The Need for Further Bond Market Reforms

1. Introduction

The Japanese Big Bang is premised on making financial markets more free (allowing market principles to work)， fair (transparent and credible)， and global (international and on the leading edge). In this context， as corporate financing shifts from indirect to direct means， the role of the bond market is becoming increasingly important.

This paper reviews recent bond market deregulation and market reforms， and discusses further desirable reforms in public and corporate bond markets from the viewpoint of institutional investors， with special attention given to the corporate bond market.

2. Present Status of Bond Markets

Judging from present levels of transactions and outstanding issues in the public and corporate bond markets， the public bond market shows considerably greater liquidity (Table 1). This can largely be attributed to restrictions in the corporate bond market which hamper transactions.

Figures 1 and 2 compare financing scale and costs for direct financing methods such as bond issuance， and indirect financing such as bank loans. We see that bank financing is decreasing， while financing through straight bonds is increasing， indicating that corporate financing is shifting from indirect to direct means. Moreover， the expansion of public and corporate bond markets can be attributed to the following factors:

increased focus by management on ROE，¹ causing a growing orientation toward debt financing;²
deregulation and market reforms in government and corporate bond markets;
reduced financing cost through direct financing.

Further expansion of bond markets will entail addressing issues such as product diversification， acceleration of issuance procedures， and development of secondary markets. Below we review recent deregulation and market reforms in both the primary and secondary markets.

First， let us look at the status of product diversification in the primary markets (Table 2). The abolition of issue standards in January 1996 has made possible the issuance of junk bonds³ rated BB and lower， enabling a vast number of companies to engage in bond financing.

In addition， in legal revisions related to regulation of businesses involved with special credit， provisions were established for the issuance of asset backed securities (ABS). An ABS instrument is backed by assets such as various credits such as credit card credit and lease credit. It not only improves the issuer’s balance sheet but enjoys a high rating due to the backing.

For medium term notes (MTN)， an MTN program is set up prior to bond issuance， and bonds are issued with diverse conditions when the issuer desires based on this program. This enables bonds to be issued flexibly to meet the needs of investors.

We next review reforms in the secondary market (Table 3).

(1)Introduction of Rolling Settlement

In October 1996， the settlement method for government bond transactions was changed from being conducted six days per month (five and ten-day settlements) to a rolling settlement method conducted every business day， thereby reducing the settlement risk. To use this type of settlement in short sales， bonds must be available for immediate borrowing. Since a bond repo market is needed， maximum interest rates and other restrictions were abolished in January 1996. Until then， repo transactions entailed problems such as: (1) credit risks had to be considered since almost all transactions were unsecured， and (2) due to maximum interest rate limits on cash collateral (1% below the secured call rate)， putting up cash collateral incurred opportunity costs. The development of the bond repo market has promoted the use of cash collateral (thus securing the bonds)， enabling even financial institutions who had shied away due to credit risk concerns to participate more easily.

(2) Creation of a Bond Settlement Network

Proposals to reform the corporate bond delivery and settlement system were compiled to satisfy two requirements: the new system was to become operational quickly， and was to encourage greater participation in the market. The reform proposals contained the following two points.

Eliminate the registration certificate， build an online trading network， and set up a corporation to serve as network administrator (a relay institution).
By connecting the network to the BoJ network， enable DVP (delivery versus payment， or the simultaneous settlement of securities and funds) and rolling settlement.

Based on these proposals， the Japan Bond Settlement Network (JBNet) was set up in November 1996， and is slated to begin operation in December 1997.

(3) Enhancement of the OTC Standard Quotation System

In April 1997， the public and corporate bond OTC standard quotation system was revised as follows:

the number of standard quotation issues was increased;
calculation methods for yields and basic prices were changed;
the number of members reporting quotations was increased;
the method of announcing standard quotations was enhanced.

In particular， the selection method of standard quotation issues was changed from using one security for each type， maturity and interest rate， to using fixed interest bearing bonds with lump sum payment at maturity. As a result， many corporate bonds were added， and quotations more accurately reflect credit risk. In addition， the announced yields were changed from simple to compound yields. The number of members who report quotations was increased from 15 to 28 by adding securities firms affiliated with banks and foreign securities firms. Furthermore， in addition to the standard quotations， ratings information is also released not only on paper but on the Internet (http://www.jsda.or.jp/). In the future， investors will seek higher levels of quality rather than quantity with regard to OTC standard quotations.

3. Requisite Conditions for the Development of Bond Markets

While the bond markets have continued to grow steadily due to deregulation， we look at what conditions are needed for the further development of bond markets from the viewpoint of institutional investors.

Let us first consider the final objective of institutional investors−to obtain the maximum return possible while managing risk within tolerable limits.

From this viewpoint， even after all the scheduled market reforms are carried out， the following reforms would be called for.

(1) Introduction of STRIPS

For financial institutions， the introduction of STRIPS government bonds would be beneficial in terms of both risk management and higher returns on managed assets. A Strip is created when the interest payment coupons are separated from the principal portion of a government bond， and both are then sold as individual zero coupon investments. They have already been introduced in the U.S. and France， and are scheduled for introduction in the U.K. and Germany.

