CORPORATE BOND MARKET EFFICIENCY
A comparison between the Finnish corporate bond market and
the Norwegian corporate bond market
Master’s thesis
in Accounting and Finance
Author:
Saara Backberg
Supervisors:
D.Sc. (Econ) Antti Fredriksson
D.Sc. (Eng), M.Sc. (Econ) Eija Vinnari
19.6.2014
Turku
Turun kauppakorkeakoulu • Turku School of Economics
TABLE OF CONTENTS
1
2
INTRODUCTION ................................................................................................... 7
1.1
1.2
1.3
Background of the study ................................................................................ 7
Objectives and scope ...................................................................................... 9
Methodology, method, and data ................................................................... 10
1.3.1 Methodology .................................................................................... 10
1.3.2 Data collection method .................................................................... 11
1.3.3 Description of the interviewees ....................................................... 12
1.3.4 Data analysis method ....................................................................... 14
1.4
Structure of the study ................................................................................... 15
BOND MARKET CHARACTERISTICS............................................................. 17
2.1
Importance of the bond market .................................................................... 17
2.2
Different types of bonds ............................................................................... 18
2.2.1 Government versus nongovernment bonds ...................................... 18
2.2.2 Plain vanilla bonds versus variations of the plain vanilla ................ 19
2.2.3 Exchange versus over-the-counter bonds ........................................ 19
2.2.4 International versus domestic bonds ................................................ 20
Issuing and trading of bonds ........................................................................ 21
2.3
2.4
2.5
2.6
2.3.1 Corporate bond market participants ................................................. 21
2.3.2 Primary market................................................................................. 22
2.3.3 Secondary market............................................................................. 23
Pricing of bonds ........................................................................................... 24
2.4.1 Interest rate and duration ................................................................. 25
2.4.2 Credit ratings .................................................................................... 25
Bond yield .................................................................................................... 28
2.5.1 Price-yield relationship .................................................................... 28
2.5.2 Nominal yield, current yield, and yield to maturity ......................... 29
2.5.3 Yield curve ....................................................................................... 30
Utility functions and bond market risks ....................................................... 31
2.6.1 Utility functions ............................................................................... 31
2.6.2 Market risk ....................................................................................... 32
2.6.3 Reinvestment risk............................................................................. 33
2.6.4 Call risk ............................................................................................ 33
2.6.5 Inflation risk ..................................................................................... 34
2.6.6 Liquidity risk .................................................................................... 34
2.6.7 Credit risk......................................................................................... 35
2.6.8 Rating downgrade risk ..................................................................... 35
3
CORPORATE BOND MARKET EFFICIENCY ................................................. 36
3.1
3.2
3.3
4
Differences between bond market efficiency and stock market efficiency . 36
Market transparency ..................................................................................... 38
3.2.1 Principal-agent problem and monitoring ......................................... 38
3.2.2 Pre-trade and post-trade transparency.............................................. 39
3.2.3 Impacts of transparency ................................................................... 40
Market liquidity............................................................................................ 41
3.3.1 Dimensions of liquidity ................................................................... 42
3.3.2 Liquidity measures ........................................................................... 43
3.3.3 Macro- and microeconomic effects on liquidity .............................. 45
COMPARISON BETWEEN THE FINNISH AND THE NORWEGIAN
CORPORATE BOND MARKET ......................................................................... 47
4.1
Economic structure of the countries ............................................................. 47
4.2
4.3
4.1.1 Economic structure of Finland ......................................................... 47
4.1.2 Economic structure of Norway ........................................................ 48
Nordic high-yield market ............................................................................. 49
Norwegian bond market specialties ............................................................. 51
4.3.1 Trustee model .................................................................................. 51
4.3.2 Bond documentation ........................................................................ 54
4.3.3
5
Post-trade reporting system ............................................................. 55
EMPIRICAL FINDINGS ON CORPORATE BOND MARKET EFFICIENCY 56
5.1
5.2
Corporate bond market efficiency in general ............................................... 56
5.1.1 Factors affecting efficiency ............................................................. 56
5.1.2 Level of efficiency in terms of transparency and liquidity .............. 73
Comparison between Finland and Norway .................................................. 78
5.2.1 Differences between Finnish and Norwegian market structure ....... 78
5.2.2 Focal points towards increased efficiency ....................................... 83
6
CONCLUSIONS AND IMPLICATIONS ............................................................ 92
7
SUMMARY AND EVALUATION OF THE STUDY ....................................... 101
7.1
7.2
7.3
7.4
Summary .................................................................................................... 101
Reliability and validity ............................................................................... 103
Limitations of the study ............................................................................. 105
Further research opportunities.................................................................... 106
REFERENCES.............................................................................................................. 108
APPENDIX 1: INTERVIEW QUESTIONS ................................................................ 114
LIST OF FIGURES
Figure 1 Research approaches in economics (Kasanen et al. 1991, 317) .................. 10
Figure 2 Multiplicity of interpretation (Hirsijärvi, Remes & Sajavaara 2007, 224) .. 15
Figure 3 The price-yield relationship (Choudhry 2010, 22) ...................................... 29
Figure 4 A normal yield curve (Zipf 1996, 15).......................................................... 31
Figure 5 Three attitudes towards risk (adjusted Katz & Rosen 1998, 167–169) ....... 32
Figure 6 Regional new issue split in 2013 between investment-grade and high-yield
bonds in the Nordic area (Scandi high-yield handbook 2013, 2) ....... 49
Figure 7 Share of total Nordic issuance volumes in the Nordic high-yield market
(Nordic high-yield update 2014, 8) .................................................... 50
Figure 8 Breakdown of Norwegian high-yield issuance 2013 (Nordic high-yield
update 2014, 9) ................................................................................... 51
Figure 9 Trustee model in Norway ............................................................................ 52
Figure 10 Undeveloped bond market model .............................................................. 53
Figure 11 Triangle of efficiency in the corporate bond market ................................. 95
Figure 12 Measures to improve the Finnish corporate bond market efficiency ........ 99
LIST OF TABLES
Table 1 Summary of credit rating agency bond ratings (Choudhry 2006, 109) ........ 27
7
1
INTRODUCTION
1.1 Background of the study
Bond market efficiency is a much less studied subject than stock market efficiency, and
for that reason it is meaningful to pay more attention to the bond market dynamics.
Some of the same factors used to analyze stock market efficiency can be used in bond
market analysis, and furthermore, transparency and liquidity are always related to market efficiency. However, there are also many differences because of the specific features
of the bond market, and for that reason, bond market efficiency has to be studied as a
separate entity.
Few studies about bond market efficiency have been conducted before, for example,
Edwards, Harris & Piwowar (2007), Bessembinder, Maxwell & Venkataraman (2007),
and Goldstein, Hotchkiss & Sirri (2006) have studied bond market transparency, whereas, Chen, Lesmond, & Wei (2007), Sarig & Warga (1989), and Alexander, Edwards &
Ferri (2000) have focused on bond market liquidity. However, none of these studies
have tried to grasp the concept of bond market efficiency as a whole, nor have they been
qualitative in nature, and therefore, there is a demand for a qualitative study in this field.
Furthermore, comparative studies have not been conducted, which makes this study the
first of its kind.
Corporate finance, and how it is arranged, is a dilemma that every company has to
resolve. Companies can use equity or debt financing, or a mixture of these two, depending on what the most cost-effective alternative for the company is. Debt financing in
Finland can be arranged through banks, finance houses, public financial institutions, or
private investors in the money or bond market. Money market consists of short-term
investments, generally with less than one year maturity, for example bills and notes,
while bond market is a market for long-term debt securities. Usually a debt security has
to have a term longer than five years, to be called a bond. (Zipf 1997, 3–21.) However,
the term of a bond varies between 1, 5 and 10 years according to different literature.
In the past, the Finnish corporate bond market has been less significant for the Finnish economy, while banks and other credit institutions have played a more important
role in providing capital for companies (Nyberg & Vaihekoski, 2011, 13–15). Moreover, even if the bond market in Finland has nowadays become a somehow considerable
option for funding investments, it still revolves around government bonds with very few
corporate bonds. However, this might not be the case in the future when circumstances
change and companies are forced to look for different kinds of funding opportunities.
(The wind of change in the Nordic bonds market.) Because debt financing in Finland
has mostly relied on bank loans, the financial structure of Finnish companies is ex-
8
tremely one-sided. It is essential to keep in mind that diversification on the borrower’s
side in the debt capital market is very important, and it is the only way to protect oneself
against a credit crunch (Banks loans have edge over bond market borrowing - UK treasurers). If the financial structure of the company is unbalanced, problems might evolve
when growth of the Finnish economy starts slowing down and banking regulations
tighten. (Yritysrahoituskysely 2012.)
The Basel Committee on Banking Supervision has designed a set of reform measurements to strengthen the vitality of banking sector. Basel I and II were implemented
earlier, in addition to Basel III capital, whereas Basel III liquidity was introduced at the
beginning of 2013. The main purpose of Basel III liquidity is to decrease banking leverage and increase liquidity of banks. The goal is to improve risk management, strengthen
transparency of banks, and especially improve the ability of the banking sector to deal
with financial distress. This will reduce the capacity of banks to finance companies
since banks have to hold a bigger stock of liquid assets in case of economic distress.
(Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools.) Companies have to come up with other ways of financing their operations since bank loans will
become more expensive and harder to get. This means that companies will, sooner or
later, have to turn to market-based financing.
Why are bank loans then so popular if companies can access lower interest rates and
longer-term funding from the bond market and they do not have to worry about restrictive debt covenants placed by the banks? The biggest threats for the bond market are
macroeconomic swings. This leads to the fact that the system has to be well-organized
and transparent enough for investors to trust the bond market and be willing to invest in
bonds. (Banks loans have edge over bond market borrowing - UK treasurers).
Although the Finnish corporate bond market has not been very established, at least in
the past, it is noteworthy that the case is not entirely same in other Nordic countries.
Especially, Norway has been a forerunner in developing their corporate bond market
and making it a desirable option for issuers and bondholders. Norway has a few specialties, for example, a standardized documentation model and a trustee function which give
positive signals to the issuers and investors about the efficiency of the market. In fact, in
Norway fifteen times as many corporate bonds are issued per year than in Finland (Jvkmarkkinat remontissa).
Although the Finnish bond market has not been paid attention to that much in the
past, the situation is currently changing. In addition to the trustee model, a new standardized form of documentation has recently been introduced in Finland. This means that
actions have been taken in order to give more companies the possibility to issue bonds
in Finland, in addition, to attract more investors to the Finnish bond market. The Finnish
government has also established working groups in order to bring together experts to
discuss the future of the Finnish bond market. Furthermore, in these discussions the
9
inspirational example Norway is giving has not remained unnoticed. (Rakennepoliittinen ohjelma talouden kasvuedellytysten vahvistamiseksi ja julkisen talouden kestävyysvajeen umpeen kuromiseksi, 13; Jungner & Männistö 2013, 6.)
1.2 Objectives and scope
The objective is to study corporate bond market efficiency through transparency and
liquidity, and specifically to focus on efficiency in the Finnish and Norwegian corporate
bond markets. There are two research questions of which the first one focuses on the
corporate bond market efficiency in general. The aim is to find out which factors affect
corporate bond market efficiency, and to define the level of efficiency regarding transparency and liquidity. The second research question focuses on the comparison between
the Finnish and the Norwegian corporate bond markets in order to discover the similarities and differences between these two markets, and to find out what makes the Norwegian corporate bond market so efficient. The purpose of this comparison is to discover
what could be learned from the Norwegian corporate bond market to make the Finnish
corporate bond market more transparent, liquid, and efficient. The research questions
are as follows:

Which factors affect efficiency in the corporate bond market, and what is the
level of efficiency in terms of transparency and liquidity?

What are the similarities and differences between the Finnish and the Norwegian corporate bond market, and what makes the Norwegian corporate bond
market more efficient?
This study focuses on corporate bonds, whereas treasury bonds and municipal bonds
fall outside the scope of this study. Corporate bonds can be divided into investmentgrade bonds and high-yield bonds, and in this study the focus is on high-yield bonds.
This is due to the fact, that high-yield bonds are the reason why corporate bond market
infrastructure has been developed – the risk being greater the better the investors have to
be protected. High-yield issues are also an important part of the corporate bond issuing
in Finland and in Norway.
In addition, the focus is on small and midsize companies, because the interest is in
the national bond markets and their functioning. The bigger the company the more likely it is to issue bonds in foreign markets, for example, in London. It is also the small and
midsized companies that need help to start utilizing bonds as an option for funding. Also the government working groups have been discussing a corporate bond market for
small and midsize companies.
Usually the Nordic corporate bond market is treated as a whole and all the Nordic
countries are included in the analysis, but in this study the Finnish corporate bond mar-
10
ket is only compared to the Norwegian corporate bond market. The reason for this is
that, among the Nordic countries, Norway has been a forerunner in developing the trustee model and other bond market infrastructure, and this makes Norway the most significant benchmark out of the Nordic countries.
1.3 Methodology, method, and data
1.3.1
Methodology
Picking the right research approach is a significant part of a research process. Every
branch of science has its own unique research approaches – in business economics the
approaches are usually divided into five: conceptual approach, decision-orientated approach, nomothetic approach, action-oriented approach, and constructive approach.
Neilimo & Näsi (1980) introduced the first four of these, and Kasanen, Lukka & Siitonen (1991) added the constructive approach later on to the model.
Descriptive
Normative
Theoretical
Empirical
Conceptual
approach
Nomothetic
approach
Decisionoriented
approach
Action-oriented
approach
Constructive
approach
Figure 1 Research approaches in economics (Kasanen et al. 1991, 317)
These approaches differ from each other based on whether they are descriptive or
normative, and theoretical or empirical. Descriptive studies describe the subject of research, whereas normative studies try to discover concrete solutions to the problems.
Another distinctive factor is the use of research material. Theoretical studies focus on
previous research literature to come up with models and explanations for the research
questions, while empirical approaches are all about gathering research material by, for
11
example, observing, interviewing or measuring the subject of research, and analyzing
the gathered material. (Neilimo & Näsi 1980.)
This study is approached from an action-oriented perspective, which means that this
study is empirical and simultaneously descriptive and normative. The aim is to understand the subject of research better. Also some suggestions for further improvements
can be made. Typical for an action-oriented approach is that the environment will be
studied through human perspective, which means that the empirical evidence might be
affected by personal opinions. The researcher’s competence of understanding the research problem, and the interpretations he or she makes might influence the results he or
she gets. Although one has to keep in mind that the point of this kind of study is not
necessarily to find out information about reality, but to find out information about people’s perceptions of the phenomenon. This qualitative study is also a comparative study
because two different countries and their systems are compared to each other.
1.3.2
Data collection method
The empirical data was collected through five semi-structured interviews. The interviews had a framework of themes, and each theme included a different amount of predetermined questions. The four different themes were: 1) corporate bond market issuing
and trading, 2) corporate bond market efficiency, 3) Norwegian corporate bond market,
and 4) Finnish corporate bond market. Only the test interview had a different structure,
because the interview framework took its final shape after the test interview.
Although the questions are predetermined in a semi-structured interview, they can
still be modified, their order can be switched, and even some new questions can be added to the framework during the interview – these alteration possibilities were utilized in
this data collection process. The questions for each interview are attached at the end of
this study.
The strengths of a semi-structured interview are that the number of interviewees can
be rather small and the informational knowledge received is usually comprehensive.
