of Corporate Bonds* Ray H. Lim Vol. 20, No. 28 (16 July 2011) Abstract

Transcription

1 w Vol. 20, No. 28 (16 July 2011) Liquidity Premium & Liquidity of Corporate Bonds* Ray H. Lim Abstract Corporate bond spreads are determined by credit and interest rate risks. But because Korea's corporate bond market is illiquid, premiums on those having high liquidity risk are often more than 100bp. Consequently, greater investment in the corporate bond market must be encouraged by improving its liquidity, which will go towards lowering corporate funding rates. While it is equally desirable and important to increase investment demand by bringing internal investment procedures for pension funds up to speed with current development and introducing a credit rating system for funds, a multi-pronged policy could contribute to normalizing the corporate bond market by strengthening the governing regulations of securities firms that intermediate the bonds. * Opinions expressed are those of the author and do not necessarily reflect the official positions of the Korea Institute of Finance.

2 The asset's profitability is determined by adding a premium taking into account the risks of that asset against another that is regarded risk-free, such as a government bond. As a result, what the market sees as important risk has a significant impact in the pricing an asset. One illustration is the impact that a volcano would have on Korea's financial markets and assets although the chances of an eruption may be the same in Korea or, say, Iceland. What kind of risk the market sees as being important has a significant impact in determining the price of an asset. Corporate Bond Spread Determinant: Credit & Interest Rate Risk The risks that investors are mindful of when it comes to corporate bonds is largely credit risk where the principal is not repaid, and interest rate risk where the bond price changes in interest rates. It was through these credit and interest rate risks that many studies attempted to explain the difference in (credit) spread between the profitabilities of corporate and government bonds. There are many instances, however, where the credit spread is very wide between two corporate bonds having identical credit ratings, and no difference in interest rate risk because they have the same duration and convexity. 1) This suggests there is a limit in attempting to explain the credit spread of corporate bonds exclusively through credit and interest rate risks, known as the 'credit spread puzzle'. The studies conducted through the credit spread puzzle in the 2000's tried to find the cause for the difference in government and corporate bonds, including their tax treatment, corporate characteristics, and liquidity premiums. 1) Duration and convexity shows first and second changes in the bond price that follows each change in interest rate. Vol. 20, No. 28 1

3 Liquidity Risk & Liquidity Premium Unlike stocks and futures, corporate bonds are difficult to standardize due to their own peculiar terms and conditions, including issuer, date of issue, face value, coupon and repayment schedule, and covenant. Whereas trade in Corporate bond spreads are by and large determined by credit and interest rate risks, but liquidity risk is also important in the Korean corporate bond market. government bonds are active, because they can be classified according to their issue and maturity dates, the distinctiveness of each corporate bond does not easily facilitate trade on either the listed exchanges or in the OTC market. A cursory glance might show that Korea's secondary bond market to have developed in the 2000's without any covenants, but in contrast to the growth in the government bond market, the trade volume in the secondary corporate bond market was KRW162.0 trillion in 2000, little changed from the KRW130.0 trillion in The turnover rate was much the same with 86% in 2006 and Likewise, the liquidity in Korea's corporate bond market today is extremely limited compared to the liquidity in other domestic financial markets. An asset's liquidity points to the degree with which a desired volume could be transacted at a desired price, namely a low bid-ask spread. If the liquidity of an asset is limited, an investor runs a greater risk of not being able to execute a buy or sell order as he sees fit. This sort of risk is commonly referred to as liquidity risk while the additional compensation required for the added risk of holding such an asset is referred to as the liquidity premium. 2 Weekly Financial Review

