Topic 2Bond market developments Overview Financial markets have been subject to significant changes in recent years due to the credit crisis. Experts believed that risk was being under-priced, which was expressed in the markets by a narrow spread. They believed that once the market corrected this under-pricing and re-priced the risk, it would likely cause a dislocation in financial markets by overshooting its equilibrium. Hence the prices, yields and returns on bonds have been significantly effected by the global financial crisis.
Looking at the effects this credit crisis had on the short term money market by evaluating bond performance over the past 10 years can give us significant insight into the extent of this dislocation. – Describe the trends in the issue of government bonds in the past 10 years Although the credit crisis has had a significant effect on the money market, Government bonds have remained quite stable for the past ten years. This is because government have decided to maintain the issue of CGS constant at 50 billion to keep the market liquid and also announced an increase issuance of up to 25 billion in May 2008.
However the spreads have widened and the maturity dates have narrowed on all bonds over recent years. The trend however is relatively stable in the grand scheme. – semi govt bonds in the past 10 years. The trend in semi-government bonds has been similar to that of government bonds. They have been relatively stable and have also been running budget surpluses. However they have recently raised their issuance by 12% due to their need to raise funds for infrastructure projects. – main issuers of non government bonds in the past 10 years.
Non government bonds have grown to three times that of public sector debt from 20 billion in 1996 trending upwards to 200 billion in June 2006. This was throughout all four sectors of non government bond issuers (Financial institutions, non resident bonds, corporate bonds and securitization vehicles) a) Financial institutions: Made up of banks mainly and had a fairly steady growth over the past 5 years. The spreads are much wider than they used to be prior to 2007 as 3 year bonds issued this year have an average of 47 basis points above the banks swap rate as compared to 10 b. . prior to the credit crisis. We have also seen a decrease in average maturity by two years. b) Non – resident bonds: Represented by Kangaroo bonds, showed an increase from having a market share of less than 5% to over 20% from the 1990s to present respectively, averaging about 45% in the past five years. The increase was not steady however as they had a significant decrease in the second half of 2007, with and issuance of 1. 5 billion per quarter compared to 8 billion per quarter in months preceding the credit crisis. c) Corporate:
Are business issued bonds and have been minimal since the credit crisis, trending downwards. d) Securitization Vehicles: Spreads for SPVs have increased sharply, meaning that bond issuance dropped significantly. This is evident as they fell from 48 billion to 8 billion from the first to second half of 2007 respectively. The average deal size has dropped significantly as well, from around 370 Million during September 2007 where as it stood at 1. 6 billion before august of the same year. Explain the growth in the amount of bonds issued by securitization vehicles
There has been an overall decrease in the issuance of bonds issued by securitization vehicles. This is because spreads for MBS’s are currently too high above the bank swap rate. Prior to August 2007, the MBS had a spread only 18 BP above the banks swap rate, thus they could remain competitive. Now that the rate is around 60 BP above the swap rate, it has become un-economical for SPV’s to issue MBS’s. This is the reason that there was a 40 Billion decrease in MBS’s from the first to the second half of 2007. – the amount of bonds issued by non residents
Bonds issued in Australia to Australians from overseas institutions are known as Kangaroo bonds. Although Kangaroo bonds had a significant decline in the second half of 2007, they managed to bounce back. This is due to overseas investors wanting to take advantage of the arbitrage that can be gained from raising funds in Australia and converting them to US dollars when they need to instead of raising funds straight in their own currency. This allows them to take advantage of slightly lower funding costs, meaning the investor demand for kangaroo bonds would increase significantly.
This is the reason for recent upturn in the kangaroo bond market. – the amount of bonds issued by financial institutions Financial institutions have had a steady issuance growth and were not significantly impacted by the credit crisis as they have such sound balance sheets. This makes investing with them fairly “risk free” thus investors are confident enough to purchase their bonds. They still however had to widen their credit spreads and shorten their average maturity, both to survive in the current climate and to accommodate investor preference of not wanting to lock into any long term investment right now.
Banks also are able to keep their bond issuance constant as they use is as a precautionary measure to raise enough funds to meet their obligations incase of further market dislocation. – Explain the impact of the global financial crisis on the issue of bonds by securitization vehicles. Bonds issued by securitization vehicles or SPV’s have experienced a significant decline in the past year. SPV’s issue a special type of bond called mortgage backed securities (MBS’s) to investors, allowing them to receive regular payments from the loan repayments made by households.
Recently, spreads on MBS’s have become too high over that of the bank swap rate. It used to be at around 18 BP above the swap rate prior to the credit crisis, which allowed for SPV’s to offer competitive spreads and meet their financial obligations and still remain profitable. Now that spreads are around 60 BP above the swap rate, it makes it very hard to profit from MBS’s. This coupled with investors selling their MBS’s in order to reduce some of their leverage has caused demand for MBS’s to drop significantly along with investor confidence.
Thus the credit crisis in 2007 has had a very detrimental effect on securitization vehicles as it has caused MBS’s to no longer be profitable or viable in the current financial climate. REFERENCES Hunt & Terry, 5th edition, section 8. 2 RBA, (2008), “Recent developments in the Australian bond market”, Bulletin, March, pp. 10-15 RBA (2008), “Recent Debt Market Developments”, Bulletin, August 2008, pp. 71-top of page 77 RBA (2008), Financial Stability Review, September, pp. 30-1