However, there are also some weaknesses, e.g., the amount of information in the analysis phase is overwhelming, and the workload put into the process enormous. The semistructured interview model was chosen because it gives an in-depth understanding of
the complex phenomenon studied in this research. (Hirsjärvi & Hurme 1991, 36–38.) A
large sample size is not as important as the silent, detailed, information that can be accessed through fundamental interviews with the experts in this field.
Before the actual interviews a test interview was held. The purpose of a test interview is to test the interview questions, and to find out whether the themes are in a purposeful order and the interview questions appropriately phrased. After the test interview
12
the questions can be modified so that everything is in order before the first proper interview. A test interview can also help to discover the average length of an interview. If
the interview is too long, something can be left out, and vice versa. For instance, it is
important to be able to tell the next interviewees for how long the interview is going to
last. The test interview also gives the interviewer a chance to practice and get to know
the structure of the interview, so that fewer mistakes will be made in the future. Test
interview is a necessary and an important part of a qualitative research process, especially, when using a semi-structured interview model as a research method. It might be
very difficult to come up with all the essential questions immediately, and the test interview can help the researcher in this. Since the interviewees have so much more experience and information about the research topic, it would be silly not to use their expertise
in all possible ways. (Hirsjärvi & Hurme 1991, 57–58.)
The interviewees were selected as a result of proper reflection. All five of them are
experts in this field and have a great amount of knowledge of the studied subject. They
all represent a different perspective, which gives this study a more thorough angle. Because all of the five interviewees represent a different perspective, some questions were
added specifically to each interviewee.
All the interviews were held in English, and four of them were held in person at each
interviewee’s workplace. One of the interviews was, however, held, as a telephone interview because the interviewee C lives and works in Norway, and the resources allocated for this study did not allow a trip to Norway to meet the interviewee in person.
1.3.3
Description of the interviewees
All of the interviewees represent a different perspective and they were chosen so that a
comprehensive, overall understanding would be developed. The first interviewee, who
was also the test interviewee, works as an investment manager in a Finnish insurance
company. He has a long history in specializing in fixed income market investments, and
he has been working for 13 years as a portfolio manager before this position. In addition, he has previous working experience as a researcher and a controller. The interviewee has been managing many different asset classes from government bonds to
money markets and from technology stocks to European growth companies, but for the
last ten years he has been focusing on the European high-yield market, and the European convertible bond market. The first interviewee will be referred to as interviewee A in
the empirical analysis.
The second interviewee works as a head of credit investment for a Finnish parent
company with insurance operations. At the parent company their job is to manage the
investments of the subsidiaries, and the interviewee is responsible for all credit invest-
13
ments in the company. He also has a long history in the business – he has been working
at various banks including big multinational banks abroad. The interviewee has been
working with credit his whole life and has done everything between credit analysis to
investment banking and corporate coverage side. The second interviewee will be referred to as interviewee B.
The third interviewee knows the Norwegian bond market extremely well and has
been developing the trustee model in Norway. He represents a slightly different angle
working as a legal director and taking care of all the legal matters of a Norwegian trustee company. He has been in the financial business for over 20 years and especially
working with bonds for the last ten years. At the moment, he is also a Nordic coordinator helping other Nordic countries to strengthen their bond market functions. The third
interviewee will be referred to as interviewee C.
The fourth interviewee works as a Finnish country representative of the biggest trustee company in the Nordic countries. He has been in this position for over a year now
and is the only one working for this company in Finland. Besides working for the trustee, the fourth interviewee has also other duties as one of the partners of a small Finnish
corporate finance and advisory company. His working experience is versatile including
a lot of international experience, which indicates a strong know-how of the financial
sector overall. As a representative of the trustee company, his mission is to root the trustee model into the Finnish bond market and convince the Finnish issuers of the necessity of the trustee function. He will be referred to as interviewee D in the analysis.
The fifth interviewee works as a head of high-yield origination in a large financial
service company which has functions in the Nordic area as well as Baltic region. The
fifth interviewee has worked in a local engineering company and stayed there during his
studies and after graduation before starting to work for his current employer. The work
at his current employer has involved fixed income origination for the past eight years
and before that he was doing ratings analysis for a couple of years. For the past three
years he has been focusing on high-yield issuers, but he feels fixed income primary actions in general are his specific area of expertise. The fifth interviewee will be referred
to as interviewee E.
Interviewee B, D, and E have also been part of working groups formed by Confederation of Finnish Industries (EK) and corporate advisory board in 2013–2014. These
working groups were aggregated by the Finnish government in order to increase Finnish
bond market efficiency.
14
1.3.4
Data analysis method
After the interviews were gathered the recorded material was transcribed to get a better
understanding of what was actually discussed in the interviews in addition to become
more familiar with the collected data. Interviews were then analyzed trough thematic
analysis which is one option out of many different possibilities in analyzing qualitative
data. In a qualitative research there is no right or wrong way of analyzing data, but in
fact, many different techniques can be used. Thematic analysis was chosen for this
study because there were obvious themes that arose from the data, and thematic analysis
felt like a natural way of approaching these thematic interviews. (Denzin & Lincoln
1994, 428–434.)
Thematic analysis is formed by identifying patterns which form sub-themes, and ultimately, these sub-themes are assembled into actual conclusive themes. Related literature is utilized in building arguments for choosing the themes. (Aronson 1994.)
Themes that arose from the data were not categorized exactly to correspond to the
four themes used in the interview structure because already during the interviews it became clear that certain themes were discussed at many different stages of the interviews.
However, according to Hirsijärvi & Hurme (2001), it is quite common that issues related to the same theme are discussed at different stages of the interview, and themes that
are selected to the analysis usually occur in many different interviews and surface as the
most relevant themes according to the study. Some of the themes used in the analysis
phase of this study correspond to the themes used in the thematic interviews and these
themes are the starting point for the analysis. However, also new themes can arise that
are more interesting than the original themes. Themes that are brought up in the analysis
are based on the interviewer’s interpretations of the answers the interviewees have given. (Hirsijärvi & Hurme 2001, 173.)
In a qualitative analysis the researcher’s aim is to make justified interpretations from
the data. The same interviews can be interpreted in many ways, but the key is to be able
to make the same conclusion as a reader, who is looking at the issue from the same perspective, does. Whether the reader agrees with the angle or not, is irrelevant. In qualitative research the interpretations are made at different stages. First, the interviewer interpreters the interviewee’s opinions, and, finally, the reader interpreters the study. The
interpretation process is demonstrated in the picture below.
15
Figure 2 Multiplicity of interpretation (Hirsijärvi, Remes & Sajavaara 2007, 224)
The bigger the black part in the middle is the more the interviewee, interviewer, and
reader agree on the interpretations. If the black part is very little the three different parties have very different views on the data. (Hirvijärvi, Remes & Sajavaara 2007, 224;
Hirsijärvi & Hurme 2001, 151.)
In this study conclusions are made by inductive reasoning, which means that this
study focuses on making conclusions based on the data collected. The opposite of inductive reasoning is abductive reasoning, which focuses on verifying theoretical notions
through data. (Hirsijärvi & Hurme 2001,136.)
Quotations are used abundantly in the analysis in order to give the reader as reliable
an image of the data as possible. Quotations are presented in the study as authentic as
possible – only some grammar is altered to meet the written language requirements.
1.4 Structure of the study
This study begins with an introduction which includes background information, objectives and scope including research questions, presentation of methodology, method and
data, and the structure of the study. The second chapter is for introducing the most relevant features of the bond markets, e.g., different types of bonds, issuing and trading of
bonds, pricing of bonds, and bond market risks. In the third chapter, the focus is on cor-
16
porate bond market efficiency and on factors that are related to efficiency, such as
transparency and liquidity.
The aim of the fourth chapter is to illuminate the features of corporate bond markets
in Finland and Norway, the economic structures of these two countries, in addition to
Nordic high-yield markets. Also Norwegian specialties are specified in this chapter.
Fifth chapter includes the empirical analysis of the study, and endeavors to give answers
to the research questions. The sixth chapter consists of conclusions and implications,
and contains discussion linked between theory and empirical findings, and finally the
seventh chapter is for summary, evaluation of the study, and further research opportunities.
17
2
BOND MARKET CHARACTERISTICS
Bond financing can be described as something between equity markets and bank loans.
For investors the yield typically exceeds the deposit rate of banks but is less than what
the investors would receive from the stock market. The risks are very different in bond
and equity markets since the value of bond is largely independent of issuer’s market
performance. Many risks are however related to bond investing, and the investor has to
be aware of these risks and take them into consideration in the pricing process. For
companies, issuing of bonds is an efficient way of gathering large sums of money to
finance longer-term investments. There are different kinds of bonds to choose from to
suit the issuers’ and investors’ needs. After having been issued in the primary market,
the bonds can be traded in the secondary market between third parties who would not
generally take part in the primary market transaction. (Zipf 1996.)
2.1 Importance of the bond market
Bonds offer several advantages over stocks and bank loans for issuing corporations, and
there are many positive outcomes that arise from functioning bond markets. First of all,
issuing stocks can weaken the company’s founders’ control over decision making,
whereas bond issues do not dilute the ownership of current shareholders. Second, bonds
are preferable to bank loans because they provide capital at lower interest rates than
banks would do. Moreover, when bonds are sold directly to investors and banks are not
acting as middlemen, the borrowing process becomes more efficient and less expensive.
Third, corporations are spared the burden of having to negotiate with every potential
creditor separately since a single, uniform instrument can be used to gather plenty of
money from hundreds or even thousands of investors. (Zipf 1996, 117–118.)
Furthermore, Batten et al. (2004, 31) point out that bond markets make it possible for
issuers to finance large investments and get their hands into financial resources which
might exceed the lending capacity of a single bank. They add that issuers are also less
dependent on the lending policies of a bank which might make it easier for the company
to get the financing they need. Moreover, Takagi (2002) argues that the average costs of
external finance drop due to competition, and managements of companies are better
monitored since capital markets exert discipline on management. Takagi (2002) also
points out that financing of innovations in companies increases when bonds are used as
a source of finance. Sharma (2001) adds that advanced bond markets reduce maturity
mismatches when corporations are not taking short-term loans to finance longer-term
projects. Schinasi and Smith (1998), in turn, argue that efficient securities markets are
capable of distributing financial risks and potential losses more widely, at the same time
18
they are able to price financial risks at least as well as banks. Finally, Hakansson (1999)
notifies that the abundance of available financial securities tends to enhance economic
welfare, and additionally, is likely to have a spillover effect on banking system.
A company that has more debt than equity is considered to be highly leveraged. The
optimal level of leverage has to be determined by the company. Leverage is a useful
thing for the company and the investor since it can be exploited to finance investments.
If the investment is profitable, returns for the investors will be greater likewise. However, a leveraged investment can turn against the investor also since leverage magnifies
both gains and losses. (Tirole 2006.)
2.2 Different types of bonds
2.2.1
Government versus nongovernment bonds
There are different kinds of bonds, and one way of making a rough division is to separate government bonds and nongovernment bonds. Government bonds are issued by
governments or municipalities, whereas nongovernment bonds are issued by corporations. The idea of these two bonds is significantly distinct. Government bonds are issued
to raise money to provide public services which have to be financed in spite of everything, whereas, companies exist to make profit. This means that companies have to earn
more money than they spend. They also have to pay attention to interest rates since the
interest becomes part of their expenditure. Corporate bonds also differ from government
bonds in the ability of the issuer to pay back the principal. Government bonds are
backed by taxing power, whereas, nongovernment bonds depend on the performance of
the company and must be secured in other ways. As a result corporate bonds are usually
collateralized. Collateralization means that the loan is secured. Corporate bonds can be
secured by general credit of the company, or if the issuer is not financially sound, investors might require tangible assets as collateral. All in all, secured bond is collateralized,
whereas unsecured bond is not secured against any assets. Seniority of a bond means
that the senior debt holders have the first claim over the collateral in a case of bankruptcy, whereas junior debt holders have a lower priority in case of liquidation. The junior
debt is also referred to as subordinated debt because the bond holders have a subordinate status in relation to the normal bond holders. (Zipf 1996, 128–129.)
The nongovernment bond market is just a fraction of the bond markets in general in
Europe because the nongovernment bond market is not as deeply rooted in the financial
system as the government bond market (Batten et al. 2004, 41). This makes the nongov-
19
ernment bond market, or the corporate bond market an interesting subject to study and
this research focuses only on corporate bond market.
2.2.2
Plain vanilla bonds versus variations of the plain vanilla
The most common bond is called a plain vanilla bond (or conventional bond or bullet
bond). This kind of bond pays a regular, annual or semiannual, fixed interest over a
fixed period of time, and the principal of the bond is returned on the maturity date. All
the other bonds are variations of the plain vanilla. All bonds, other than zero-coupon
bonds, make periodic interest payments for the investors called coupons. Usually the
interest rate of the bond is fixed, but it can also be floating. In floating rate notes the
coupon of the bond is benchmarked against a predetermined index. (Choudhry 2010, 3.)
The principal of a bond can be repaid at maturity, or repaid over the life of the bond.
Bonds that have a schedule for principal repayments are called amortizing bonds,
whereas, bonds that do not have a schedule of periodic principal repayments are called
non-amortizing bonds. The more common of these two is the non-amortizing bond in
which the plain vanilla is also included. (Fabozzi 2000, 4.)
Some bonds may include embedded options that give the right either to the bondholder or the issuer to enforce early redemption of the bond. The more frequently used
is the call feature which grants the issuer the right to redeem the bond before the specified maturity date. The issuer might want to use the redemption option if the interest
rates in the market have declined, and it would be cheaper for the company to replace an
old bond issue with a lower coupon rate issue. The call option is considered to be harmful to the bondholder’s expected interests, and this will be taken into consideration in
the pricing of the bond. A put feature, in contrast, gives the bondholder the right to sell
the bond back to the issuer before the maturity date. The bondholder might be interested
in this kind of feature in order to hedge against a rise of interest rates, and furthermore,
a decline in value of the bond. One type of a bond is a convertible bond that entitles the
bondholder to convert the bonds into shares of the issuing company to exploit favorable
movements in the share price. (Choudhry 2010, 3, 5–6.)
2.2.3
Exchange versus over-the-counter bonds
Securities can be traded via established exchanges where transactions are completed
through a centralized source that acts as a mediator to connect buyers and sellers, or
over-the-counter (OTC), through decentralized mechanism which means that the trades
are negotiated directly between buyers and sellers (Over-the counter versus exchange
20
traded bonds). Exchange removes counterparty risk because it is always on the other
side of all trades since the buyer is not buying from the seller directly, but through the
stock exchange. Since all the trades flow through one central place, the price quotes are
always the same, regardless of who is making the trade. Exchange also provides a secure environment for investors since only listed products can be traded on the exchange.
In the OTC markets, in contrast, there is no centralized exchange and little regulation
which leads to heavy competition between different providers. OTC market is exposed
to counterparty risk because parties are dealing directly with each other. Prices might
also vary from trade to trade, and this means that the deals are not always executed at
the best price. (Secondary market: exchanges vs. OTC market.)
Exchange traded markets offer access to broad array of assets, however, only a limited number of fixed income securities are traded in the exchange. Especially, trading
frequency in the nongovernment bond market is usually low and trading costs high, and
therefore, the nongovernment bonds are usually traded over-the-counter rather than in
exchanges. Since most of the bonds are traded over the counter, brokers are the exchange mechanism. Investors will have to contact a fixed income broker to be able to
buy and sell bonds, and this usually keeps the price transparency low in the bond market. (Batten et al. 2004, 41–44.)
