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Analysis of the operations of the bond market

 

Analysis of the operations of the bond market

 

 

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Analysis of operations of the bond market

Portfolio diversification presents investors with one of the most effective ways of maximising return on investment, in addition to reducing the risk to investment (Pillar & Helena, 2016).  Wang and Bilson (2016) opine that in order to effectively undertake diversification, it is imperative that investors consider investing in alternative investment vehicles. Investing in the bonds market is one of the most effective approaches that investors use to diversify their portfolio. Bo and Victoria (2015) describe the bonds market as a financial market in which investors are provided an opportunity to trade and issue debt securities. The bond market is primarily comprised of corporate and government-issued securities that enable governments or corporate organisations to access long term funding for different projects (Bae, Jun-Koo & Wang, 2015).

The efficacy of the bond market is due to the fact that it is characterised by a relatively low degree of unprecedented volatility compared to investment in other securities. Jasiene, Paskeviciuos and Austraauskaite (2013) report that ‘the bonds market is one of the most attractive risk free or least risky investments during economic shocks’ (p. 223). Choudhry and Feasey (2011) describe a bond as comprising of a debt instrument that provides investors fixed interest over a predetermined period. Thus bonds, present investors with predetermined cash flows. This element increases a bond’s attractiveness to investors. Bonds present investors with the probability of making high gains. Thus, high net-worth investors prefer to different types of bonds in order to maximise return on investment (Dubil, 2016).

 Investing in the bond market can thus significantly caution investors against the volatility associated with the financial securities market. For example, bonds caution investors against the risk of financial contagion. Pillar and Helena (2016) are of the view that the bond market is characterised by a relatively low degree of financial contagion compared to the stock market.  The size of bonds also market differs significantly across countries. For example, the corporate bonds market in the United States is valued at $7.5 trillion, which makes it the largest assets market in the country. This paper seeks to evaluate the operations of the bonds market. The analysis largely focuses on the bond market in the Caribbean region.

Analysis

            Investors in the bonds market are presented with an opportunity to invest in different categories of bonds that include the corporate bonds, asset-backed bonds, government, municipal, agency, mortgage-backed bonds, and collateralised debt obligations (Bittlingmayer & Shane 2014). Corporate bonds are issued by corporate with the purpose of sourcing finance to cater for ongoing business operations or expansion (Thomas, Li & Yang, 2015). On the other hand, government bonds are issued by governments in an effort to source funds to finance major projects. Shanaka (2013) opines that government bonds are largely attractive to conservative investors. This arises from the fact that they are characterised by predetermined periodic interest payments and maturity date.

Size of the bond market

The bonds market in the Caribbean is relatively small compared to other investments such as the stock market. For example, a survey conducted in 2005 shows that the bond market in Trinidad and Tobago accounted for 17% of the country’s Gross Domestic Product while that of Barbados accounted to 1.1% of the country’s GDP (Limited, 2006). The table below illustrates the relative size of bonds market in the Caribbean region.

Country

Size [Relative to GDP]

Barbados

1.10%

Jamaica

3.90%

Eastern Caribbean

0.20%

Trinidad & Tobago

4.80%

 

Source: (Limited, 2006)

Despite the existence of different categories of bonds, government bonds dominate the Caribbean market (Dookeran, 2016). The dominance of the government bonds in this region is as a result of the government’s over-reliance on bonds to finance development and infrastructure projects. Subsequently, most businesses do not use the bond market to finance their activities but tend to rely on internal equity and bank credit (Bauer, Cashin & Panth, 2008). The relatively small size of the bonds market in the Carribean indicates that there is a high probability of the market experiencing remarkable growth in the future.  For example, corporate institutions should consider investing in the region’s bond market by developing different types of bonds. Through this move, the bonds market will considerably contribute to improvement in the effectiveness with which the market provides investors an opportunity to develop a diversified investment portfolio. In addition to the above aspects, the bond market in the Caribbean is characterised by a high degree of volatility.

Analysis of the operation of the bond market

Market efficiency is one of the most important elements in promoting trade in securities. In spite of the importance of bond market to governments and corporate organisations, most investors prefer investing in stocks (Thompson, Williams & Findlay, 2003). One of the most essential elements in the success of the bond market is the presence of a well established clearing and settlement infrastructure (Sophasteinphong, Mu & Carlotta, 2008). The infrastructure should further comprise of the systems and procedures used in facilitating trade (Dowers, Masci & Desarroollo, 2003). Therefore, the requisite institutional infrastructures should be established (Parrenas, Waller & Sinsiri, 2005).  

