increased levels of credit risk transfer activity – particularly on the part of U.S. banks
– has resulted in a helpful diversification of risks which should, on balance, improve the stability
of the financial system. The risks in the financial system have not simply gone away, however,
but have moved elsewhere, we hope to institutions that are better able to bear them. But it is not
possible to be sure of this since there is insufficient available data on such risk transfer activities.
Sure many of these risks have been transferred to insurance and re-insurance firms as well as
other institutional investors.
In addition to possibly carrying concentrations of transferred risks, the institutional
investor sector has been directly battered by events of the past few years. The terrorist attacks of
2001 aggravated the already shaky profitability of property and casualty insurance companies.
Life insurance companies, which accept long-term commitments to policy holders, must finance
these liabilities through their own investment portfolios. In the 1990s, life insurance companies
aggressively expanded business in investment-type products, including many with guaranteed
returns, but now these companies are suffering the consequences of the bear markets. Similarly,
many defined-benefit pension plans developed serious funding gaps since they were based on
relatively optimistic assumptions concerning future returns on pension fund assets. The need of
some corporations to fill such funding gaps is aggravating their already serious problems of
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balance sheet quality. Meanwhile individuals have experienced sharp decline in the value of the
mutual fund and defined contribution pension plan holdings.
Although we see no cause for alarm at this point, it is worth highlighting some risks
that could put considerable additional stress on the financial system in the coming period:
 Further declines in equity markets cannot be ruled out. Despite the large correction
since 2000 and the beginning signs of a recovery, some analysts believe that equity
markets are still overvalued.
 A further weakening of equity markets would refocus attention on life insurance
companies with relatively high equity exposure (in particular in Europe and Japan).
Some reduction of this equity exposure has taken place by moving into bonds.
 Equity market weakness would aggravate funding gaps in corporate defined-benefit
pension plans.
 Highly indebted household and corporate sectors in several countries remain sensitive
to changes in interest rates and exchange rates. High debt burdens could become
particularly severe if deflationary pressure were to produce a rising real debt burden
accompanied by poor growth prospects.
These downside-risks are not part of our central scenario, to be sure, but they are a reason for
policy makers to remain vigilant.
The Bond Markets
The strains in the financial system have had visible repercussions in bond markets.
Sluggish real activity and declining inflation have generated downward pressures on interest
rates. In addition, central banks throughout the OECD area have been easing interest rates
during the period. In addition, the loss of confidence alluded to above, as well a deterioration in
credit quality, has generated a “flight to safety". The unloading of riskier assets by investors in
2000-2002, worked to compressed government bond yields even further while pushing yields on
risker paper higher. Bond yields on government debt are now near their lowest levels in forty
years. To take the 10 year US Treasury Bond, for example, the yield has declined almost 300
basis points since end 1999. (See Chart 1).
There are serious doubts about the future direction of interest rates. On the one hand,
concerns have been growing about the risk of deflation. If investors become convinced that the
prospects for deflation have grown, interest rates could decline further, which would lead to a
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new widening of credit spreads coupled with further rises in government bond prices. Conversely,
in the more likely case that the deflationary scenario does not materialise, government bond
prices will eventually fall from their current lofty levels. In that case ,institutional investors
presently with overweight portfolios in government bonds face the risk of substantial losses. The
drop in prices could be particularly dramatic since with weaker fiscal positions, government debt
issuance is projected to rise sharply in coming years. Indeed, a sudden snap-back in bond yields
could expose a significant amount of unhedged positions in the markets for government bonds.
There has been a great divergence between the yields on the government bonds of
OECD countries and other top rated borrowers, on the one hand, and the yields for lesser rated
borrowers, on the other. Corporate accounting scandals and large, high-profile bankruptcies
marked the second phase of the stock market downturn; and the pursuant increase in the riskaversion of investors has had a distinct impact on corporate bond markets. Reflecting the
general deterioration in credit quality, corporate bond defaults last year amounted to some 3 per
cent of bonds outstanding, well above the pervious record of the early 1990s. Through the
middle of 2002, credit-rating downgrades were at extremely high levels. The telecoms sector was
the most adversely affected, but downgrades occurred in virtually all sectors. Not surprisingly,
investor appetite for lesser rated paper dropped sharply. This can be seen in Charts 2 & 3 , which
show spreads for lesser rated investment grade bonds and for high yield (or junk) bonds,
respectively.
The widening of spreads ceased in late 2002. Investors began to purchase higher risk
paper as the record spreads began to appear attractive, even after allowing for risk. Accordingly,
spreads have come down on both sides of the Atlantic. This may partly reflect some easing of
investors’ fears following action taken by the authorities to increase corporate accountability and
strengthen accounting and audit practices. Nevertheless, high-yield spreads remain above their
five-year average. In addition, issuers have reduced the amount of new paper being placed on
the market, as declining capital spending plans reduced firms’ financing needs.
One result of investor resistance to lower rated bonds and the softening of business
investment was a sharp reduction in the volume of non-government new issues. New issues
volume for the United States is shown in Table 4 and the comparable table for the Euro area is
presented in Table 5. Weaker fiscal positions led to accelerated issuance of government debt.