Although corporate bonds are not traded electronically on exchanges, but rather in
the OTC market, they can still be listed in exchanges. This means that the issuers of the
bonds are facing tighter regulations on what kind of information has to be made available to the investors because as a part of the listing process the company is subjected to a
duty of disclosure. As a result of listing the bonds can gain access to a bigger investment base since a number of investors will only invest in bonds that are listed. Investors
feel that listed bonds are more secure than unlisted ones. Listing can guarantee greater
flexibility, transparency, and liquidity for the investors, and this might be a crucial factor, at least, regarding international investors. (Issuing corporate bonds in Oslo – an efficient, flexible and mature market for raising debt capital, 6–10.)
2.2.4
International versus domestic bonds
Bonds can be offered to domestic investors or international investors. Domestic corporate bond market is composed of all the bonds that are issued by corporations which are
located in the country where the bonds are traded. International bond market consists of
the Eurobond market and foreign bond market. Eurobonds are bonds that are issued in a
currency, other than the currency of the country in which they are issued. The name
Eurobond does not refer to the European bond markets, or Euro as a currency. Eurobonds are usually issued in more than one country and traded across international finan-
21
cial centers. These kinds of bonds are usually issued by large supranational organizations. Foreign bonds, in turn, are bonds issued by those who do not reside in the country
in which the bonds are issued. Foreign bonds are issued in the host country’s currency,
and this makes them desirable investment targets for the host country’s investors since
they can add foreign content to their portfolio, without the currency risk. Regulators
usually make difference between domestic and foreign issuers, and may have different
requirements for these two. (Types of bonds: Overview – the European and global bond
markets.)
International bonds can also simply mean bonds of foreign currency issued by an international corporation. When investing in foreign bonds, investors have to be prepared
to bear greater risks. For one thing, international investments involve currency risk. If a
foreign currency goes down, the investment could be negatively affected. In addition, if
the investor is not a citizen of the country in which the company does business, the investor has no legal right to get his or her money back if the company goes bankrupt.
This adds considerably the risk associated to international investing. (International
bonds vs domestic bonds.)
2.3 Issuing and trading of bonds
2.3.1
Corporate bond market participants
The corporate bond market is based on two parties – one is in need of money and the
other in need of a suitable investment opportunity. The ones in need of money are the
companies issuing the bonds and the ones lending the money are the investors. The
bond market can be divided into two, based on what kind of investors the bonds are
targeted to. The so called wholesale market is tailored for large, institutional investors,
whereas the so called retail market is meant for the smaller, individual, private investors. Institutional investors are bigger players in the corporate bond market and invest in
bonds more than private investors in terms of money and quantity. The bond issuers
actually decide to whom the issuance is directed to when they determine the denomination of the bond. If the face value is hundreds of thousands, the bond is clearly directed
to institutional investors, whereas a bond with face value of one thousand is rather targeted to private investors. Of course, there can be rich private investors that are able to
buy any kinds of bonds in spite of the denomination. In retail bonds the disclosure requirements are also tighter in order to protect the private investors. (Bond market transparency - wholesale & retail.)
22
In addition, the institutional investors can be divided based on their investment horizon. Short-term institutional investors, e.g. banks, central banks, or treasury desks of
corporates, are driven by short-term investment views and the total return on their investments, whereas long-term institutional investors, e.g. pension funds’, mutual funds’,
and life assurance companies’ investment horizon is long-term and reflects the nature of
their liabilities. (Choudhry 2010, 7.)
As mentioned before, brokers also have a very important role regarding the bond
markets. Since the trades are made OTC, brokers are the ones connecting the buyers and
the sellers together. The broker’s role as an intermediary in the secondary market is so
significant that they can have a major influence on the markets’ functioning.
2.3.2
Primary market
New securities are issued in the primary market. When the board of directors decides to
offer a bond issue, they usually hire an investment banker to take care of the issue. The
investment banker acts as an underwriter in a primary offering. He may act as either
principal or agent. As a principal, the investment banker purchases the issue from the
firm and resells it to the public, while carrying the final responsibility of selling the securities. Regardless of the success of the issue, the underwriter must pay the full contracted price to the issuer. Generally, companies that have proven before that their
bonds sell are the ones who can get such arrangement. When acting as an agent the investment banking firm does not buy the issue itself but tries to resell the bonds to outside investors. As an agent, the investment banker is only committed to sell as much of
the issue as possible. It has no financial responsibility for the part that has not been distributed. The fees are lower since the risk is also lower when acting as an agent than as a
principal. Small corporations with little or no track record have to settle for this kind of
arrangement. Sometimes an all-or-none offering can be made which means that if the
entire offering is not sold, then none of it will be. Another possibility is for the investment banker to act as a standby. In this case the present holders are given a right to purchase portions of the new issue within a fixed period of time before the issue may be
offered to public. After the rights period has expired the underwriter acts as a principal
and agrees to buy and distribute the leftover bonds. (Zipf 1996, 118, 122–123).
After the investment bank and the company have come up with a plan of what kind
of bond to issue, the issuing process starts by drawing up legal loan documents. Since
the bonds are eventually intended to be traded on the secondary market, a master loan
agreement of the issue has to be written. This agreement between the issuer and the investor is called the bond indenture, or deed of trust, and it has to contain all the information agreed on. The most important features of a bond indenture are: loan amount,
23
rate of interest, schedule of interest payments, date of maturity, call feature, if any, put
feature, if any, refunding possibility, and collateral. (Zipf 1996, 3–4.)
Next, the company has to decide whether to list the bond or not. Listing of bonds depends usually on the investor requirements. If the bond is not listed, an information
memorandum will still be drawn up for the investors. After this the company will go
public with the issue and hold a roadshow to find possible investors and to promote the
bond. The issuance process, for example in Norway, usually takes from 2–6 weeks.
However, this is said to be faster than in other markets on average. (Hamre Øyvind
2012.)
2.3.3
Secondary market
After the securities have been issued, they can be traded in the secondary market. In the
secondary market the bonds are traded between third parties who would not generally
take part in the primary market transaction. In this sense, bonds differ from commercial
bank loans which are usually seen as non-tradable in the secondary market. Although,
this does not hold entirely true since there is a thriving secondary market for at least US
dollar and pound sterling commercial bank loans at the same time. However, the commercial bank loan market is separated from the bond market and is not as liquid as the
latter one. Therefore it is fair to say, that it is a special feature of a bond that it can be
traded in the secondary market, and that it is, in fact, tended to be bought and sold.
(Choudhry 2010, 3.)
Bonds can be traded in exchanges or over-the-counter (OTC) as mentioned previously. More often trading takes place as an OTC transaction, where the potential bond buyer or seller cannot observe quotes on a centralized or electronic exchange. In this case
the investor must call one or more dealers for quotes or have an access to the list of
broadcast bonds that are trading from various dealers through electronic platforms. Usually, only institutional investors have an access to these kinds of electronic platforms.
(Hartzmark, Schipani & Seyhun 2011, 9–10.) L
Liquidity of the secondary market is a crucial factor towards functioning bond markets because investors have to be able to liquidate their holdings in reasonable time
without major costs. OTC-trading diminishes the level of transparency, whereas, instruments that are traded on electronic platforms allow better price transparency and
availability of market data. (Batten et al. 2004, 41–44.) However, illiquidity and enormous number of different bonds make it almost impossible for the trading to take place
in electronic platforms, and for this reason the bond markets have to be made as efficient as possible under the existing limitations.
24
2.4 Pricing of bonds
Bond prices are determined by the present value of the expected future cash flows they
generate. More specifically, the price of a bond can be determined by future cash flows,
which include coupon payments and principal value, periodic rate of interest, and number of periods that the amount is invested.
∑(
(
)
(
)
)
P = price
n = number of periods until maturity
C = coupon payments
r = interest rate
M = principal value
t = time period when the coupon is to be received
The present value, or price, can be determined by discounting the future value. The
future value includes coupon payments and the principal payment at maturity. The discount factor is determined by the interest rate and number of periods. Equation applies
to plain vanilla bonds – in other words, to investments earning annual interest payments.
If the interest payments are semi-annual or even more frequent, the formula has to be
modified. All in all, the equation gives the present value of a known future sum.
(Choudhry 2010, 13, Fabozzi 2000, 20.)
Many different factors affect corporate bond prices, like the issuer’s ability to make
interest and principal payments, and the fact how the bond is collateralized. Merton
(1974, 449) lists three factors that affect the value of corporate debt: 1) the required rate
of return on riskless debt (e.g. government bonds), 2) the various provisions contained
in the indenture (e.g. maturity, coupon rate, call terms, and seniority in the event of default), and 3) the probability that the issuer will not able to meet all the indenture requirements, in other words the probability of default.
As companion, Hartzmark et al. (2011, 12) add some other components to bond pricing. They argue that the possible liquidation rate, in case of a bankruptcy, affects bond
prices in addition to the tax consideration of the bond payments. The probability of being able to sell the bond in a liquid market has to be taken into consideration in the pricing process too. Despite all these various factors, the most important component that
affects bond prices across-the-board, and is also introduced in the simplest model of
bond pricing above, is the interest rate. (Zipf 1996, 8–10.)
25
2.4.1
Interest rate and duration
Interest rates fluctuate, and cause changes in the value of bonds. If interest rates go up,
the values of outstanding bonds start to go down. Bond prices react to the same factors
as interest rates. These factors are: 1) business cycle, 2) inflation, and 3) flow of funds.
Business cycle means that when economy picks up, borrowers start competing for diminished funds and ask for more money to roll their companies. There is a bigger demand for money, so the cost of money increases, and interest rates go up. If the bond
market wants to attract money, yields must also rise. Inflation, in turn, means that costs
of goods rise, which causes losses in purchasing power. Lenders want to compensate
this loss by increasing interest rates, and the borrowers are willing to pay the higher
rates since they expect higher returns due to higher prices. Therefore, most economists
agree on higher inflation also meaning higher interest rates. Finally, flow of funds refers
to capital flowing through the economy, and it has an impact on interest rates. Economists usually try to analyze the flow of funds, and protect future borrowing because if
they can gauge the supply side and demand side, they can possibly forecast the future
interest rates side by side. (Zipf 1996, 10.)
Duration is a measure of price sensitivity to interest rates in the bond market. In other
words, it tells the investors how much prices change in response to a change in interest
rates. Duration is expressed in a number of years. The bigger the duration is, the greater
the interest rate risk, which also refers to greater rate of return. (Choudhry 2010, 77.)
Although, interest rate fluctuation is a very important factor in bond pricing, another
important factor in pricing, especially, of corporate bonds is the creditworthiness of the
issuer. Credit ratings are one way for the investor to find out about the company’s ability to repay the loan.
2.4.2
Credit ratings
The investor has to take into consideration the risk that the issuer might not be able to
make interest payments or ultimately repay the principal of the bond at the maturity. In
assessing the creditworthiness of a company, investors can utilize credit ratings. Credit
ratings mean that bonds are rated in order to indicate corporation’s ability to make repayments of the loan. Bond rating is an estimate of the current quality of the company
issuing the bond. A highly rated bond is less risky and commands a lower interest rate
than a lower rated bond. Although, the rating exercise involves a credit analysis of the
issuer, one also has to keep in mind, that the rating may actually only be applied to a
specific debt instrument, instead of the whole company. (Choudhry 2006.)
26
Bonds are rated by bond-rating agencies. In the international markets the two most
influential rating agencies are Standard & Poors Corporation and Moody’s Investors
Service, Inc, both based in the USA. In addition, FitchIBCA is another influential rating
agency. (Choudhry 2006, 105.) Bonds can also be rated by parties such as the credit
research staffs of securities firms (Fabozzi 2000, 7). In the 1960s, the rating agencies
did not charge a fee for their rating services. After that, however, the agencies have
started to charge a fee, and nowadays everybody has to pay to get their bonds rated.
Rating agency has a critical role in determining the interest expenses of the company.
Different agencies might not always see eye to eye about the company’s creditworthiness, so the company really has to think through which agency to turn to. (Zipf 1996,
132.) Ratings go from triple-A, being the best, all the way to D, meaning a high risk of
default. However, different agencies use slightly different letter and symbol combinations in their ratings.
27
Table 1 Summary of credit rating agency bond ratings (Choudhry 2006, 109)
Bonds that have a better credit rating are called investment-grade bonds, whereas,
bonds with lower credit ratings are called high-yield bonds. The high-yield bonds pay a
higher yield to compensate the higher risk of default. Usually the high-yield bonds have
credit ratings below BBB or Baa3. (Choudhry 2006, 102.) Nowadays the high-yield
market has become more popular, since investors have an incentive to take risks in
search of higher returns, and the high-yield bonds make it possible for investors to gain
higher profits also in the fixed income markets. (High yield bonds: an appetite for junk.)
28
Credit ratings are provided to benefit investors; however, it is also in the issuer’s interest to request a rating, because it raises the profile of the issuing company and its
bonds. This is why issuers are also willing to bear the costs caused by the rating process. Although, getting a credit rating may be a blessing for the company, it can be also
harmful, since the rating for an issue is kept constantly under review. If the credit quality is predicted to decline, the rating will be also changed accordingly. The agency may
announce that it is putting the issue under credit watch, and the outcome of a credit
watch is in most cases a rating downgrade. When an agency announces that an issue is
under a credit watch, the price of the bond will fall in the market as the investors are
eager to sell their holdings. (Choudhry 2006, 107.)
Not all bonds are rated, and likewise there is a whole market for unrated bonds. The
Nordic market is especially known for being a non-rated or shadow rated market. The
issue sizes in the Nordic market are so small that it would be too expensive to obtain an
official rating. Nevertheless, a shadow rating can be made but this means that the third
party making the rating does not officially have the authority to rate bonds. It just shares
its views about the company although the rating is not necessarily entirely valid. However, the Nordic market mainly lacks official ratings; it still functions well because the
Nordic investors have generally a wider acceptance of non-rated papers compared with
their European counterparties. This is due to the fact that the unrated companies are
well-known in their own countries, and investors might be able to rely on the
knowledge the domestic markets have about these companies without any ratings.
(Nordic high yield update 2014, 9.)
2.5 Bond yield
2.5.1
Price-yield relationship
Yield and price of a bond are closely related to each other. Yield describes the percentage amount that returns to the owner from a security. The yield of a security is the discount rate that will make present value of its cash flows equal to its initial price. The
yield of a bond can be calculated given its price. Specifically, the price-yield relationship works so that price and yield move in the opposite directions. When yield increases, the present value of the cash flow decreases, and vice versa, if the yield decreases
the price of the bond rises.
Price
29
p
y
Yield
Figure 3 The price-yield relationship (Choudhry 2010, 22)
In a market with number of different kind of bonds with different issuers, coupons,
and terms to maturity, it is actually the yields that are compared, and not the prices. This
is because bond prices do not really tell anything about the money the investor will be
getting. (Choudhry 2010, 23.)
2.5.2
Nominal yield, current yield, and yield to maturity
There are three basic types on yield: nominal yield (or coupon yield), current yield, and
yield to maturity (YTM). Nominal yield is the percentage rate that you get by dividing
the coupon with the face value of the bond. Because the coupon or the principal do not
change for the term of the loan, the coupon yield does not change either. Current yield is
the coupon divided by the current value, in other words, the spot market price of the
bond. If the bond’s spot price is less than its principal value, the bond is said to be selling at a discount which means the current yield is greater than the nominal yield. In the
opposite situation, when the bond is selling for more than its face value, it is selling at a
premium, and the current yield is less than the nominal yield. If the bond is trading at
par, it means that its coupon will equal the yield that the market requires. Bonds can be
sold for more or less of their par values, because of fluctuating interest rates. If interest
rates go up, the price of a bond will fall, which means that the yield will also go up. The
difference between current yield and yield to maturity is that current yield does not take
into account the difference between the purchase price and the principal repayment at
the maturity. If the bond is selling at a discount, the difference between the face value
and the purchase price divided by the number of years to maturity, also known as the
prorated discount, has to be added to the calculation, so that the yield to maturity in-
30
creases, whereas, if the bond is selling at a premium, the prorated premium has to be
subtracted from the calculation, so that the yield to maturity decreases.