            Amongst the notable infrastructures in promoting operations in the bond market entails establishing secondary market intermediaries (United Nations, 2003). The secondary market intermediaries play an vital role in enhancing the degree of liquidity in the bonds market. Therefore, different participants must be involved in the operations of the bond market (Dowers, Masci & Desarroollo, 2003). Well established secondary market intermediaries enable investors to easily liquidate their investment hence contributing to improvement in the degree of market efficiency. Secondary market intermediaries further contribute to reduction in the cost of trading in bonds (World Bank, 2011).  Banks constitute one of the most important secondary market intermediaries that facilitate operations in the bond market (Bertocchi, 2014).

            Besides a well established infrastructure, a well functioning bond market requires integration of an effective legal and regulatory framework (Dierks, 2001). The regulatory and legal framework should focus on monitoring and controlling the behaviour of market participants and to ensure that the relevant regulatory approaches or standards are entrenched (Fay & Morrison, 2007). One of the bodies that regulate the bond markets in the Caribbean region includes the Eastern Caribbean Securities Regulatory Commission (ECSRC). The Commission is charged with the responsibility of formulating and enforcing legislations that govern trade in securities in the Eastern Caribbean Currency Union. The regulatory and legal framework should further constitute a well established authority that governs operations in the bond market such as ensuring effective settlement of payment (Caprio, 2012). According to Fay and Morrison (2007), ‘deficiencies in the legal and regulatory framework for sub national bond issues, such as application of different regulatory and tax treatment of sub national bank lending relative to bond issue may distort operations in the bond market’ (p. 80). This aspect may lead to establishment of an uneven bond market, which might lead to reduction in the efficiency of the bond market.

Conversely, incorporating an effective legal and regulatory environment plays an essential role in improving the robustness of the bond market and hence its attractiveness to domestic and foreign investors (Fay & Morrison, 2007). One of the most effective ways through which performance of the bonds market can be achieved entails deregulating the market (Sophasteinphong, Mu & Carlotta, 2008). This move will play an essential role in improving investment by both local and foreign investors.  

Over the counter trading and liquidity levels in the bond market

According to Schipke, Aliona and Thacker (2013), the bond market in the Caribbean is not adequately developed which limits operations in the bond market. Subsequently, the volume of trading on fixed-income securities such as government securities is considerably low (International Monetary Fund, 2015). The bonds market in the Caribbean region has been characterised by varying performance over the past decade. Between 2000 and 2009, the bond’s market capitalisation was the lowest, due to reduction in the volume of new bond issues. Thus, the market’s growth was significantly low during this period.  The bond market is further characterised by low liquidity levels (Hall & Chung-A-Sang, 2007).

  This aspect is evidenced by the fact that the region does not have a well-developed secondary market. Thus, trading in fixed income securities such as bonds in most of the Caribbean countries such as Barbados and Trinidad & Tobago occurs over-the-counter (Masci & Rowland, 2004). According to Curley and Walker (2005), over-the-counter system of trading significantly reduces the volume of financial securities traded within a specific period.  Additionally, the volume of bonds traded under the OTC system is significantly reduced due to lack of investor confidence and trust. Investors also spend a substantial amount of cost searching for trading partners. According to Kolb and Overdahl (2003), the level of trust amongst investors is a critical determinant of investor confidence in purchasing securities. Thus, the OTC system creates liquidity challenges in the bond market. 

The prevalence of the OTC system in the Caribbean bond market signifies that the market is characterised by a high degree of inefficiencies. According to Torre and Schmukler (2007), operations in the bond market should be efficient in order to enhance the attractiveness of the market to investors. The efficiency of the bond market can be enhanced by providing investors with alternative mechanisms to undertake trading in bonds. For example, bonds market should be characterised by trading in the stock market and interbank market as opposed to over-reliance on over-the-counter trading. Kleinbrod (2006) accentuates that reliance on over-the-counter trading creates inefficiencies in the secondary market because ‘ investors face restrictions on where they can trade and bond issuers are subject to regulations on where they may position their bonds for primary issuance and secondary trading and to what amount’ (p.171).

Lack of extensive and well established exchange markets in the Caribbean has further limited contract standardisation, which is a fundamental element in the operations of the bond market. The main exchange markets in the region include the Trinidad & Tobago Stock Exchange, Jamaica Stock Exchange and Barbados Stock Exchange (Witter, 2010).  These stock exchange markets are relatively small. In 2010 only 58 securities were listed in the Jamaica Stock Exchange market. Additionally, trading in bonds in these stock markets is significantly low. For example, the government of Jamaica delisted trading of government bonds from the country’s stock exchange market and listed them in an electronic platform (Witter, 2010).  Kolb and Overdahl (2003) emphasise that ‘contract standardisation is essential in lowering the cost of a trading in securities in addition to promoting market liquidity’ (p. 18). The bonds market in the Caribbean region has only one formal regional securities’ exchange market commonly referred to ‘the Eastern Caribbean Securities Exchange (ECSE) (Witter, 2010).  This indicates that operations in the bond market in the Caribbean region is characterised by significant structural barriers.