But in the United States, net issues of non-financial corporate bonds declined by 60 per cent in
2002 against the previous year. In Europe too, corporate bond issuance declined - by 11 per
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cent - over the last year as compared to previous levels. Borrowing by the financial sector in the
US actually increased last year – by 17 percent; whereas in Europe the financial sector’s
borrowing declined by some 44%. Preliminary data suggest some recovery in new nongovernmental issues in early 2003.
Developments in emerging market financing
The ‘feast and famine’ pattern of emerging market financing was again in evidence last
year. To some degree, this followed the pattern of growing risk aversion after 2000. During 2002,
countries at the low end of the credit rating spectrum (especially in Latin America) were facing
difficulties in market access and high funding costs. Greater investor caution was evident, partly
reflecting the aftermath of the Argentine collapse. Spill-overs into neighbouring countries
seemingly posed risks for wider contagion throughout Latin America. Investors’ risk aversion led
to record low net private capital inflows in some regions and countries. But starting in the fourth
quarter of last year and moving into 2003, better news emerged and primary markets reopened,
especially for those with above investment grade ratings. Markets continued to differentiate
borrowers by perceived risk and spreads were much lower in other regions than in Latin America.
As a result, spreads, which had become exceedingly wide in late 2002, have been contracting.
(See Chart 6.)
Inflows into emerging market bonds have been rising in recent months. In Central and
Eastern Europe, continued large inflows of FDI and comfortable levels of forex reserves limit the
risks to external debt servicing across the region. Global credit conditions facing Latin America
have improved. Most observers expect a moderate recovery of net private capital inflows this
year after the record low of 2002. Also for the Africa/Middle East region net private flows to the
region are likely to rise in 2003. In the Asia/Pacific region net private capital flows strengthened
from around $52 billion in 2001 to almost $62 billion in 2002. Earlier in the year, it was expected
that flows for 2003 would be sustained close to the 2002 level. But now, Asia’s growth prospects
are being overshadowed by the uncertain impact of SARS.
The timing of the rebound in OECD growth will continue to influence the recovery in
emerging market regions. Concerns would likely arise if the global economy were to remain
weak or if sound policies were not followed. But recent policy developments in major emerging
markets have been, on the whole encouraging.
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Development of local securities and derivatives markets to reduce feast and famine
volatility
Many emerging markets have made it a policy priority to lessen their dependence upon
international financial markets in order to reduce vulnerabilities to losses of market access
associated with contagion from a crisis in other emerging markets and/or to volatility in capital
flows and asset prices that can be associated with developments in the mature markets. The
measures taken have differed across countries and regions. Examples include changing
management practices with respect to sovereign external assets and liabilities; adapting
exchange rate arrangements to the degree of capital account openness; strengthening domestic
financial institutions and enhancing prudential supervision and regulation in order to increase
resilience to volatility.
Typically, emphasis is given to the development of domestic securities and derivatives
markets as a means of creating a more stable source of local currency funding for both the public
and corporate sectors. In most emerging markets, the corporate sector still depends heavily upon
banks for financing. This is a potential source of financial fragility. A well-functioning corporate
bond market would permit a diversification of the sources of finance, which could be especially
useful during episodes of strong credit rationing in the banking sector or a full-fledged credit
crunch. Bond market investors may not be subject to the same sorts of restraints that might
inhibit banks from lending, such as fears of interest rate mismatches or insufficient capital. A
domestic bond market, in addition, should mitigate the funding difficulties created by “sudden
reversals” in cross-border capital flows. In addition, the development of the bond market is seen
as a vehicle for improving the efficiency and stability of financial intermediation, reducing the
currency and maturity mismatches associated with cross-border lending, and creating new
opportunities and instruments for hedging various financial and exchange rate risks. The
measures adopted to contribute to the development of domestic securities and derivatives
markets often include efforts to strengthen market infrastructure and create benchmark issues, to
expand the institutional investor sector, and to improve corporate governance and market and
corporate transparency. In all of these areas the OECD has very active work programmes.
A recent study by the IMF1 gives the following interesting picture indicating that
corporate bond market development has already become an alternative source of funding in
1
IMF
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emerging markets. In the period 1997-2001, there has been a strong increase in the issuance of
corporate bonds in emerging markets. Even more significantly, local bond markets have become
the largest single source of domestic and international funding. Although this latter finding reflects
primarily the heavy reliance of the public sector on bond issuance (by itself a favourable
development), issuance of bonds by the domestic corporate sector increased from 5% of total
corporate domestic and international funding in 1997-99 to 31% in 2000-01 (over the same
period domestic bank credit fell from 52% of total corporate funding to 40%).
In addition to contributing to financial stability, the progress in bond market development
probably has also led to a better allocation of capital. One of the main conclusions that virtually
all analysts reached after the Asian crisis was that patterns of financial intermediation in many
Asian markets tended to be characterised by opaque insider relations and that vast sums of
money changed hands without being exposed to tough market scrutiny. The bond market’s
requirement of regular disclosure to investors contributes not only to better financial
intermediation but also more responsible activity on the part of the corporate sector.
