Most of the time, an effective bond market silently does its job like an underground drainage pipe hidden from view. But the underlying current of a bond market has the power to shake the entire financial system. Even a slight blockage in drainage is felt across the city. That’s why a deep and well-developed bond market is always considered a sign of a mature financial system. The bond market plays a crucial role in mobilizing financial resources overflowing unproductively from one corner of our economy to some other corner, where they can be productively utilized.
Johnny: Before talking about its importance, can you briefly explain what exactly a bond market is?
Jinny: The bond market is a mechanism by which governments and companies borrow money by issuing securities in the form of bonds. A bond market, much like many other financial markets, is not located at one single physical location. The entire mechanism works through direct negotiations among brokers in case the security is not listed, or through orders placed on the trading platform of stock exchanges in case the security is listed.
Based on whether the bond is being issued by the government or companies, the bond market can be broadly divided into the government securities market and the corporate bond market. In many economies, the government securities market completely dominates the corporate bond market and so the focus of development requires to be placed more on the corporate bond market.
Johnny: I don’t understand what’s so unique about the bond market. Our banks and stock market also help in mobilizing financial resources, so why should we care at all about the bond market?
Jinny: First and foremost, the development of the bond market is all about bringing more market efficiency through competition. The bond market acts as an alternative to mobilization of savings and investments through banks and the stock market. In a society where the financial system is non-existent, there would perhaps be no system for mobilizing the money lying useless with one individual to be put into productive use by some other individual. For borrowing and lending money, you would need to cultivate a personal relationship with the other party, which is not feasible for everyone. In a society with a more developed financial system, you would find banks acting as an intermediary between the borrowers and lenders. You simply deposit your money in a bank and the bank in turn decides whom to lend your money to.
The banking model of intermediation works on paying less interest to depositors and charging more interest from borrowers. You may wonder why you can’t lend your money directly to a borrower at a much higher interest rate without bringing your bank into the picture. But you can’t do that unless your financial system has a well-developed bond market. The problem is that a bond market can’t start working just in an instant.
Illustration: Jayachandran / Mint
Many a time you may find a financial system with a well-developed banking system, a vibrant stock market but a very shallow bond market. The entire bond market may be dominated by just government securities, without much space for corporate bonds. India and many other developing countries face that situation.
The development of the bond market requires a long and steady effort.
Johnny: But is the return worth the effort? Can you clarify a bit more on what the other advantages of a well-developed bond market are?
Jinny: First, a well-developed bond market enables companies to borrow money directly from people, which reduces the cost of borrowing. Some of the better-rated companies are really able to borrow at a much lower interest rate.
The investors are also able to earn a higher return than what is normally offered by a bank deposit, provided they are ready to assume more risk. Second, the bond market also provides a good alternative to raising money through the stock market.
Raising money through bonds does not involve dilution of the present shareholding, and hence is preferred by some borrowers. Third, a well-developed bond market works as a more reliable spokesman of the financial market. Often, movements in stock prices are without any fundamental reason. But prices of bonds more closely follow the fundamentals. The prices of bonds move only when there is something affecting the market—interest rates, inflation, chances of default, high fiscal deficit or anything good or bad for the market.
The bond market mostly speaks through interest rates. When the bond market is in a good mood, the yields go down, but when the market is in a bad mood, the yields go up.
The remarkable thing is that the bond market never moves one way or the other without reason. The bond market is loyal only to the value of money. It has no other loyalty. That’s why policymakers have to more closely listen to what the bond market has to say. The verdict of the bond market often plays a decisive role.
Johnny: That’s true, Jinny. You can love or hate the bond market but you can’t ignore it.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org