4 The Impact of Liquidity Premium on Corporate Bond Spreads If the above is indeed the case, what is the impact of the liquidity premium on the corporate bond spread in Korea's corporate bond market? Related data was gathered on corporate bonds outstanding between March 2009 and September The bonds analyzed were speculative-grade, ABS, and plain vanillas, but excluded CB, BW, and other equity-linked issues. The point was to find if liquidity risk could explain parts where credit and interest rate risks could not, and the analysis was done by controlling long-term interest rates and duration for interest rate risk and the credit ratings and the spreads all along the corporate bond yield curve for credit risk. Even after the credit and interest rate risks are controlled between bonds with high and low liquidity risk, the difference in the rate of return was found to be as much as 100bp. The results found that the liquidity risk of bonds regarded as having significant liquidity risk, such as those with low trade volume and outstanding issues or those bonds closer to maturity than those not 2), were on average higher by 100bps or more. Corporate bonds with high profitability meant in effect that issuing corporations had to forego larger costs when raising funds. Despite the prevailing low interest rate environment, many corporations in Korea are finding it hard to raise funds as a result of high bond rates. But results from such empirical analysis above show that high funding costs cannot be laid solely at the feet of high credit risk. Rather, it is that corporations are having to absorb the costs associated with higher rates in raising funds rather than those appropriately based on their credit risk, because of the liquidity risk in the corporate bond market. 2) According to the literature on the subject, if the face value of the issue is small the percentage of the assets moved to the portfolio that hold assets till maturity is high while the liquidity risk is high if the trade volume is low since the cost of information is high. The pre-existing literature also reveals that besides the frequent number of cases of profiteering through arbitrage immediately after issuance and other trades with similar objectives, the liquidity risk lower the more recent the issuance date of the bond. Vol. 20, No. 28 3

5 Improving the Liquidity in the Corporate Bond Market Investment in the corporate bond market can be increased if its liquidity improved since this would lower the issuer funding costs. In this case, an investor would earn lower profits than before, but because liquidity risk itself has fallen the investor would not have absorbed any losses in terms of risk against return. Because inactivity in Korea's secondary corporate bond market is ingrained and structural, countermeasures must be multi-pronged, making approaches from the investor buy-side, issuer sell-sell side, and from the view of securities firms. If the overly restrictive limitations on the internal investment rules of pension funds can be brought up to speed on current realities, investment in corporate bonds can stimulated while improving funds' the risk -adjusted rate of return. From the investor buy-side view, the investment procedures of pension funds should be brought up to speed with current and prevailing conditions, and a review conducted on ways to add tailwind to corporate bond funds and hedge funds. Not only is the required investment amount large for corporate bond investing, but because credit and interest rate risk management functions are also important, portfolios need to be large and as a result, the market cannot but be centered on institutional investors. With regulations having been strengthened noticeably since the global financial crisis, pension funds have not been actively investing in high credit risk corporate bonds. But because total funds under management at pension funds, such as the National Pension Fund, is expected to continue growing until the mid-2020's, it would be favorable to lower its long-term credit risk and improve its expected rate of return for increased corporate bond investment. Whereas bond funds have grown largely through government and monetary stabilization bonds, the launch and sale of funds that include corporate bonds in their portfolios have been less stellar as a result of rules that prohibit 4 Weekly Financial Review

6 funds from investing in speculative corporate bonds rated lower than BBB. Under the current system of regulating bonds based on credit ratings, it is difficult to construct the so-called credit barbell portfolio, which helps manage credit risk and improve earnings, where bonds with high and low ratings are co-managed. It may be worth the effort to review the possibility of introducing a fund credit evaluation system that assesses the credit risk of a bond fund's portfolio rather than regulating the individual credit rating of a bond that is incorporated into a fund. Furthermore, the introduction and development of hedge funds are raising expectations that it would add tailwind to the corporate bond market. Since the biggest current corporate bond investors such as pension funds, insurers, and funds realize earnings by holding till maturity, the launch of hedge funds and other investors that seek profits on near term basis trading are needed. From the issuer sell-side view, there is the need to increase the proportion of equity-linked issues, such as CB and BW aside from increasing demand for corporate bonds, by adopting longer-term plans for both plant and equipment, but also in funding structures. A particular characteristic of bond investing is that there is no upside potential like there is in equity investing while it has all of the exposures to downside risk. For these reasons, investment in corporate bonds cannot grow more active if there are many conflicts of interest through governance that is not transparent between creditors and management- shareholders. In addition to improving corporate governance, increased issuance of equity-linked corporate bonds would do much to encourage investment demand while increasing corporate value. In addition to this, it is imperative to raise the capacity of credit rating agencies in conducting evaluations. The slowdown in the market for bonds below BBB+ is taken to be largely driven by a lack of confidence in credit Vol. 20, No. 28 5