Bond selling at a discount:
(

)
Bond selling at a premium:
(
)
Yield to maturity is the most realistic of these three yield models, and it is used by
investors to compare bonds with different coupon rates and terms to maturity. (Zipf
1996, 5–8.) The model is, however, only close to reality. YTM is closest to reality when
the investors buys the bond on first issue at par and holds it to maturity. Even, then the
YTM would be different from the actual realized yield at maturity. For the YTM to hold
true, the investor would have to invest all the coupons during the bond’s life at the same
yield to maturity rate. Yet, it is very unlikely that the coupons will be reinvested at the
same rate since market interest rates are in a constant flux, and for this reason the YTM
does not reflect the reality entirely. (Choudhry 2010, 30).
2.5.3
Yield curve
A great deal of the analyses and pricing that is done in the bond market revolves around
the yield curve. The yield curve describes the relation between YTM and bond’s maturity, and it is a portrayal of bond market rates over time (Choudhry 2010, 42). The yield
curve reflects all the buying and selling in the market, and demonstrates how much
market participants are willing to pay for debt instruments with different maturities. The
yield curve is also known as the indifference curve, since it shows that the market is
indifferent with different yields at different maturities. A normal yield curve is upward
sloping, and it reflects higher future rates. The short term securities have a greater li-
31
quidity, and investors attach greater value to these securities because they are closer to
Yield
cash according to liquidity preference theory. If the yield curve was horizontal, there
would be a buying pressure on the short-term side and selling pressure on the long-term
side.
short-term intermediate-term long-term
Maturity
Figure 4 A normal yield curve (Zipf 1996, 15)
Prices become more volatile as the term to maturity increases, and to reflect this risk,
the prices of longer-term securities tend to be lower than those of shorter-term securities. Since lower bond prices have greater yield to maturity, as shown in figure 3, longer-term maturities are related to higher YTMs. However, a yield curve can also be
downward sloping if the future rates are expected to decrease. Yield curve combines
price, yield, liquidity, and risk into one model, and gives a great tool for investors to
understand the bond markets. Investors must be able to “ride the yield curve”, in other
words, to buy and sell securities with different maturities to obtain the greatest total of
return. (Zipf 1996, 13–18.)
2.6 Utility functions and bond market risks
2.6.1
Utility functions
The investors have to choose between safe bet and high profit because they cannot have
both. How much risk the investors are willing to take depends on their utility of money.
Utility function illustrates the relation between money and perceived value of money.
32
There are three different attitudes towards money among investors: risk averse, risk
Wealth
Risk neutral
Utility
Risk averse
Utility
Utility
neutral, and risk seeking.
Risk seeking
Wealth
Wealth
Figure 5 Three attitudes towards risk (adjusted Katz & Rosen 1998, 167–169)
Decreased marginal utility means that each additional unit of wealth increases utility
by a smaller amount. As a consequence, risk averse investors have decreasing marginal
utility, and they value certain outcomes over uncertain ones. Even though, the bet would
be fair, a risk averse investors will reject the bet because of the uncertainty it creates.
Risk neutral investors are indifferent between certain and uncertain alternatives as long
as they have the same expected value, whereas, risk seeking investors pursue for risky
investments because of the increasing marginal utility. They prefer an uncertain prospect with a particular expected value to certainty with the same expected value. Modern financial and economic theory states that if a person is faced with uncertainty he or
she should base his or her decision on expected utility. Investors have to first choose
what their utility function looks like and then make decisions based on that function.
(Katz & Rosen 1998, 167–168.)
2.6.2
Market risk
Market risk refers to the uncertainty of asset’s price when it is sold. Market risk arises
from movements in financial market prices. There are different factors that affect the
prices, but with bond markets there are especially two risks that are relevant:

Currency risk – this risk arises from exposure to movements in foreign exchange rates. If the bond is foreign, it’s usually issued in different currency,
and the investor is exposed to a currency risk.
33

Interest rate risk – one of the biggest risks associated to bond markets is the interest rate risk. The basic risk arises from revaluation of the asset after the interest rates have changed. Interest rate risk means that the outstanding bond issue starts to lose its value due to rising interest rates, as mentioned before. The
prices of longer-term bonds response to the same interest rate fluctuation more
than the prices of shorter-term bonds. That is, the shorter the term to maturity,
the less volatile the security is. (Choudhry 2013, 3–5.)
2.6.3
Reinvestment risk
Since all the other bonds, except for the zero-coupon bond, make payments before the
maturity of a bond, the cash flows received will have to be reinvested. There is always a
danger that the coupons will have to be reinvested with lower rate than what the funds
were previously earning. Odds for the same rate are very slim, which means that when
the asset is purchased, the final cash flow is uncertain. Reinvestment risk is greater for
longer holding periods, and for bonds with larger early coupons. (Choudhry 2013, 3–5.)
It is noteworthy that interest rate risk and reinvestment risk have offsetting effects.
Interest rate risk is the risk that interest rates will rise, whereas, reinvestment risk is the
risk that interest rates will fall. (Fabozzi 2000, 6.)
2.6.4
Call risk
As mentioned before, callable feature allows issuer to hedge oneself against interest rate
downturn. If there is a call option added to the bond, the issuer has the right to redeem
the bond prior to maturity. The issuer benefits from doing this, whereas the investor is
left with a pile of cash, and might not be able to reinvest it at a comparable rate. For this
reason, the reinvestment risk is greater in callable bonds, and therefore they generate a
higher yield than bonds that are not callable.
However, the cash flow pattern of a callable bond is not known beforehand with certainty, and it is hard to determine the sufficient compensation for this risk. Returns from
callable bonds can be dramatically different from those otherwise comparable noncallable bonds, and this is why some market participants consider it the second greatest
risk in the bond market right after the interest rate risk. (Fabozzi 2000, 6–7.)
34
2.6.5
Inflation risk
Every time an investor attaches his money to a fixed income asset, there is a risk that
future inflation will be greater than the income from the investment. Investor will receive a certain coupon payment from the asset until the maturity date. In the meantime,
if the inflation increases dramatically, and becomes more than what the coupon rate is
said to be in the bond indenture, investor loses his purchasing power, and may actually
receive a negative rate of return.
Inflation is related to investment rates and depends mostly on its movements. Investor has a way to protect himself against the negative rate of return, and this is the put
option. Investor can return the bond to the issuer before maturity, and invest the money
into more profitable assets to fight against inflation. (Fabozzi 2000, 7.)
2.6.6
Liquidity risk
In the bond markets liquidity risk is a highly considerable factor, since the markets are
not established enough. This a problem especially in the corporate bond markets in Europe. Liquidity risk means that the markets are too thin, with too few buyers and sellers,
to enable fair and efficient trading to take place. This leads to the fact that assets cannot
be sold and bought at any time, and the price may not correspond to previously discovered fair value. One measure of liquidity is the size of the bid-ask spread, meaning the
difference between the bid price and the ask price quoted by a dealer. The wider the
dealer spread is, the greater the liquidity risk is. When the markets are thin, a seller may
be forced to take a much lower price than expected to be able to execute a trade. Furthermore, if there are very few participants in the market, the asset may not be sold at
all. For an investor who plans to hold on to the bond until the maturity, there is no liquidity risk. (Choudhry 2013, 3–5; Fabozzi 2000, 8.)
Liquidity has a great deal to do with the market place. In some countries the corporate bond market is more established than in others and the liquidity is also greater in
these well-established markets. The fact, that corporate bond market is an OTC-market
has a harmful effect to liquidity. If corporate bonds were traded in exchanges, the markets would be more transparent and prices would be easy to detect. However, since the
trades are executed as OTC-trades they have a low transparency, which also has a negative impact to liquidity of the asset.
35
2.6.7
Credit risk
Credit risk refers to the risk that the issuer will default and not be able to meet the repayment terms of the bond. Credit risk is something the investor has to keep in mind,
especially, when dealing with corporate bonds. Corporate bonds have usually a higher
risk of default than government bonds, which are backed by taxing power. For this reason the corporate bond holders are compensated with a higher yield. The higher yield
reflects higher probability of default, and expected loss in the case of default.
(Choudhry 2013, 3–5.)
Corporate bonds and their credit risks can be analyzed by assessing companies’ incoming cash flows, and weighing that against companies’ debt expenses. The greater
the coverage is, the safer the investment. Collateral is also affiliated with companies’
credibility. If the investment has a big credit risk, the issuer has to pledge tangible or
intangible assets as collateral. Credit ratings are also usually required due to default risk.
The high-yield bonds with lower credit ratings have greater risk of default, as mentioned earlier.
2.6.8
Rating downgrade risk
The rating downgrade risk is associated with changes in the credit risk since the company’s impaired situation will have an effect to the credit ratings. If company’s credit ratings are downgraded, investors will take notice and charge the company a higher interest rate for future loans.
The existing bondholders will suffer from this situation since the rate of return in
their bond indenture is not as high as it should be considering the lower credit rating. If
current bondholders would like to sell the bond, they might have to sell it with lower
price and they would lose money in the trade. As we can see, the rating downgrades will
have an immediate impact on the value of the bond. (Types of bonds – what are the
risks?; Fabozzi 2000, 7.)
36
3
CORPORATE BOND MARKET EFFICIENCY
Bond market efficiency is less studied than stock market efficiency, and for that reason
also less understood. Some of the same factors used to analyze stock market efficiency
can be used in bond market analysis; however, there are also many differences because
of the specific features of the bond market. Efficient markets require an adequate level
of transparency and liquidity. Transparency is needed to find out what kinds of securities are offered in the market and at what price. Transparency also creates trust between
market participants. Liquidity, correspondingly, is needed in the execution of a trade at
a reasonable price level within a reasonable amount of time. A seller needs to find a
buyer, or otherwise there will be no trade.
3.1 Differences between bond market efficiency and stock market efficiency
Fama (1970, 383) introduced a model of market efficiency in 1970 that was tested in the
stock market. Fama argued that in efficient markets the prices fully reflect all available
information and provide accurate signals for resource allocation. Firms can make investment decisions and investors can choose the securities they want to invest in with
confidence since all the information available is reflected in the market. Fama tested the
market with weak form tests, semi-strong form tests, and strong form tests to find out
the level on efficiency in the market. In these three forms market prices are affected by
different kind of information. 1) In the weak form, traded assets reflect all past publicly
available information, which basically means that future prices cannot be predicted by
analyzing historical prices. 2) In the semi-strong form, prices efficiently adjust to also
other kind of information that is publicly available, e.g. announcements of annual earnings and stock splits, so that no excess returns can be earned based on that. 3) Finally, in
the strong form, the question is whether some investors have a monopolistic access to
any kind of information that is relevant in price formation. In other words, the market is
strong if no-one can earn excess returns by hidden or insider information. Although,
some like corporate insiders and specialists might have more information about the
markets than others, it is still a minor group of people, and for the most investors the
efficient market model seems like a good approximation of the reality. (Fama 1970,
383.)
There are also other studies that are not as well-known as Fama’s market efficiency,
but can be still brought up as an example of what stock market efficiency means. For
example, according to Black (1971, 34–35) stock market efficiency means that:
37

The costs of trading should be low, and an investor who knows what he wants
should have a direct access to the market, without going through a salesman.

The trading should be continuous, so that an investor who wants to buy or sell
should be able to do so immediately.

The trading should be fair so that small and large investors are treated equally.

The price should also follow a random walk, so that series of movements in
one direction should be followed by movements as often in opposite direction.
Bond market efficiency is not well understood probably because it is much less studied than stock market efficiency. Fama’s (1970) and Black’s (1971) definitions of efficiency were created for the stock market and for that reason cannot be entirely implemented in the bond market. Of course, some of the factors used to analyze stock market
efficiency can also be used in bond market efficiency analysis. (Hartzmark, Schipani &
Seyhun 2011, 1.)
Despite the fact, that similarities can be found, bond market efficiency still differs
significantly from stock market efficiency. First of all, the characteristics of bonds attract certain kind of investors e.g. pension funds and insurance companies and these
investors tend to follow a buy-and-hold strategy. This limits the activity in the secondary market and reduces liquidity. The institutional investors might also get treated differently than the private investors since they are much bigger players in the market than
the private investors, which is against Black’s (1971) ideas of market efficiency. Secondly, it is difficult to short sell bonds, at least in Europe. This reduces liquidity in the
market – when there is no additional buying and selling in the market, the difference
between bid and ask prices do not narrow, and the overall efficiency will not be increased by quickening price adjustments. Thirdly, stock market activity is concentrated
in relatively small number of securities which are traded frequently every day. In contrast, the bond market is much less concentrated and in the bond market trading is
spread across thousands of securities. In the stock market, large operators have an interest in the most active securities whereas in the bond market large operators have only
interest in a subset of securities. This makes it a lot more difficult to identify counterparty in the bond market than in the stock market. (Biais, Declerck, Dow, Portes & von
Thadden 2006, 28.) This means that market participants cannot have a direct access to
the markets without going through a broker, the trading is not necessarily continuous,
because it is hard to find buyers and sellers and the prices do not necessarily follow a
random walk since different market participants have the ability to affect the prices.
Accordingly, neither in this sense, do Black’s (1971) criteria on market efficiency apply
to the bond markets.
38
3.2 Market transparency
In a transparent market people know what kind of products are available, how much
they cost and where they can be bought. In other words, market is transparent if all information is available to all market participants. In an open and developed securities
market information has to be available regarding of the company and its business. Market transparency is a huge factor in market efficiency, because markets have to be transparent in order to be efficient. Transparency creates trust between market participants
and without trust there can be no transaction. (Ross 1973.)
One basic aspect of transparency is the principal-agent problem. The issuer of the
bond might be misusing the funds loaned to them unless there is a sufficient amount of
information in the market. Therefore, monitoring becomes extremely important so that
the investors can be sure that the loan terms are followed as agreed.
There are two kinds of forms of transparency in the market: pre-trade transparency
and post-trade transparency (Bessembinder, Maxwell & Venkataraman 2007, 256).
Market transparency has been a subject of many studies, but the researches have not
come to a conclusion on whether increased transparency really enhances the market
quality or whether the markets were better off with less transparency (Bessembinder et
al. 2007, 252).
3.2.1
Principal-agent problem and monitoring
All contractual agreements in the market contain elements of a principal-agent relationship, where one is designated to act on behalf of the other. The former one is called the
agent whereas the latter one is known as the principal. These two parties might have
opposite objectives, since both are only looking after their own interests. This might
create conflicts of interest and problems of moral hazard. Moral hazard is known as a
situation where an agent has the tendency to take risks more easily since he is aware that
the potential costs will be born by someone else. There is a possibility for moral hazard
in markets with information asymmetry, where one party has more information than the
other. The party with more information is the one insulated from costs of the risk and
the party with less information will be paying for the negative consequences. (Ross
1973.)
