The year of booming bonds

The hunt for high yields has been one of the striking features of the bond market. In some developed countries, investors this year have poured cash into the high-yielding part of the municipal bond market. Even in the US, states, local governments and other public entities can borrow money from the market. Moreover, the US government does not tax interest income on municipal bonds, attracting more investment to such public projects and helping investors accomplish their income targets.

Although it is a long way from getting back to the pre-crisis boom, we can still see a good pickup sign in mortgage-backed securities investment in the US and Europe. Consequently, many banks can now catch their breath to fund their mortgage lending through the securitization market, which had virtually halted since 2008.

It is a positive sign that covered bonds, which typically carry lower interest rates than senior unsecured debt because they are backed by ring fenced assets as collateral, are expanding in some countries. This opens a new way for banks to obtain long-term, fixed-rate funding, and makes it easier for lenders to offer stable products to customers.

After years of improvement, emerging market bonds are shedding their reputation for poor creditworthiness. In contrast to many debt-ridden Western countries, investors have been increasingly attracted by the better fiscal, demographic and economic fundamentals of emerging economies, and poured money into their bonds, in particular, those denominated in international currencies.

For Asia, this has also been a peak year of bonds issuance. International currency bond issuance almost doubled from last year, and local currency bond issuance grew by 40 percent.

Nevertheless, investors holding bonds could see their income being eroded by inflation. The yield on 10-year US Treasury bonds is below the rate of inflation, and in Germany and the UK there is negative real yield as well. The average yield on investment grade US corporate debt fell from 5.9 percent in 2007 to 2.67 percent in November 2012.

Another risk for bond investors is that the value of their holdings might fall sharply when interest rates start to rise.

Credit risk cannot be ruled out, either. There is a debate over whether the recession in Western countries could bring about a big jump in defaults for municipal bonds. City bankruptcies in California this year have fanned such fears. After all, investment in high-yielding sectors has always been prone to higher risks.

In China, the rapid evolution of financing channels is playing an important role in supporting the nascent economic rebound. Traditionally, bank lending has dominated the financial market. But with a booming corporate bond market and other forms of financing, the share of bank credit in total financing fell to 55.5 percent in October.

Some economists say the notable increase in non-bank lending this year appears to be in line with the new investments on infrastructure, railways, environmental protection and clean energy.

Issuance of urban investment bonds by local government financing vehicles in China has surged with an estimated value of 500 billion yuan ($79.93 billion) in the full year, providing those vehicles with the financial capabilities to avoid immediate defaults.

It is a good record for China's bond market never to have defaulted. But it is, to some extent, actually a sign of immaturity. In fact, this phenomenon does not reflect true market conditions.

Given the growing diversification in China's financial structure, more attention must be paid to the total financing amount, which includes all the funds raised by enterprises and individuals in the real economy. That can help better monitor liquidity conditions and adjust policies accordingly.

Looking ahead, there is huge potential in the bond markets of the developing world, particularly China, and this will be a new powerful engine driving economic and financial reforms and development.

(China Daily 12/17/2012 page8)