7 ratings of the agencies, but the situation is one where it would be difficult to expect the agencies to make improvements on their own. It appears that the only way to solve this problem would be for the pension funds, funds, and insurers to lower their dependency on the agencies' credit ratings and raise their own capacities in credit evaluation fundamentals and credit evaluation strategies. Market research, due diligence, and private lending should be made part of securities firms' duties and rules on verbal agreements strengthened to normalize the primary corporate bond market. Lastly, it is essential to raise the capacity of securities firms that purchase the corporate bonds to facilitate links between the issuing company and the investor. While adding book building and corporate due diligence as parts performed by securities firms that buy corporate bonds, there is the need to demand the role of private lenders as they relate to covenant planning and regulations to be strengthened. What is more, any verbal agreement reached between a securities firm and an investor before the securities report comes into effect should be regulated. It would also be important to eliminate the practice of 'erasing fees' by preventing securities firms from selling within a given period at a price lower than the purchase price. Strengthened market regulations such as these would to build risk-intolerant securities firms in the market while adding tailwind to the corporate bond market by making competitive securities firms even more so. 6 Weekly Financial Review

8 Focus & Brief July 25 - July 29 Policy Issue in Focus: Employee Retirement Benefit Security Act Amendment & the Retirement Pension Market News Briefs: -FSC Proposes Bill to Amend FSCMA -Q GDP Growth Rate Lowest in 7 Quarters -Enforcement Decree & Regulatory Amendment Bill Proposed for Savings Bank -Direct Financing Rises Sharply H Market Indicators: July Policy Issue in Focus: Employee Retirement Benefit Security Act Amendment & the Retirement Pension Market (Byung-Duck Kim, Senior Research Fellow) Overview: A strong tailwind is expected in Korea's IRA market through sole proprietor subscriptions after the Employee Retirement Benefit Security Act amendment bill was ratified by the National Assembly. With financial institutions likely to employ customer-specific and customer-targeted strategies for a larger share in the IRA market, rapid growth is particularly expected from insurers now that organized teams of insurance planners can be tapped for marketing operations. For the IRA market to make develop efficiently, it will be necessary to review the possibility of introducing a multiple employer system, unifying the IT systems used by administrative operators and asset managers while also exploring ways to ease subscription fees. Vol. 20, No. 28 7

9 Current Status: Upon National Assembly ratification of the Employee Retirement Benefit Security Act (ERBSA) amendment bill on June 30, it is expected that the new legislation, which is focused on bringing about a veritable retirement pension system, will come into effect after a transition period from the second-half of The amended ERBSA provides for stronger financial soundness through a bona fide system and verifiable minimum funded ratio requirement, and includes the introduction of a multiple employer system, allowing for multiple subscriptions to retirement pension plans, strengthened conditions for early-redemption of severance payments, forced transition to individual retirement accounts (IRA) upon payout from accumulated funds, allowing subscriptions by sole proprietors, and automatic adoption of retirement pensions at newly-established businesses. The amendment has made available more options to employees and employers alike, and the IRA market is expected to see a growth spurt as a result of the broadened base of potential subscribers. Compared to other countries Korea has a larger percentage of sole proprietors, and their eligibility for IRA subscription promises to expand the retirement pension market alongside provisions allowing additional IRA subscriptions by those already employed and the mandatory transition to IRA of early retirees with previous contributions. With KRW32.95 trillion in contributions as of the end of April 2011, the proportion of IRA within the total retirement pension market was 10.34% or KRW3.41 trillion, much lower in market share than defined contributions and defined benefits. But this is expected to change markedly in the future to possibly even reverse the trend in terms of market share. 8 Weekly Financial Review

10 With expected growth in IRA and the chances of increased competition between financial institutions to approach the market through costumer-focused strategies, financial institutions should possess the capacity to strategically allocate assets according to the subscriber preferences. In this respect, financial institutions are likely to move forward with customer-focused strategies since the subscriber base for the IRA market is categorically comprised of sole proprietors, irregular workers among other temporary and specialized staff, those having terminated pension plans and transfer workers, and regular employees making additional subscriptions. Insurers have an advantage in private sales, and they are expected to make significant headway in the IRA market by redirecting organized teams of insurance planners towards retirement pensions, especially for sole proprietors and temporary/specialized staff. Securities firms are expected to focus on results-oriented life-cycle funds aimed at clients with risk tolerance. Conclusion: For the IRA retirement pension market to develop efficiently, it is necessary to review adding the following provisions to the amendment, including the introduction of a multiple employer system, rationalizing the market structure by merging the operations administrator and asset manager, unifying the IT system, and easing subscriber fees. Allowing multiple subscriptions for many unsophisticated would be subscribers and opening this competition up to fund operators, which would make it possible to offer reduced subscription fees. If the multiple employer system is introduced, financial authorities should forward an appropriate guideline and follow up regulatory measures when subscribers do not have a preference since standard contracts normally set it as the default subscription. Because the main task of operation administrators is pension bookkeeping and the more important Vol. 20, No. 28 9