In the bond market the issuer is the agent taking care of investor’s, also known as the
principal’s, money. If the market is not transparent enough, the issuer has the possibility
to misuse the investor’s trust and fail in putting the money to good use so it can be returned to the investor as agreed. Excessively great risks can be taken, which might lead
39
to disastrous results, and this is why market unquestionably has to be transparent in order to function at all.
Monitoring can be seen as a way of reducing informational asymmetries between investors and issuers – the investors have to be sure that the terms and conditions of a loan
agreement will be followed. There are many ways to cover ones backs and the investors
should be utilizing these opportunities as much as possible. A lot has to do with how the
market has been organized, but the more safety the investors require the more measures
will be actually taken. Monitoring costs always a lot of money and requires resources,
so the measures should be made as efficient as possible to lower the expenses. (Tirole
2006, 331–354.)
3.2.2
Pre-trade and post-trade transparency
Transparency can be divided into two: pre-trade transparency and post-trade transparency. Pre-trade transparency refers to information received on the prices and volumes in
the market prior the trade. This can entail information about quotations or other indications of trading interest, such as unexecuted orders. Information in this case can be indicative or firm. Post-trade transparency, in contrast, refers to information about prices
and volumes of trades that have already been executed. (Bessembinder et al. 2007, 256.)
The amount of pre-trade and post-trade information can vary significantly depending on
the market. There is a difference in what kind of information is available. Some markets, such as equity markets, tend to have much greater transparency than bond markets.
Retail markets are also usually expected to have greater transparency than wholesale
markets. There are also differences in how frequently the information is made available
– it can be made available on a real-time basis, or on a delayed basis. (Bond market
transparency - wholesale & retail.) Markets that disseminate little or no price data are
known as opaque markets. This means that the markets are non-transparent, and information is available to only some market participants. (Bessembinder et al. 2007, 256).
González-Páramo (2007), a member of executive board of the European Central
Bank (ECB), points out that bonds are normally traded outside regulated markets or
exchanges and therefore bond markets are generally less transparent than equity markets. Infrequently traded corporate bonds are less suitable for trading on multilateral
trading facilities, which often publish transaction data. Corporate bond market has traditionally been opaque, with quotations available to only few market participants. Usually
there is no public transaction reporting either, but trades are traditionally only reported
to the parties involved, which makes it impossible for investors to compare their own
execution prices to other’s transaction prices. Little information has been available to
institutional investors through a Bloomberg messaging system, but individual investors
40
have been precluded from accessing all real-time market information. (Bessembinder et
al. 2007, 252, 257).
González-Páramo (2007) adds that fortunately pre-trade transparency level has become adequately high, due to technology improvements and competitive forces even
without regulation. However, post-trade transparency has stayed on an alarmingly low
level, and needs to be regulated. In many countries, like the United States, there are regulatory requirements for reporting transactions data to a reporting system to make the
post-trade transparency higher. Program developed in the United States is called the
TRACE (Trade Reporting and Compliance Engine Transparency), and dealers all over
the country are required to report all corporate bond transactions to the TRACE system.
TRACE became mandatory already in 2002. (Bessembinder et al. 2007, 257.)
Importance of the publication of pre-trade and post-trade information has also been
noticed in the European Union, and the ECB has come up with its own system of reporting bond transactions. The Markets in Financial Instruments Directive, also known as
MiFID, is a European Union law that provides harmonized regulation across member
states. Primary objective of MiFID I is to increase competition and improve investor
protection. MiFID was introduced in 2004, and came into force in Finland in 2007. MiFID II, released in 2011, continues where MiFID I has left, and tries to address issues
raised by the financial crisis by improving transparency and regulation of more opaque
markets, like the bond market. MiFID II has not been implemented yet by the member
states, but implementation will most likely happen in 2015. One of MiFID II’s aims is
to launch a European version of the American TRACE system which is a program that
allows reporting of OTC-transactions in fixed-income securities. This program would
allow an improved transaction reporting, and ultimately enhance transparency in the
market. (Executive summary of the impact assessment 2011.)
3.2.3
Impacts of transparency
Market transparency has been a subject of many studies, but neither the theoretical predictions nor the empirical evidence is conclusive as to whether increased transparency
really enhances the market quality (Bessembinder et al. 2007, 252). TRACE system in
the United States, and bond market quality, after and before the TRACE, has been a
subject of many studies. Although, González-Páramo (2007) argues that the studies of
regulated reporting system have shown only positive impacts on market liquidity, this is
not entirely true. In fact, the previous literature makes mixed predictions on the effect of
increased transparency on transaction costs and liquidity.
Some argue that better price transparency in the bond market will facilitate better detection of fraud and even act as a deterrent. Better transparency will also improve pric-
41
ing efficiency and competition in the bond market, which will ultimately lead to lower
transaction costs. However, at the same time, others claim that greater transparency increases dealer’s costs of providing liquidity. This will lead to lower dealer participation,
less competition, less liquidity, and finally higher transaction costs, and in fact, hinder
the market efficiency. (Edwards, Harris & Piwowar 2007, 3–4.) For instance, Bloomfield and O’Hara (2000) point out that, low-transparency dealers are able to outdo their
more transparent counterparts in many different dimensions, including profitability.
Furthermore, low-transparency dealers are able to set prices more efficiently, since they
have an increased aggressiveness to attract order flow, and a following ability to reduce
their losses due to adverse selection.
However, Bloomfield and O’Hara (1999) also show that dealers earn higher profits
on markets in which all dealers are transparent than in markets where all dealers are
low-transparent. Therefore, all dealers would be better off if the markets were transparent, but since one cannot trust everybody to work for increased transparency, dealers
choose to defect to low-transparency to secure their own profits. A solution for this social dilemma could be a world where transparency is mandated by regulation, and this is
where the markets are evidently headed to. To strengthen this decision, Edwards, Harris
& Piwowar (2007), Bessembinder, Maxwell & Venkataraman (2007), and Goldstein,
Hotchkiss & Sirri (2006) all show that greater transparency in the bond market leads to
lower transaction costs and greater liquidity.
3.3 Market liquidity
The academic literature considers price transparency to have a substantial effect on liquidity of securities (Edwards et al. 2007, 3). This means that transparency and liquidity
are closely related to each other, and they both have a significant role in creating market
efficiency. There is no standard definition of market liquidity, and academics use a
number of definitions and measures to describe liquidity (Choudhry 2009, 15). Essentially, the general understanding of it is clear, and liquidity can be defined as the ability
to sell a security promptly, with minimal loss of value at any time within market hours
without this transaction causing prices to move in the market (O’Hara 1995). Another
way of describing liquidity is that it is a two-way market made available to market participants, where there is openness in determining assets’ fair value (Choudhry 2009, 16).
This definition brings liquidity again close to the definition of market transparency.
A more concrete way of measuring liquidity is to define the gap between the fundamental value of an asset and the price at which the asset is actually transacted in the
market, also known as the spread. Furthermore, liquidity of a product can be measured
by how often it is bought or sold. This is also called the volume. However, one thing
42
that is undisputable is that liquidity has an effect on the prices and expected returns in
the market, and rational investors require higher returns on assets that have lower market liquidity to compensate the higher costs of trading. (Ericsson & Renault 2006;
2219–2220; Datar, Naik & Radcliffe 1998; Amihud & Mendelson 1986.) Market liquidity is such an important factor that also central authorities desire the maintenance of
liquid markets (Choudhry 2009, 16).
3.3.1
Dimensions of liquidity
Besides efficient markets, Black (1971, 28) describes liquid markets for stocks in the
following manner. The market is liquid if the following conditions apply:

There are always bid and asked prices available for the investor who wants to
buy or sell securities.



The difference between bid and asked prices, in other words the spread, is always small.
An investor, who is buying and selling a large amount of securities can expect
to do so over a long period of time at a price not very different form the current
market price.
An investor can buy or sell a large amount of securities immediately at a pre-
mium or discount – the larger the block the greater the premium or discount.
In other words, market is liquid if it is continuous, in the sense that any amount of
securities can be bought or sold at any time. Liquid market, however, is a market where
small amounts of securities can always be bought or sold very near the current market
price, and large amounts, can be bought or sold near the current market price over a
long period of time or, conversely, bought or sold immediately at a premium or discount. Although, the model has been created to reflect stock market liquidity, it can be
seen as an example for bond market liquidity as well. Nevertheless, in the empirical
analysis it will be discovered that these conditions do not entirely apply to the corporate
bond market because of the limitations of the market.
In addition, European Commission suggests that there are three different factors that
make the bond market efficient: size, depth, and breadth. Size indicates the number of
issuers and investors. Depth can be measured by the units of assets that move the market a given amount when sold or bought. A deep market needs a large order to change
the price of the asset – a deep market is also a liquid market. If the market is deep, there
is a sufficient number of pending orders on the bid and ask side to prevent a large order
to significantly moving the price. The opposite of market depth is the market breadth,
which indicates the price impact per unit that the asset has in the market. If the breadth
indicator is strong, the market will be rising and vice versa. In other words, positive
43
market breadth is a sign of a bullish market. These three factors together enable market
liquidity, which determines the cost and ease of trading and the willingness of people to
participate in the bond market. (Bond Market Integration in the EU.)
Another way of describing liquidity is through four dimensions: width, depth, immediacy, and resiliency. These dimensions are interrelated and most liquidity measures
capture several of these dimensions at once. Width reflects the cost of supplying liquidity versus demanding liquidity. A more liquid security has typically a tighter spread,
meaning smaller width. In other words, width measures how much an investor will have
to increase (or decrease) his bid to obtain immediate execution. Although, width
measures the cost of demanding one unit of liquidity, it does not tell us how much liquidity is available at various price levels and this is where depth comes along. If the
buyers are impatient and they want to buy a large volume rapidly, they usually have to
pay a higher average price than the average price of a smaller batch. Comparing the
depth of the bid and ask sides, it can be noticed that sellers need to change their prices
less to sell a similar batch, than the buyers do. Immediacy aspect of liquidity means how
quickly one can find an opposite side of trading interest. In liquid markets the number
of buyers and sellers is greater, which means that liquid markets are more immediate.
Finally, resiliency captures a very important aspect of the secondary market liquidity.
This dimension is very difficult to measure, but it has been modelled theoretically in
many studies. It tells us how fast after a shock, caused by a large uninformed liquidity
demand, the market spread and the depth will be restored to the pre-trade level. It is
important that the market will return to its equilibrium as quickly as possible. (Harris
1990.)
All these liquidity models have similarities and differences. However, all of these
factors are very important regarding the bond markets. These models show the different
dimensions of liquidity, however, liquidity has to be also measured somehow.
3.3.2
Liquidity measures
There are a range of commonly accepted measures of liquidity that academics and practitioners use, and furthermore, all of these measures are closely related to bond prices.
Yield spread, bid-ask spread, trading volume, liquidity ratio, and observed price error
(OPE) are some of the measures studied in the previous literature and will be introduced
in this study.
Yield spread is the difference in yields between different investments. It is debatable
what causes the yield spread. In the credit risk literature it is assumed that the yield
spread represents default risk, (Chen, Lesmond, & Wei 2007, 145), but for example
Longstaff, Mithal & Neis (2005) estimate that default risk only explains 50 % of the
44
spread between the yields of AAA-rated bonds, and 70 % of the spreads of BBB-rated
bonds. There has to be another factor that simultaneously affects the yield spreads, and
that non-default component is strongly related to measures of bond liquidity. Chen et al.
(2007) make the same observation, and suggest that liquidity is a key determinant in
explaining yield spreads. Furthermore, Sarig & Warga (1989), Warga (1992), and
Crabbe & Turner (1995) argue that liquidity is a likely source of explaining yield
spreads. In some researches taxes have been suggested to have a significant effect on
why similar bonds have might have different mean returns. Warga (1992, 615), however, shows that tax effects are found to be an unlikely source of yield spreads, and liquidity is rather the reason for these spreads.
Bid-ask spread is the difference between the bid price and the ask price of the same
bond. Bid-ask spread is the essence of liquidity since if the bid and ask prices differ
only slightly from each other, the market transaction is more likely to happen. If the bidask spread is significant, the seller might decide to wait. However, there is also a risk in
waiting because the market prices might fall. An important intermediary is the broker,
who tries to make profit on the bid-ask spreads by buying the securities at the ask price
and selling them at the bid price. Broker behavior in this OTC dominated market is not
governed by rules that limit the bid-ask spreads or price changes to minimum or maximum. On the contrary, spreads and prices can adjust endogenously. (Fleming &
Remolona 1999, 1902.) The brokers might buy the securities before they even have a
buyer and this way carry the risk. However, the broker, unsure of the true price of an
illiquid bond, is likely to require a high margin for error. (Sarig & Warga 1989, 370.)
Furthermore, the brokers are likely to use a larger spreads in volatile periods, since in
such periods, uncertainty about a bond’s price, and especially an illiquid bond’s price, is
larger (Garbade & Silber 1976).
Trading volume is an important component of liquidity (Alexander, Edwards & Ferri
2000, 178) and it describes how often trades actually are executed. Annual averages of
daily spot transactions can be computed as well as the dealers’ turnover ratio for bond
transactions. (Kamara 1994, 405.) High trading volume indicates a high level on interest
in a security at its current price. Volume is, however, not a perfect measure of liquidity.
Liquidity is the ability to trade a security quickly with little cost, and volume does not
incorporate the cost of trading. For instance, volume can be high during periods of low
liquidity, and this tends to happen during periods of high risk when transaction costs
have risen. (Alexander et al. 2000, 179.) The trading volume in the OTC-dominated
corporate bond market is hard to detect unless the trades are reported afterwards into a
system, like the TRACE in the US. Transparency in this sense also helps to discover the
level of liquidity as well.
Another widely used measure of liquidity is the liquidity ratio. It is defined as the ratio of average dollar, or any currency, volume of trading to the average price change
45
during an interval. A high value for the ratio indicates that many securities are traded
with little price change and low value suggests that a trader bringing a large block to
market will induce a large adverse price change. Liquidity ratio tells us only about past
average associations between price changes and volumes – it does not tell us about the
critical question of how a sudden arrival of an order larger than average would affect
prices. (Grossman & Miller 1988, 630.)
Difference between a theoretical price of a bond and its actual market price can be
seen as an indicator of market liquidity. The difference between these two prices is
called the observed price error (OPE). A zero-coupon interest rate yield curve can be
derived from the actual market prices. Bond prices calculated from the spot yield curve
represent the correct theoretical price for those bonds. The difference between the theoretical price of the bond and its actual price as observed in the secondary market indicates a mispricing in the market. (Choudhry 2009, 18.) A reduction in the OPE over a
period of time may be considered to be an indicator of increased liquidity (Kalimipalli
& Warga 2002). Ceteris paribus, the more liquid the market the narrower the yield
spread between these two yields. This is due to the fact, that in the liquid markets the
transparency is presumably greater and therefore there is also less mispricing in the
market. In theory, in liquid markets there should be no, or only a small, spread between
the theoretical bond yield and the market-observed bond yield. (Diaz & Skinner 2001,
Brown, In & Fang 2002.)
3.3.3
Macro- and microeconomic effects on liquidity
The liquidity or illiquidity of a bond fluctuates over time. In particular, the market wide
illiquidity increases strongly during market turmoil, e.g., the subprime market crises
starting in August 2007 and the bankruptcy of Lehman Brothers in late 2008. (Bao,
Pang & Wang 2011, 942.) The study of Bao et al. (2011), once again, shows the importance of macro-economic stability in the bond market and its effects to liquidity. The
more stable the markets are the more liquidity there can be expected to be. Fleming et
al. (1999, 1913–1914) examine how liquidity is affected by macroeconomic announcements. Prices adjust sharply to a just released announcement, while trading volume declines. This demonstrates that price responses to public information do not require trading, and furthermore, the moments when prices adjust sharply to public information are
accompanied by a significant disruption of liquidity. The inventory risks become too
great in times of economic turmoil and for this reason the market makers widen or
withdraw their bid and ask quotes.