While there seems to be general agreement that an active corporate bond market can
play a valuable role, it is also clear that these markets cannot flourish unless the proper
infrastructure is in place. A well-functioning banking sector is part of the infrastructure needed for
the development of a sound bond market. As will be discussed at some length at this Forum,
governments make important contributions to the development of a proper infrastructure in their
roles as issuer and regulator. In many countries governments are usually the largest suppliers of
this kind of instrument. The existence of a benchmark yield curve for government securities
facilitates the pricing of corporate bonds. Governments also support the development of fixedincome securities markets via their role as regulators and supervisors of the market. An important
responsibility is ensuring the compliance with market rules of conduct by its participants and, as
will be discussed in session III, rules on transparency and adequate disclosure.
Thank you.
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28 1/2 0
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4 1
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1 2
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28 1/2 2
/0 00
2
31 /20 3
/0 03
30 3/2
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4/ 3
20
03
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ANNEX
Figure 1.
Long-term interest rates (10-year government bonds)
Daily data until 20 May 2003
8
7
United States
6
5
4
3
Euro area
2
Japan
1
0
Note: 10-year government benchmark bond yields.
Source: Thomson Financial Datastream.
3/
20
15
01
/0
4/
2
0
15
/0 01
5/
20
15
01
/0
6/
2
0
15
/0 01
7/
20
15
01
/0
8/
20
15
01
/0
9/
2
0
15
/1 01
0/
20
15
01
/1
1/
2
0
15
/1 01
2/
20
15
01
/0
1/
20
15
02
/0
2/
2
15
0
/0 02
3/
20
15
02
/0
4/
2
0
15
/0 02
5/
20
15
02
/0
6/
2
0
15
/0 02
7/
20
15
02
/0
8/
20
15
02
/0
9/
15 200
2
/1
0/
20
15
02
/1
1/
15 200
2
/1
2/
20
15
02
/0
1/
20
15
03
/0
2/
15 200
/0
3
3/
20
15
03
/0
4/
15 200
3
/0
5/
20
03
15
/0
basis points
11
Figure 2.
300
Corporate spreads
Daily data until 20 May 2003
400
350
United States
250
200
150
100
Euro area
50
0
Note: Aggregate corporate BAA bond yields (Lehman indices) minus 10-year government benchmark bond yields.
Source: Thomson Financial Datastream.
Note: Aggregate corporate high-yield bond yields minus aggregate corporate BAA bond yields (Lehman indices).
Source: Thomson Financial Datastream.
15/05/2003
15/04/2003
15/03/2003
15/02/2003
15/01/2003
15/12/2002
15/11/2002
15/10/2002
15/09/2002
15/08/2002
15/07/2002
15/06/2002
15/05/2002
15/04/2002
15/03/2002
Figure 3.
15/02/2002
15/01/2002
15/12/2001
15/11/2001
15/10/2001
15/09/2001
15/08/2001
15/07/2001
15/06/2001
15/05/2001
15/04/2001
15/03/2001
basis points
12
High-yield spreads
Daily data until 20 May 2003
1600
1400
Euro area
1200
1000
800
United States
600
400
200
0
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Figure 4.
Net issuance of US bonds
Billions of US dollars
Government
Financial sectors
Non-financial corp.business
900
800
billions of US dollars
700
600
500
400
300
200
100
0
1999
2000
2001
Note: Government includes Treasury, municipal and agency securities.
Source: US Federal Reserve Board, Flow of Funds Accounts of the United States.
2002
14
Figure 5.
Euro-denominated bond markets: volumes issued by type of issuer
Billions of euros
Government
Financial sectors
Non-financial corp.business
900
800
billions of euros
700
600
500
400
300
200
100
0
1999
2000
2001
2002
Notes: Figures comprise all euro denominated issues of an amount of EUR 50 million or more, and include all issues of
a maturity of one year or more (incl. in particular Italian and French discounted paper of a usually significant issue
amount). Dates of new issues are based on payment dates (as opposed to announcement dates). “Government”
comprises bonds of agencies, central governments, municipals, regions, cities, and supra-nationals. “Financial”
comprises asset-backed securities, financials’ bonds, and Pfandbriefe. The latter includes Pfandbrief-style paper
issued in EU-countries, like for instance French Obligations foncières, Spanish Cedulas hipotecarias, etc.
Source: European Commission (DG ECFIN).
15
Figure 6.
Emerging market spreads
Daily data until 20 May 2003
Emerging markets (total)
Americas
Asia
Middle East
1300
1200
1100
1000
basis points
900
800
700
600
500
400
Note: Lehman indices, redemption yields minus 5-year US government bond index yield.
Source: Thomson Financial Datastream.
01/05/03
01/04/03
01/03/03
01/02/03
01/01/03
01/12/02
01/11/02
01/10/02
01/09/02
01/08/02
01/07/02
01/06/02
01/05/02
01/04/02
01/03/02
01/02/02
01/01/02
01/12/01
01/11/01
01/10/01
01/09/01
01/08/01
01/07/01
01/06/01
300