Liquidity in the bond market

Goswami and Sharma (2011) are of the opinion that ‘secondary market liquidity for an instrument can be facilitated if issuance if sizeable and regular, the trading life of the instrument is sufficiently long and turnover is large’ (p. 12).  Kleinbrod (2006) cites lack of liquidity as one of the major factors that limit the growth of the bonds market and hence the yield curve. Liquidity in the bonds market plays a fundamental role in ensuring that the market is stable. Developing liquidity in the bonds market can arise from different sources amongst them improving the attractiveness of the bond market to dealers, borrowers, domestic and foreign investors (Goswami & Sharma 2011). Enhancing the attractiveness of a bonds market contributes to improvement in the size of its investor base. Therefore, lack of adequate players in the Caribbean bond market has significantly increased the volatility of the bond market, which in extreme situations can lead to financial instability. 

In an effort to deal with this problem, respective governments in the Caribbean region are undertaking extensive efforts to address the liquidity problem.  One of the notable efforts relate to the governments’ commitment to increase the volume of foreign investors in the region’s bond markets. For example, the government of Trinidad and Tobago issued a 10-year bond that specifically targeted foreign investors from the United States. The bond’s interest rate was set at 4.625% but was later adjusted to 4.5% because of the high demand. The bond’s issuance generated $ 1 billion (Oxford Business Group, 2016).  Through this effort, the Trinidad and Tobago government will significantly improve the liquidity problem that characterises the country’s bond market.  

Impact of the country’s economic performance on the bond market

Despite the efforts being undertaken by Caribbean governments to promote growth in the bonds market, the government might not achieve the intended goal due to the countries’ poor economic performance. For example, in 2014, Moody’s, a renowned financial services agency, downgraded Barbados government bond rating from Ba3 to B3 due to the countries negative economic performance. The country’s government bond rating was further downgraded to Caa1in 2016 (Global Credit Research, 2014; Global Credit Research, 2016). The decline in the country’s government bond rating might negatively impact the attractiveness of the bond to investors. The ultimate effect is that the country might not succeed in attracting foreign and domestic investors to purchase the bond.  According to Moody’s Barbados high fiscal deficit, which was estimated to exceed 11% of the country’s Gross Domestic Product in 2013/2014 adversely affected the countries attractiveness to domestic and foreign investors. In spite of the efforts to reduce the country’s fiscal deficit, the country is characterised by high and rigid government expenditures (Global Credit Research, 2014). For example, public sector wage level is substantially high, which means that most of the government enterprises incur significantly high losses.

In addition to widening fiscal inflexibility, operations in the Caribbean bond market, for example with reference to government bond is affected by the prevalence of huge government debt. According to a survey conducted by the Moody’s Investor Service, the ratio of government debt to GDP in Barbados increased substantially from 85% in 2012 to 97% in 2014, which represents a 12% increase. As a result of the Barbados government incurs a significant proportion of interest expense (Global Credit Research, 2014). The prevalence of these conditions has a negative impact on the attractiveness of investors to the countries’ bond market.    In order to promote the growth of the bonds, market, it is imperative for the governments in the Caribbean region to consider enhancing their country’s economic growth. This move will play a fundamental role in improving the attractiveness of the region to local and foreign investors.  

Conclusion

            The bond market constitutes one of the fundamental components of the securities market. The market provides investors opportunity to invest diversify their investment portfolio hence limiting investment risks. However, the capacity of investors to diversify their investment in the bond market is influenced by different factors. First, the bond market must be characterised by well established legal and regulatory framework. The rationale of the framework is to ensure that positive investment behaviours by the issues and traders in bonds are adhered to.  A well established infrastructure is also critical in development of a bonds market.  Amongst the notable infrastructures include the presence of secondary and primary infrastructures.  Examples of secondary infrastructures in the bond market include banks and stock exchange markets. These institutions play an essential role in limiting the cost of trading in bonds. 

The bonds market in the Caribbean is relatively small compared to the well established markets such as the United States. An evaluation on the operations of the bond market in the Caribbean region shows that the market is characterised by significant structural gaps that limit the efficiency in the bond market. First, the region does not have a well established primary and secondary intermediaries system such as the stock exchange market. Subsequently, trading in bonds largely occurs through over-the-counter system. Despite the establishment of different stock exchange markets in the region, the markets have not fully supported trading in bonds.  The regulatory and legal framework in the Caribbean region does not also adequately support operations in the bonds market.

The analysis further reveals that the operations in the bond market are significantly affected by lack of adequate liquidity, which arises from the limited trading in bonds.  One of the factors that have contributed to decline in the level of liquidity in the bonds market entails overreliance on over-the-counter trading. Lack of liquidity in the bonds market significantly reduces the attractiveness of the market to local and foreign investors.   Therefore, to stimulate the growth of the region’s bond, market, it is imperative for governments in the Caribbean regions to focus on eliminating the structural barrier that hinder operations in the bond market.

 

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