Microeconomic factors, on the contrary, are related to firm specific or even bond
specific features. Illiquidity of a bond is related to several bond characteristics. Illiquidi-
46
ty increases with its age and maturity, but decreases with its issuance size. (Bao et al.
2011, 941.) Once a bond becomes illiquid, it tends to stay illiquid until it matures and
therefore liquidity of a bond tends to decrease with its age. Because age of a bond and
time to maturity are correlated, it is justified to make a conclusion that illiquid bonds are
more common among long-maturity bonds than short-maturity bonds. (Sarig & Warga
1989, 369.) Alexander et al. (2000) have come to similar conclusions and propose that
volume is positively associated with issue size and negatively associated with age. This
means that larger issues are more liquid and, furthermore, bonds are more liquid for the
first two years after the issuance before they settle into portfolios. They also argue that
bonds issued by private firms, without publicly traded equity, trade more often than
bonds issued by public firms. This might be because the debt of private firms can be
seen as a substitute for equity when equity is not available. Volume is also higher for
bonds with more default risk, which means that, according to this study high-yield
bonds are more liquid than investment-grade bonds.
47
4
COMPARISON BETWEEN THE FINNISH AND THE NORWEGIAN CORPORATE BOND MARKET
The economic structures of Finland and Norway are quite similar but simultaneously
there are many factors that distinguish these two countries from each other. Companies
have been able to utilize the Norwegian corporate bond market efficiently, and Norway
is clearly dominating the Nordic high-yield market. A big part of Norway’s success is
the offshore business which constitutes most of the Norwegian high-yield market but
other factors can also be detected, and these factors are referred to as the Norwegian
specialties.
4.1 Economic structure of the countries
4.1.1
Economic structure of Finland
Finland is a welfare country in which a significant share of the economy consists of
service industries. Private services have become more important but government services are still a big part of the Finnish industry. All in all, services constituted approximately 70 per cent of the Finnish economy in total in 2006, followed by manufacturing
and refining 25 per cent of the economy. Primary production accounts for the remaining
part of the Finnish economy. Finland has traditionally been a country of capitalintensive production and high investment rates. Forest industry has always been a big
part of the Finnish economy and Finland is still one of the world’s leading wood producers. Besides forests, Finland has also other natural sources including a number of
rock types suitable for industrial purposes. However, in the last decades Finnish production structure has become less capital-intensive because of the brisk growth in services
and in electronics industry. Finland is a knowledge driven economy with a strong focus
on education and research. In fact, Finland is one of the leading innovation economies
in the world and produces relatively large volumes of new-to-market products. It is fair
to say, that electronics and information and communications technology are big part of
the Finnish economy nowadays. As regarding industrial branches, the most significant
change has been the relative decline in exports of paper, pulp and wood industries for
the benefit of metal industries and electronics. (Ilmakunnas, Kröger & Romppanen
2008, 13–25; Structure of the Finnish economy.) Game industry is one of the new
branches in Finland that has been growing rapidly during the past couple of years. There
are approximately 150 companies in the game industry in Finland, among which Rovio
and Supercell are probably the most well-known. (The game industry of Finland.) Suc-
48
cess in the game business is possibly an outcome of the innovation driven society as
well as the strong educational system in Finland. Gross domestic product (GDB) in Finland was worth 250 billion US dollars in 2012 (Trading economics – Finland GDB).
Finland became a member of the EU in 1995 and a member of the Eurozone in 1999,
which has had an influence on the Finnish economy too. Finland has ever since been
committed to the single currency, strengthening of the Economic and Monetary Union
and supporting closer integration. Thanks to the EU, Finland has been able to become
more globalized in terms of labor, company locations and business mergers. Also a
large share of equity of the Finnish listed companies has been sold to foreign investors.
Although, Finland has lost its right to individual decision making in many areas, such as
monetary policy, it has still benefitted greatly from the stability that the EU and the Euro has brought to its economy. (European Union – Finland; Finland in the European
Union; Ilmakunnas, Kröger & Romppanen 2008, 25.)
4.1.2
Economic structure of Norway
Norway is a welfare country in which service industries, including wholesale and retail
trade, banking, insurance, engineering, transport and communications and public services, account for a significant share of the economy. In 2006 the service sector as a
whole accounted for approximately 49 per cent of GDP but also much of the well-being
in Norway has been fuelled by the abundance of natural resources and especially oilrelated industry. The primary sector in Norway is significant with 42.6 per cent of the
GDP out of which 24.5 per cent comes from petroleum industry including crude oil and
gas extraction. The petroleum industry also accounted for about 50 per cent of exports
in 2006. Manufacturing in Norway accounted approximately 8.4 per cent of GDP in
2006. The major manufacturing industries in Norway are industrial and agricultural machinery, construction of oil platforms and ships, paper products, metal products, basic
chemicals and electrical and electronic equipment. In fact, manufacturing also revolves
in some way around the oil-industry and has benefited from the availability of raw materials and hydroelectric power.
In 1960 substantial petroleum deposits were discovered in the Norwegian sector of
the North Sea and thanks to the North Sea oil production substantial petroleum related
service sector was developed in 1971. From that moment on, the oil sector has been the
predominant growth sector in the Norwegian economy. The discovery of the petroleum
resources has had a significant impact on the Norwegian economy. (Information about
the Kingdom of Norway and the Norwegian economy, 4.) Gross domestic product in
Norway was worth 499.70 billion US dollars in 2012 (Trading economics – Norway
GDB).
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Norway has also kept its own political independence by not joining the EU. However, Norway is an EFTA (European Free Trade Association) state and for this reason also
part of the Agreement on the European Economic Area (EEA). The purpose of EEA is
to create a comprehensive economic partnership between EU and EFTA states and it
provides free movement of goods, people, services, and capital among signatory countries. As from 2007, there are four EFTA members Norway, Iceland, Liechtenstein, and
Switzerland, from which Switzerland is the only one not part of the EEA agreement
(European economic area and competition policy). The EFTA members have their own
taxation policies, agricultural and fishing policies, economic and monetary policies and
EU customs union. This means Norway is included in the internal market of the EU, but
has still obtained its economic independence and its own currency, Norwegian Krone
(NOK). (Information about the Kingdom of Norway and the Norwegian economy, 2.)
4.2 Nordic high-yield market
The high-yield market has become a desirable option for investors seeking for greater
yields than what the less risky credit-market assets would offer. The high-yield market
has also done well in comparison with the stock markets and has outperformed the more
risky equity market throughout the financial crisis in 2008. High-yield market is also a
big part of the bond markets in the Nordic countries and Norway is especially wellknown for its high-yield bonds. The high-yield bond market in Norway, and similarly in
Finland, accounts for more than half of the issues, whereas the investment-grade market
accounts for a smaller portion of the markets. (Scandi high-yield handbook 2013, 1–2.)
Figure 6 Regional new issue split in 2013 between investment-grade and high-yield
bonds in the Nordic area (Scandi high-yield handbook 2013, 2)
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In 2013 more than half of the new bond issues in Norway and in Finland have been
in the high-yield segment, whereas Swedish and the Danish markets have been dominated by the investment-grade issues. (Scandi high-yield handbook 2013, 1–2.) Investors are searching for higher yield and increased risk and the rising market has allowed
riskier credit candidates to also receive money from the bond markets (Nordic highyield update 2014, 8). The Norwegian bond market has also attracted international investors, and approximately one third of all debt capital in the Norwegian market in held
by investors outside of Norway (Issuing corporate bonds in Oslo – an efficient, flexible
and mature market for raising debt capital, 6).
Norway has dominated the Nordic high-yield market for many years and after the financial crisis in 2007–2008 the market has been developing steadily. In 2013 Norway’s
share of the total high-yield markets has been slightly under 70 %, Sweden being the
second biggest high-yield market and Finland coming in third with a smaller share of
the Nordic issuance volumes. The Danish market has been almost nonexistent and Iceland has just issued their first high-yield bonds in 2013 after surviving form the financial crisis.
Figure 7 Share of total Nordic issuance volumes in the Nordic high-yield market (Nordic high-yield update 2014, 8)
Although, the Norwegian market has grown very rapidly, from now on the growth is
expected to be more modest which gives the other Nordic countries, Finland, Sweden,
Denmark and even Iceland, the ability to increase their total share of the Nordic issuance volumes. For the Norwegian market to keep on growing, Norway will need to attract non-Nordic issuers to show continued strong growth. (Nordic high-yield update
2014, 4,8.)
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The Norwegian industry is very capital-intensive and requires a lot of debt and leverage making it a big high-yield market. The oil & gas and transportation segments continue to account a lion’s share of Norwegian high-yield issues. The reason oil & gas
bonds are classified as high-yield is that the business is quite cyclical and volatile and
therefore also risky for investors.
Figure 8 Breakdown of Norwegian high-yield issuance 2013 (Nordic high-yield update
2014, 9)
While the oil & gas industry accounted for almost 70 per cent of the high-yield issues
in Norway in 2013 the Finnish corporate bond market is much more diversified by industry. Because the Norwegian high-yield market is much bigger than all the other Nordic markets together, the entire Nordic high-yield market has revolved around gas & oil
industry. However, Norwegian high-yield market has possibly reached its peak and for
this reason in the future the market is expected to be more diversified both geographically and by industry. (Nordic high-yield update 2014, 8–9.)
4.3 Norwegian bond market specialties
4.3.1
Trustee model
Because the Norwegian corporate bond market has grown so big, an absolute premise
for the market is that it functions well. Since the investment process is well-organized
and each time the same pattern is followed, investors want to invest in the Norwegian
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market. The Norwegian bond market has taken its current shape in 1993 after the financial crisis in 1991–1993 that hit all the Nordic countries. Due to financial liberalization,
the old macroeconomic stability had been suddenly undermined and a banking crisis
arose. Norway managed to move into safe waters already in 1994, while for other Nordic countries the rescue took a couple of years more. (Steigum 2010, 2–3.)
After the banking crisis, many sectors in the financing business had to be improved
and one of them was the bond market. Investors became cautious and they wanted to be
sure their money was safe, and because of this the independent trustee function was
established. What actually happened was that banks gave up one of their functions to an
external player, an independent bond trustee, who could take care of the bond sector
more thoroughly and be part of dynamic developments in the bond market. (Norsk Tillitsmann.) Norway does not have a specific trust legislation, which means that according to the law bond issuers do not have to use a trustee in their issues. However, the
trustee is used almost every time in the corporate issues, because the market demands it.
(Sveinsson, 2013.) Also a bond has to be registered in a security register when issued
and the register is not open for the public (Act on securities trading). There is one bond
trustee that takes care of 90 % of the corporate bond agreements in Norway called
Norsk Tillitsmann. However, other trustee functions have also entered the market, but
Norsk Tillitsmann is still the original trustee of Norway with the most experience, and it
takes care of most of the issues. (The bond trustee function in the Norwegian market).
Figure 9 Trustee model in Norway
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Figure 10 Undeveloped bond market model
Norsk Tillitsmann ASA was established in 1993 and it is an independent bond trustee
in Norway, which core business is related to the role as a trustee for fixed income securities. Norsk Tillitsmann is mainly owned by banks, insurance companies and investment firms. The company has currently 1,900 assignments and the portfolio is worth of
NOK 8 billion, which is almost EUR 1 billion. Norsk Tillitsmann has 500 clients, who
organize their issues through them. (The Bond Trustee function in the Norwegian market.) Costs of the trustee function are covered by the issuers, who pay an annual fee to
the bond trustee. The fee covers both establishing and supervision of the bond loan according to the agreement. (Bond Trustee Fees.) The trustee acts as an intermediary between the two parties, bond issuer and bondholder. Trustee’s tasks involve documentation, monitoring, crisis management and pricing of bonds to make the loan process as
easy as possible for both parties. (Bond Trustees in Norway.)
One of the most important tasks that the trustee takes care of is monitoring of the issuing companies. The main purpose of monitoring is to ensure that all the obligations
under the loan agreement are met during the loan period. Trustee also helps the investors in crisis management. One of the trustee’s most important duties is to go to the representatives of the company and negotiate about restructuring and enforcement of legal
actions. None of the investors are allowed to go individually to the issuer and seek for
settlement. There has been a disagreement in Norway whether the trustee can take legal
action against the borrower on behalf of the creditors. The dispute was resolved in Supreme Court where Norsk Tillitsmann was awarded with the right to take legal action
on behalf of the investors. The Supreme Court justified their decision by stating that the
role of a trustee is so central and important in the Norwegian bond market and the arrangement entail several benefits. This means that the trustee is able to sue on behalf of
the bondholders and to secure and collect claims against solvent debtors. Norsk Tillitsmann has also joined forces with Verdipapirfondenes forening (VFF) to establish a
new entity to simplify pricing of bonds. The new company established is called Nordic
Bond Pricing AS and its main purpose is to provide independent pricing of bonds. To-
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day, market actors have to price bonds that are not traded on a daily basis individually,
and this can be complicated and expensive. Norsk Tillitsmann envisions that this new
simplified bond pricing service will make the market even more efficient and professional. The new entity will also represent a reliable source of information for investors
in the fixed income market. Nordic Bond Pricing will represent significant efficiency
gains when investors do not have to use substantial resources to carry out calculations
on an independent basis. (Simplifying of bond pricing.)
The trustee model brings benefits for issuers as well as bond holders. The main advantage for the borrower is that there is a single counterparty to be in contact with instead of many bond owners of different sizes. Also minor changes and clarifications of
the loan agreement can be determined by the trustee without holding a bondholder’s
meeting and furthermore, the issuer can discuss about different solutions confidentially
with the trustee on reorganizations of the loan. The system also protects the bond holders by monitoring that the issuers fulfill their duties after the loan agreement has been
signed. If the agreement is violated, the trustee can take legal action on behalf of the
investors. There is also another benefit that has to do with the right of majority to decide
on what kind of action to take. If a bondholder’s meeting is held, a 2/3 majority is
enough to approve decisions. This right involves protection against bond holders with
special interests. (Bond Trustees in Norway.)
4.3.2
Bond documentation
Loan documentation is an important part of the loan process because the terms and conditions are agreed on the loan document. The term sheet has to include plenty of information about the company – more than just the basic information mentioned in the previous chapter. One of the first steps Norway wanted to take in hopes of functioning
bond markets was the development of the bond documentation. What makes the loan
documentation so trusted in Norway is that the loan documentation of bond agreements
is standardized. Every time a document is made over a bond issue it follows the same
pattern. The model document is owned by Norsk Tillitsmann and the trustee has also
been involved in developing the bond documentation. Every time a bond is issued in
Norway, the trustee prepares loan agreements and security documents in collaboration
with the issuers, investors and their lawyers. (Bond Trustees in Norway.) The documents are carefully drafted so that nothing important is accidentally left out that might
cause harm for the investor afterwards.
Bond documents become especially important when something goes wrong in the
loan process. The trustee uses the documents to monitor the issuing company during the
whole loan period until the bond matures. If the trustee notices anything that violates the
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prearranged rules, it takes action on behalf of the investors. The documentation serves
as a guideline for the trustee to take care of its duties and a proper term sheet is the only
thing that can protect the investor.