STRIPS bonds have the following two advantages: (1) an accurate spot yield curve can be obtained;⁴ and (2) they facilitate ALM (asset and liability management).

Presently， a variety of methods are commonly used to estimate spot yield curves using interest bearing government bonds. STRIPS will make this estimation easier and more accurate. Using this government bond spot yield curve as a standard， when credit risk and other factors are taken into account， the pricing accuracy is increased for all types of interest related products. Higher accuracy will increase the efficiency of bond markets.

Furthermore， when STRIPS bonds are introduced， zero-coupon bonds with various maturities will exist on the markets. This will greatly benefit the risk management of financial institutions and pension funds conducting ALM by making possible asset structures to accommodate the complex cash flow on the liabilities side.

However， the introduction of STRIPS bonds is hampered by the present tax system， which does not assure fair taxation between STRIPS bonds and other financial products−for instance， tax on the interest payments of interest bearing bonds (separate withholding tax). Developments in tax reforms pertaining to bonds will be followed with keen interest.

(2) Reform of Market Information

When the bond settlement network begins operation in December 1997 and all settlements become rolling settlements， the physical reforms of the bond markets will have been completed. However， the software aspect−market information−will pose problems different from the stock markets and peculiar to bond markets.

One characteristic of the secondary market for stocks is the existence of exchanges. Since market participants perform transactions and obtain information from the exchange， they can accurately grasp market conditions in real time. In contrast， the bond secondary market consists almost entirely of OTC transactions (over 99%)， and transaction terms vary with each broker. Thus each broker is in effect an independent exchange， and the contents of transactions are unknown except to the involved parties (Figure 3).

Since the transaction terms are not clearly known， the information of greatest interest to investors is the brokers data， wherein brokers post quotes and agree to buy and sell at certain prices. Investors have no choice but to trust their figures and make investment decisions. Thus there is no point to market maker data that serve as yardsticks rather than used in actual market making. In addition， prices are undergoing arbitrage not only with other financial markets but among brokers.

Investors seek responsible market make data and other market information that will enable them to compare issues and brokers. The availability of such broad-based data on issues and brokers will strengthen the integrity of bond markets， improve the market’s overall efficiency and transparency， and enable investors to use bond markets with confidence.

(3) The Impact of Other Deregulatory Measures

1.　Deregulation of ABS and MTN

It is significant that deregulation has expanded available investment alternatives through the issuance of ABS and MTN. However， the cash flow of ABS and MTN does not differ substantially from other bonds. Thus investors will first decide their relative attractiveness before buying them. These bonds are not as advantageous to investors as they are to issuers (improved balance sheets and optional timing of issues).

2.　Introduction of Bonds Indexed to Inflation

Following the governments of the U.K.， Canada， and Sweden， the U.S. has recently begun issuing bonds that are indexed to inflation. Since the interest rate on these bonds is tied to a price index， investors seeking to reduce exposure to inflationary risks find them attractive. In addition， the issuing government is motivated to pursue policies that restrain inflation (and hence minimize interest payments). The yield differential between inflation indexed bonds and interest bearing bonds of the same maturity can be thought of as the market’s expected inflation rate. If inflation indexed bonds are issued continuously， and as their maturities become diverse and liquidity increases， the expected inflation rate could become a guideline for monetary policy.

3.　Impact of the Revision of the Foreign Exchange Law

In addition， if the revised Foreign Exchange and Foreign Trade Control Law takes effect in April 1998， it will greatly affect not only the bond market but all capital markets in Japan. Liberalizing only the foreign exchange system will cause financial transactions to shift overseas， accelerating the hollowing out of domestic markets. Thus the foreign exchange law revision will be a front runner of financial reform， serving to speed up implementation of Japan’s big bang. Direct investment abroad could cause huge funds to flow into foreign bonds， raising taxation and other coordination concerns between foreign and domestic markets.

Conclusion

Considerable progress has been made in reforming the "hard" (institutional) aspects of the primary and secondary bond markets. What is needed in the future are "soft" reforms related to new product development and the supply of information.

As regulations continue to be relaxed on products to level of other countries， new products need to be developed that will satisfy the needs of both issuers and investors. Indeed， Japanese should not try to mimic the Euro market but rather develop new products in Japan that can compete based on their originality.

Furthermore， all market participants must engage in investment activities based on the principle of individual accountability. This requires the availability of information on which responsible decisions can be made. Unlike market makers， investors are not in the position to obtain market information directly. Thus market makers have an obligation to supply investors with stable and reliable information through a variety of means.

Notes

ROE (return on equity)， calculated by dividing net profit by shareholder’s equity， measures how efficiently shareholder’s equity is being used. Shareholders need to press management to assure that this value increases.
Debt financing refers to raising funds through debt (such as issuing bonds) rather than by issuing stock.
Junk bonds are bonds rated BB or lower. Bonds rated BBB or higher are called investment grade bonds.
The spot yield curve plots the spot rates for various maturities. The spot rate is the discount rate on zero-coupon bonds that mature at time T. Since zero coupon bonds generate cash flow only at maturity， the spot rate is determined for each maturity.

The Need for Further Bond Market Reforms

Takahiro Niimi