11 function can be said to be that of asset management, there appears little harm in IRA to integrate operation administrators with asset managers. By doing so, the level of subscriber appreciation for the retirement pension system can be raised while IRA costs could be lowered by standardizing contracts and integrating IT systems as well as related fees. Policy & Industry News Briefs: July FSC Proposes Bill to Amend FSCMA On July 27, the FSC proposed a revised bill to amend the Financial Investment Services & Capital Markets Act (FSCMA) to respond to changes in the financial environment following the global financial crisis and to enhance the competitiveness of Korea's capital markets and financial industry. This includes spurring greater activity of domestic investment banks, moving further along in improving asset management regulations, structural reforms in the capital markets, making a veritable difference of direct financing and shareholder meetings, and strengthening investor protection. Besides this, other measures that aim to redress systemic weaknesses include broadly revisiting regulations on financial investment products, strengthening FSC oversight authority, and making readjustments to the definition and purview of derivatives- linked securities. The proposed amendment comes some four years since the Act was adopted, and changes seem imminent in the capital markets and the financial industry with particular anticipation for the emergence of a home-grown investment bank that can compete with well-known foreign investment banks. Q GDP Growth Rate Lowest in 7 Quarters Korea's real GDP grew at a rate of 3.4% in Q2 2011, the lowest since Q This was mainly due to the stagnation in construction investment and a slowdown in exports in spite of the increase in domestic consumption and facility investments. The slowdown in exports is seen as a result of a 10 Weekly Financial Review

12 deceleration of the US economic recovery and the metastasis of the fiscal crisis in the euro zone. But with domestic consumption and facility investments remaining strong, Korea's real GDP growth rate will likely trend higher, especially with stability expected to return in the US and the euro zone. Enforcement Decree & Regulatory Amendment Bill Proposed for Savings Bank The FSC proposed a bill on July 25 to amend the enforcement decrees and supervisory regulations governing savings banks to improve its weaknesses in corporate governance, prevent excessive expansion and strengthen investor protection, and spur the return of savings banks to its original purpose of serving retail and SME customers. The driving spirit of the amendment is to strengthen savings banks in the areas of supervisory oversight, consumer protection, and competitiveness. The bill aims to prevent misappropriations by major shareholders, elimination of preferential loan treatment to financially sound savings banks, limitations on M&A between savings banks, restrictions on managing high-risk assets, and tightening regulations on the issuance and sales of subordinated bonds. It also includes permissions for installment finance, the prevention of illegal deposit withdrawals, and strengthened rules for executive disqualifications and dismissals. Direct Financing Rises Sharply H According to the FSS, corporate funding through equity or corporate bond issues rose in H1 by 18.6% on year to KRW73.61 trillion. This was mainly due to corporate bonds being issued ahead of the expected increase in costs and secondary offerings by large financial holding companies during the period. A total of KRW6.66 trillion in equity was issued during the first-half for an increase of 34.8% YoY while KRW66.96 trillion was issued for corporate bonds for a 17.2% increase YoY. Vol. 20, No

13 Market Indicators: July Avg. June Avg. July 25 July 26 July 27 July 28 July 29 Call Rate (1d) C D rate ( million won) Industrial Finance Bond Interest Corporate Rates bonds (3yr, (%) unsecured AA-) Korean Treasurys (3yr) Nat'l. Housing Bonds (5yr) KOSPI (1January 1, , , , , , , KOSPI 1980 = 100) & Trading 56,077 66,660 59,278 67,002 63,142 58,784 59,514 Trade Value 136, , , , , , mil.) Foreigner Net ,252-3,022-4,388-12,325-13,391 Purchases Won/Dollar 1, , , , , , , FX Rates Won/Yen 1, , , , , , , Won/Euro 1, , , , , , , Value Investment (KRW Balance Edited and Translated by Dennis Kim 12 Weekly Financial Review