4.3.3
Post-trade reporting system
The Norwegian regulated markets have conducted rules about post-trade transparency
for not just the exchange traded transactions, but also for the listed OTC-traded transactions. Oslo Stock Exchange has detailed requirements for post-trade transparency and
this means that the price and volume, however, in certain circumstances the volume of
the trade may be excluded from reporting, of OTC-transactions have to be made transparent in addition to exchange-traded transactions. This also includes fixed income
transactions, which have to be reported to the Oslo Stock Exchange at least by the end
of the day. (Oslo Børs regulation; Rakkestad, Skjeltorp & Ødegaard 2012.)
This regulation is an attempt to improve transparency and liquidity, and furthermore,
efficiency in the Norwegian market. As mentioned before, also EU has been looking for
opportunities to improve post-trade transparency for OTC-traded transactions in EU.
However, if and when these kinds of requirements will be put into force is not straightforward, and the implementation of different member countries might take years.
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5
EMPIRICAL FINDINGS ON CORPORATE BOND MARKET
EFFICIENCY
The empirical part of the study consists of five semi-structured interviews. Empirical
findings are divided according to research questions to corporate bond market efficiency
in general and to comparison between the Finnish and the Norwegian corporate bond
market. Corporate bond market efficiency in general includes analysis of the factors
affecting bond market efficiency and specification of the level of efficiency in terms of
transparency and liquidity. Comparison between Finland and Norway consists of the
differences between these two markets and the focal points towards increased efficiency
which Norway has been utilizing during the past few decades.
5.1 Corporate bond market efficiency in general
5.1.1
Factors affecting efficiency
Macroeconomic swings are known to have a considerable influence on all parts of the
market and all interviewees feel that macroeconomic factors also have a significant impact on bond market efficiency. Interviewee E points out that all macroeconomic factors
affect the bond market because it is a market where interest rates play a big role. Interviewee D goes into more details of the pricing process in the bond market, and how the
macro side influences the expectations of the investors.
I think all markets are interlinked and every macro-event has an impact.
Some of them have larger and some of them have smaller. It is an interest
rate product, and everything that has an impact on interest rates, as well
as, the risk sentiment will also have an impact on the bonds. (E)
You have sort of a base of expectations, which affect the demand for real
interest rate that the bond investors have. Then you add on top that the
liquidity premium and the credit default premium. When you have a good
market all of those are low – the liquidity premium is low, the default
premium is low, and when the central banks manipulate the money supplies then the sort of base rate is also low, which is sort of now the situation. We have all of these three things happening. (D)
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All of the interviewees bring up financial crises which have had very harmful impacts on the bond markets. Macroeconomic stability is an absolute premise for the bond
market to function. When the bond market is under turmoil, liquidity suffers. Even the
biggest markets will suffer from financial distress.
We have these more turbulent periods, when buyers and sellers just disappear and hide. (A)
Macro has an impact – like in 2008 everything went south. (B)
Even in the very large market during times of financial turmoil the liquidity even in billion dollar-sized government bonds may dry out occasionally. This means you cannot always secure liquidity. (E)
Although, all asset classes are effected by macroeconomic factors, interviewee B and
D point out that corporate bonds are especially vulnerable in times of economic distress
– more vulnerable than, for example, stocks. This is due to the fact that stocks have an
unlimited upside, whereas, in bonds the upside is limited but the downside is as great as
in stocks. When choosing which bonds to invest in, the micro factors become extremely
important, so that the investors are able to target the best possible yield-risk combination. Diversification in bond investing is also harder than in stock investing.
Bond is a one-way bet, in a sense, that the best thing that can happen is
that you get paid everything you were promised, the interest and the
principal on full, while as in stocks you have an unlimited upside. So you
have an asymmetrical pay-off and the bond is especially vulnerable on
the negative side. That means that it’s much harder to get diversification
benefits for bonds than it is for stocks. (D)
In equities your upside is endless. If it’s like Supercell then the upside is
huge and the downside in the equity is great too. The upside of a bond is
limited but the downside as great as in the stock. The payout profile in a
bond is very different from a stock. You have to think about the downside
very hard because there is no upside in the bond. The company might be
good but you don’t want to give them credit cause then you don’t get the
upside. Like Supercell, I’d never lend any money to Supercell. (B)
When talking about corporate bond market, the micro side becomes simultaneously
important with the macro side. Interviewee A and B add that macro economy has more
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to do with the way investors allocate capital, so whether they invest, for example, in
bonds, equities, or real estate, and this way macro side creates expectations on how the
micro side will develop. Microeconomics is more about the company specific details
and the deeper down in the capital structure one goes the more important the micro side
becomes. Risks of the asset class also have an effect on how much the investor should
pay attention into details.
The deeper down in the capital structure one goes the more important the
micro side becomes. When we are talking about high-yield bonds, one
needs to be deep in the company’s business. The riskier the asset class,
the more the investor needs to pay attention to micro side things. (A)
First you need to get macro right and then you need to find the companies you want to invest in. Government bond market is all about economics, but corporate bond market is a different story. (B)
All interviewees mention the risk and reward angle which is what ultimately determines what kind of bonds will be invested in and by whom. Investors have to determine
how much risk they are willing to take and at what cost. According to interviewee B,
there are no bad credits, only wrong prices. With the right pricing and structuring the
bonds will find their buyers. Bonds have to meet the investors risk criteria in order to be
invested in.
Either you’re getting paid or you’re not. If you’re getting paid then you
should buy bonds and if you’re not you should leave it to someone else.
What is my ideal bond, it is the bond with the right company, right characteristics, and all the bells and whistles that I want to see in a transaction. (B)
However, interviewee D mentions that a bigger risk can be compensated with a higher coupon but only to some extent. At some point even the high-yield does not compensate the risk of default.
Even if you get offered a 30 percent of interest but you are sure the company is going to default, it does not help. (D)
Interviewee A continues that different bonds attract different investors since everybody is looking for different kind of yield. The ones looking for safer investment oppor-
59
tunities do not want any surprises, whereas, the investors looking for higher yield are
willing to take even great risks.
We have investors looking for very safe, lowly leveraged companies paying a decent but still fairly low yield. They don’t want to see any surprises – no bad news, no bad headlines about environmental risks or other
nasty headlines. And then we have the other end of the spectrum – investors looking for distressed companies, who are already near bankruptcy,
near defaulting, and their yield is optically very high. (A)
When assessing the risk, interviewee B emphasizes that a company has to have a reason to exist in order to be a rational investment. If the company has a reason to exist, the
investment should be worthwhile.
Sort of first question when it comes to credit risk is that should the company exist. What’s the rationality for the company to exist? For example,
if you were to buy Talvivaara bonds, is there a reason for Talvivaara to
exist. That’s the first question you should ask, if you invest in a bond. (B)
All the interviewees indicate that basically any kind of company can issue bonds as
long as they have enough capacity to take care of the interest payments as well as the
repayment of the loan at the maturity. Interviewees present that the leverage of the
company has to be in a healthy level. It is also pointed out that there need to be operations in place and they need to be profitable for a company to issue bonds. In addition,
interviewee B adds that basically anybody can issue bonds if they find the investors
who are willing to invest in them. So it all depends on the creditworthiness of the company and on finding the right investors for every issue.
Creditworthy companies, companies that can repay the bond. It should
be a company that generates enough cash flow to be able to repay the
bond or amortize the bond over time. In general everybody can issue a
bond if they find an investor who is willing to invest in it. (B)
One thing that, however, comes up as a constraint for issuing bonds is the size of the
company. Bonds can be issued at a smaller size, for example 5 million euros, but the
usual issue size is anywhere between 30 and 500 million euros. Interviewee A argues
that usually companies that issue bonds are midsized and bigger ones since only big
issues attract institutional investors. Interviewee E adds that the size of the company is
the most relevant factor that precludes the companies from issuing bonds.
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Let’s say the bond issue itself should be at least 20 million euros to be at
any interest to institutional investors and even that is very small, but still
doable. Smaller than that is hardly attracting any bigger investors. There
are surprisingly small companies that try to issue bonds but, I’m not totally convinced they are in the right place. (A)
Bond as an instrument is typically suitable for most companies that qualify up to a certain size. Bond issue by nature is usually placed to at least
a few investors and hence it requires a certain issue size in order to be
called a bond and not a bilateral loan. I would perhaps name the size as
the most critical criteria hence I would rather not put a fixed limitation to
that. We rarely see bond issues with the size of less than couple of tens of
millions of euros. (E)
Interviewee E continues that if the company wants to attract international investors it
will need to issue bigger bonds. The larger the issue size is the more widely it will reach
the international investors.
In order to get the full international audience one typically needs to issue
a larger transaction in size. If we are discussing a deal which approximately hundred million euros, 2/3 of that is still typically sold domestically. Going above that we usually see quite a bit of let’s say other Nordic investors playing in a transaction, and when we start to be in the
scale of 200-300 million or above that it usually attracts the full international audience. (E)
One criteria interviewee E also specifies is the ability of the issuer to communicate
with the bondholders. If a company considers issuing bonds they have to have the capacity to handle the process accompanied with the infrastructure to provide the investors
with the required disclosure.
In addition is obviously requires certain capacity from the company to
communicate with the investors. It is not yet of the same requirement as
equity or a listed share, but the company will need to be able to communicate with external investors and of course have the capacity to handle the process. (E)
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The interviewees do not identify any specific situations in which bonds should be issued. Overall, bonds are excellent for diversifying sources of funding and they open up
a lot of possibilities for the company. Even very complex financing solutions can be
organized through bonds and these different types of investment opportunities might
attract new investors to the market.
We can have the equity and in the other end secured bank debt and then
we can issue bonds somewhere in between – a hybrid, a subordinated, or
a senior unsecured bond, or even a senior secured bond, and possibly
structure it so that the senior secured bond is actually subordinated to
the bank debt. (A)
Interviewee D points out that there is a reason why bonds cannot be treated as a solution for a certain situation, and it is the fact that bonds usually have a bullet structure
which means that the nominal amount has to be fully paid at the maturity of the loan.
The companies do not usually have enough money to repay the issue from their cash
flow, which means that they have to refinance the repayment with another bond issue or
by rolling the principal of the existing issue forward at the maturity. This leads to the
fact that issuing a bond cannot be a one-time thing, but rather an ongoing process for the
company.
The whole principle has to be paid at the end and usually you do not
have that kind of money to do the payment from your cash flow so you
have to roll the issue. So it is very important that this is not only one time
funding, because when the maturity starts to get closer you, have to redo
the issue so you cannot sort of treat this as let’s do this ad-hoc, because
it is also harder to go back to bank financing once you commit to bond
financing. (D)
Interviewee E brings out a view that bonds are in general not suitable for working
capital. Because the bond issues are usually bullet structured and long-term debt the
money has to be used for a purpose that requires funding of this nature.
Bonds by nature are usually bullet instruments and long-term drawn
debt. To put it that way around bonds are not suitable for working capital purposes but they are usually the underlying term debt element.
Hence, wherever company requires that kind of debt it usually suits quite
well. (E)
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A bulk of investors in the bond market consists of institutional investors. This is due
to the fact that nominal values of bonds are usually quite large and private investors
cannot afford to buy these bonds, not to mention to diversify their investments.
There are some certain requirements for minimum size of a bond, but
there are also bonds that can be issued as EUR 1,000.00 as nominal value. That’s easier for private investors and if one private investor invests
directly in bonds, it would be suggested to invest in a range of different
bonds not just one, say five to ten bonds at least, and if they are EUR
100,000.00 a piece each, it gets too big for a private investor. (A)
Accordingly, it is pointed out that individual investors in the Nordic market have
been equity focused and for that reason they have only had the willingness to invest in
stocks. However, due to the financial crisis the investors have also started to get more
interested in bonds, because of their ability to generate relative stable cash flows. In
addition, the private investors might be willing to invest in bonds if they see a local,
familiar name in the bond market whose stocks they, for example, also have in their
portfolio.
The entire Nordic region, especially when it comes to private individuals,
has been very equity focused. However, in 2007 we have seen a few times
when the equity markets have actually dived 20-30 % in a year and
bonds have become fairly attractive way to diversify or at least to have
those kind of investment in your portfolio. At the same time we have had
a lot of local, familiar names issuing bonds. If you recognize the local
company whose equity you are holding or who you can follow quite easily then you can invest into a bond – that has attracted a lot of new investors into the market. (E)
Interviewee A and B argue that bond market trading is difficult because there are different kinds of investors who have different incentives. Smaller investors are looking
for more transparent and liquid markets, whereas bigger investors are not happy to show
their interest in a certain bond. Interviewee D also points out that the institutional investors are following the buy-and-hold strategy which decreases liquidity in the market.
Their plan is not to trade the bonds actively but rather to keep the bonds until maturity
to make sure that the insurance money is generating steady cash flows. Interviewee B
continues that when the insurance payments have to be met, the institutional investors
have to sell big blocks of the issue, but it is usually hard to find suitable investors who
are willing to pay decent price for these bonds.
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If I show that, I’d like to sell a 10 % of a certain bond issue, and the other investors might be able to guess who is on the other side – who is doing it and why he’s doing it. They might push the prices away and force
the institutional investor to change the price and if they are forced to sell,
it can be highly unfavorable. It is an art in itself to try to figure this out.
The smaller the market is, the more delicate this trading process is. (A)
When the insurance companies need to fulfill these redemptions they sell
the bonds. Then you have banks or brokers in the street who could potentially buy these bonds. But if they don’t have the limits or the capability
under the new rules and regulations, and they don’t want to own this
stuff, then who do these guys sell to? They sell to other investors through
banks and then the question is at what price. (B)
The most institutional investors sort of buy bonds where they believe
there won’t be any great events or defaults during the holding period and
they will just collect the interest.so there is not that much demand from
the institutional investors to actively trade. To get liquidity it would require there to be sort of more traders who want to get in and out of positions rather frequently. (D)
Bonds in the Nordic market can be listed or non-listed, but even if bonds are listed,
they are still not traded in the exchange. Interviewee C estimates that approximately 60
percent of the Norwegian bonds are listed nowadays, but reminds that listing does not
really add anything to the markets because bonds cannot be traded in a way listed stocks
are. Formal listing only means that the listed companies are part of the regulated market
and they have to report according to the rules of the exchange within a certain period of
time. According to interviewee C, listing can be valuable for investors in a way, but
only as an addition to well-functioning trustee-system and advanced documentation.
Interviewee B also feels that because the bonds cannot be traded in the exchange, listing
does not really add anything to the market.
Listing is not that important for bonds, because bonds are not trading in
the exchange. I don’t know any markets in Europe where bonds would be
traded in the exchange – they are only listed. Listing doesn’t create any
liquidity and I don’t think it creates much transparency, so I think listing
only comes as an addition to us. (C)
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Some people need the listing, but it’s really nothing. I mean it’s just that
you tick the box listed. Listing doesn’t really bring anything. It just says
it’s listed. But no-one is really trading the bonds in the exchange and
nothing happens in the exchange. (B)
However, interviewee A and E indicate that listing can be a good thing, because
through listing more information is provided for the investors in the market, and better
transparency creates trust. Interviewee E adds that if the company’s shares are listed and
the company decides to issue bonds, then the bonds are also most likely listed. If the
company has not already been involved in the listing process in the past, their bonds
will probably not be listed either.
Formal listing means that they come with regulatory demanding, and
they have to report to the exchange rules, which is good for the investors.
The company is forced to report in a certain period of time and they are
part of a regulated market. (A)
For the investors the main item is to secure that there is information being provided in the market. The easy way of making sure that there is information is to commit to list the bonds because then the issuer will need
to fulfill disclosure requirements. Of course, it’s quite common that if the
share is listed then it’s quite natural to also list the bond. (E)
The reason why no actual trading takes place in the exchange according to interviewee A, is the fact that it would be technically too difficult and too expensive due to the
large quantity of different bonds because every single bond would have to be added to
the system separately. In addition to this, there is not enough liquidity so that trading
through electronic platforms would make sense. In the past, some trading has taken
place in the electronic platforms. However, the financial crisis has led to the disappearance of electronic bond trading. Interviewee A also thinks that the banks are much happier with OTC-trading since they make more money in the dealer based markets.
It is technically quite expensive and difficult, because there are so many
bonds out there. Somebody would need to make a market for the bonds
and it would just get too big and there is not enough liquidity. There are
some electronic platforms with a selection of the more liquid bonds, and
that has worked at times. This online trading took a big step backwards
during the financial crisis. I was trading quite actively in the electronic
platforms before the crisis but the crisis just killed the liquidity and also
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the banks were not happy to trade electronically because they make less
money. It is a more competitive market and they would have to pay fees
to these platforms. They rather keep it less transparent, less liquid and
make a bigger profit for themselves. (A)
Because most of the trading takes place as OTC-transactions, dealers are a big part of
the bond market trading. Interviewee B points out that the dealer’s role in the primary
market is to connect the companies in need of money with the investors willing to lend
their money. The secondary market role has to do with providing liquidity in the market. Interviewee E adds that dealers have two different roles, one in the primary market
and the other in the secondary market. Interviewee A emphasizes the dealer’s role in the
secondary market. He points out that dealers are able to control the prices in the market
since everything is negotiated between two people. There can be a lot of trading going
on with the same bond between different people at different prices. For this reason dealers are able to control the bond trading to some extent.
Their role is to find the companies that need the money and connect them
with the investors. Clearly that’s the role they play, that’s the primary
market. They raise financing for people. Then they have to role in the
secondary market to provide secondary market liquidity. (B)
I would separate a bond issue from the primary angle so that the primary
offering when the deal is initially sold to the market and then the secondary market where the outstanding bond is being traded. Usually the dealer of the arranger at the primary stage has a crucial part of advising the
issuer of the bond, helping to structure the bond, helping to create a
credit story and helping out in marketing of the transaction. After that the
main task is to intermediate the secondary market flows between market
participants. (E)
Here comes the importance of the dealer. Because the bond market is
pretty much entirely an OTC-market, there is no right or wrong price for
a bond; everything is negotiated between two people. And there can be a
lot of trading going on with the same bond between different people, at
different prices. (A)
There can also be other listing venues except for the stock exchange, which are easier
to get into and have more flexible requirements. First North is one of the shadow listing
venues and there has been a lot of discussion whether First North listing would improve
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market efficiency in Finland. Interviewee B, however argues, that First North listing
might actually be harmful for the retail investors because the institutional investors
would not be buying bonds through First North so the venue would be entirely designed
for smaller investors. However, since the requirements are loose the issuers might be
giving the wrong impression to the smaller investors who would then be blind sighted
by the misleading information.
The First North is close to the requirements that the real exchange has.
The European bonds have sort requirements prospective, which says that
if you are selling a bond to a retail investor you need to require more of
disclosure and a bigger prospectus. If you want to do like a retail bond
with EUR 1,000.00 as denomination then you need to do more work. So
in the big market you’re trying to protect the small guy so you need to
provide more disclosure, because it’s been sold to widows and orphans.
Ok, but in the First North we can establish a bond market where the big
guys don’t buy them but we can sell them to small investors. So isn’t that
like very contradictory to what I just said. (B)
Interviewee E, on the other hand, relates to the First North listing venue in a more
neutral way. He argues that as long as the market feels like First North has something to
offer for the issuers and investors, there is a possibility for it to grow.
I think First North is a non-regulated listing venue where it is by nature
should be a little bit easier to get the instrument listed. So as long as it
provides something for the issuers and the investors to sort of make it
easier for them to invest then I think there is a potential for the First
North to grow. (E)
Rating agencies, in general, play a big role according to two of the interviewees. Interviewee B argues that the credit market is all about ratings. Investors tend to price
bonds and risks according to the ratings, and they always have to figure out where on
the credit rating scale the credit quality of the bond will fall into. Interviewee A adds
that rating agencies create a structure on how to look at credit risk and also give issuers
a framework on how to communicate with investors and which aspects to focus on, if
they want to target a certain level of credit risk. However, interviewees point out that
institutional investors do their own credit work, but for smaller investors rating agencies
are very useful.
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I think they play a role, because the credit market is all about ratings.
You always think about the credit market against the rating sector. The
role of investors is to figure out where on this credit rating scale does the
credit quality fall into. (B)
Rating agencies create a structure on how to look at the credit risk and
also a framework for the company, how to communicate and which aspects they should focus on if they want to target a certain level of credit
risk. Many institutional investors do a lot of credit rating work themselves, but for a smaller investor, it is very helpful to have an independent credit rating from SP’s, Moody’s, or Fitch. (A)
However, in the corporate bond market not all bonds are rated, and, for example, in
the Nordic area bonds are usually unrated. The Nordic market is relatively small and if a
company is well-known in its own country, the domestic investors are able to rely on
the information they have in the market. It is a question of when the bond market becomes so big that you get the benefit from a rating and a larger investor base. Interviewee C points out that the Norwegian domestic corporate bond market is unrated mostly
because there are medium sized Norwegian companies issuing bonds in the domestic
market that cannot afford a rating. Big companies, who can afford a rating and actually
benefit from it, are usually issuing in the European Eurobond market, for example, in
London and they might be, in fact, rated.
The domestic markets in Norway, Sweden and Finland are unrated.
Norwegian bonds are unrated, and the reason for that is that all the really big companies issue in the European Eurobond market and they are
rated. The normal Finnish, Swedish or Norwegian medium sized companies are not rated because it costs too much money – this is an unrated
market. (C)
On the other hand, according to interviewee E, ratings are not that important. They
provide information for the investors but they are not indispensable for the bond market
to function.
Hence it is obviously beneficial, and the investors do appreciate an independent view by Moody’s. S&P or Fitch, it is not something that would
be a necessary item for the bond market to function. (E)
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There is also such thing as shadow ratings in the market, which are made by unauthorized companies. Interviewee B argues that in the domestic market if the big rating
agencies like S&P, Moody’s or Fitch are not rating the companies, somebody else might
be, and these shadow ratings might not always be so reliable.
If S&P or Moody’s says that it is a BBB, then it is a BBB, but if SEB or
Nordea says that these companies are BBB, then I would say that it is not
BBB, and they are just trying to bullshit me. It’s actually much lower, because they have a conflict of interest. The problem with shadow ratings is
that they are produced by the same guys that try to sell the bonds. The
bank’s shadow ratings give you some kind of guidance, but in the end of
the day you should trust your own judgment. (B)
However, interviewee E argues that while shadow ratings might come from the arranging banks and contain a certain element on marketing, the rating analysis process
has to be made extremely transparent for the investors to assess the credibility of the
shadow rating, which means that distortion of the truth would not be possible. Interviewee E also points out that there are many parties making ratings nowadays and if the
credit analysis is not valid, the market would detect that and not use it as a reliable
source of information.
The credit research will need to be fully transparent providing the information of the methodology used. Of course given that the market easily
can recognize that it is the view coming quite often from the arranging
bank, there needs to be a healthy balance of knowing that there hypothetically can be a certain element of marketing in it. O the other hand, given
that the number of transaction is nowadays already fairly large and if the
credit research would not be valid, the market would not pay much attention to it. So it is very much of a credibility issue. (E)
Shadow ratings are a contradictory subject because they might not be that reliable,
but, on the other hand, getting an actual rating does not necessarily serve the company’s
purposes in the best possible way. Some might think that getting an actual rating is too
expensive, whereas, some think it is not. However, interviewee A and B agree that it
makes more sense to get a decent rating than settle for a possibly unreliable shadow
rating. Companies issuing bonds might also have other reservations against the ratings.
All of the companies would like to be categorized as investment-grade companies because they think it is easier to be an investment-grade company than a high-yield com-
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pany. Yet, mostly all of the Nordic companies are categorized as high-yield because of
their small size.
It might be too expensive for a company to get a rating. It also requires a
lot of resources, time and money, from companies to get a rating and
maintain it. The company can’t get a rating for only a year or two – it’s a
long term project. However, I think it makes more sense for a company to
pay up a little bit and get a decent agency instead of going for the cheapest one – a small cheap one with little credibility. (A)
They think it is costly, I do not think it is costly. Of course it costs something and if you are a very small company, but if you have hundreds of
millions of debt, then it is not costly. I think the issue is that all the companies think that they are investment-grade. If the rating companies rate
them, they are actually in the junk section. And they think it is wrong to
be there because in the eighties somebody started calling it junk. If you
look at Finnish companies or Nordic companies, the fact is that you can’t
be in the investment-grade section. The size is one big factor that influences ratings. That’s why they end up in the junk section and they have a
problem being here, because they think it’s hard to be a non-investmentgrade company. (B)
Companies might be somewhere in between BBB and BB and these companies are usually called cross-over companies. Usually when a company is cross-over it does not want to be rated because they don’t want to
hear they are non-investment-grade companies, because it sounds bad.
That is why they rather stay unrated. (E)
However, it is brought up by interviewee D that companies should not be categorized
as investment-grade or high-yield. There should be one scale and not two separate investment categories because they are not serving anybody. However, bonds are still
commonly divided into investment-grade and high-yield bonds which might be harmful
for especially companies operating in smaller markets. The company might be otherwise vital but because of its small size it falls into the category of high-yield, and falsely
indicates a higher risk for the investors in the market. The distinction between these two
groups might be caused by the undeveloped infrastructure, and once everything is in
place, this polarization will disappear. Separating these two categories is simply bad
marketing.
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The whole high-yield investment-grade distinction is somewhat meaningless because it is creating a barrier between two bond markets. I think it
would make more sense to match the risk of the issuer and the investor
profile with each other. Saying, it is just a matter of doing it investmentgrade way or high-yield way, is naive. Once we have the infrastructure in
place, I think the distinction between investment-grade and high-yield
will disappear, and we’ll operate more on one scale and not on those two
baskets. Also for marketing reasons, it is bad marketing to sort of use
these two baskets, because the high-yield sounds risky and undesirable
from the issuer’s point of view. (D)
Each of the five interviewees emphasizes the importance of documentation because it
is a good way to improve market transparency. Better documentation gives better tools
for investors to monitor the company and to act on the covenants if something goes
wrong.
One thing that would make transparency better too, is the documentation. It would man that people are aware of the terms and condition and
that would mean better transparency as well. (B)
They denote that documentation becomes important especially when things go
wrong. Documentation should be proper and comprehensive because it is the only thing
that gives investors any rights in a case of bankruptcy. Even the laws might be in favor
of the equity owners, and that is why documentation becomes even more important for
creditors.
If it is sunny and everybody is happy, then there is no problem. Then it
can be a piece of paper that says who owns what. But if things go bad,
you need something else. I think there are plenty of people who don’t understand it, and in fact in Finland there are laws, bankruptcy law, is not
borrower friendly but it is equity owner friendly. The laws in Finland are
protecting the equity owners at the expense of the creditors. (B)
Quality documentation includes many aspects that are highly desirable
for bondholders protecting the bondholders from holding a bond that I
suddenly very different from what they actually bought. There can be a
conflict of interest between the equity holders and bond holders, and it is
important that the bond documentation protects the bond holders from
surprises. (A)
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However, interviewee E reminds, that the standardized documentation does not necessarily mean that there is one template that fits every bond issue. Terms and conditions
might vary between different asset classes. Interviewee E also emphasizes the two different sides of documentation; one that includes information about the company and the
other that includes the terms and conditions of the issue.
I would take two different sets of the documentation. First of all the documentation is about disclosure and providing information just to describe what the company is like; what are the company’s strengths and
strategies, as well as, risks. And then the other part is for the terms and
conditions and the terms and conditions would obviously need to reflect
the kind of company we are talking about. if we are discussing an issue
with a very high credit quality, obviously the terms and conditions will
need to reflect that , and if we are discussing a high risk company the
documentation will need to be more strict. But it’s also important to emphasize that there is no sort of one template that fits all and that is also
the convention we see in the international markets. The terms and conditions vary between the credit classes. (E)
Another way of creating transparency in the market is having a trustee between the
issuer and the investor, and according to the interviewees, a trustee function is a very
natural part of the bond market. When asked about the most important role of the trustee, all interviewees primarily mentioned it is extremely important that there is a one
place of contact for both the investors and the issuers in the bond market.
The main purpose of the trustee for the creditors is to have a sort of a
collective approach against the issuer and it is also for the issuer a one
place of contact. The bondholder is able to talk to the trustee which is
representing all the bondholders to approach the issuer – Just like what
you find in any sort of people joining together to have more power than
individuals and also the other side that you can negotiate with one person instead of one hundreds of people. (C)
I think it’s a pretty natural thing to have an agent between the bond
holder and the company. And I think that it is in the best interest of the
issuer of the bond. Because if he doesn’t have the trustee then he has to
go to all the bond holders individually and find out how the people feel
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about this, but if you have to trustee then you have someone to call and
then the trustee contacts all the guys. (B)
Interviewee B points out that trustee is only needed when things go wrong, but adds
that it is still very convenient for the investors to have a trustee involved in the issue,
just in case. Interviewee C also argues the necessity of a trustee for the issuer, and
points out that a trustee gives the issuer protection and helps the issuer to find solutions
in any case of disorder. He adds that it is very useful for the investors that the trustee is
there to monitor the bond issuers on behalf of the bondholders and to take legal action if
needed. Otherwise, not all of the bondholders would necessarily be able to take legal
action against the company because of the high expenses, and there might be investors
who would not get anything in a case of bankruptcy.
It’s really the rainy days when you need the trustee. So for the company it
would be really a good thing, well for the investor as well. We’ve been
involved in a restructuring in Norway and actually the trustee model in
there works pretty well. (B)
We also monitor the bonds on behalf of the bondholders. That means that
each bondholder does not need to follow up the bond themselves because
that is the trustee’s work. The trustee will also go to court on behalf of
the bondholder community. It can cost you a lot of money to go to the
court so it is the bond trustee who will then go to the court and the costs
will be then divided between the bondholders. If a company goes bankrupt there might be investor who doesn’t get anything without the trustee.
It’s a system that gives all the bondholders equal treatment and that is
very important. (C)
A trustee function creates trust in the market and enables people to invest in bonds.
Interviewees argue that a trustee function also makes it easier for foreign investors to
enter the market. The same phenomenon can be seen with the standardized documentation – the investors know that the market functions and it can be trusted. However, interviewee A argues that not all investors might be happy about a trustee function, because if something goes wrong, they might be eager to take action themselves. This
group of investors resisting the trustee model might form out of the bigger investors
who might benefit from not having a trustee as a mediator.
There might also be resistance from some investors to have such a trustee function because if something goes wrong with the bond the biggest
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investors might want to have direct access to the companies managements and balance sheets and everything that there is in a more or less
bankrupted company, and not have somebody in between messing things
up, or not doing everything as the investors would like them to do. In
general a trustee is highly important for smaller investors but the bigger
investors, with sufficient resources, might to some extent benefit from not
having a trustee in between. (A)
Weaknesses in the market structure give other market participants advantage over the
others and a possibility for opportunistic behavior. By utilizing these inequities they
profit more than they would in a situation where all the market participants are equal.
5.1.2
Level of efficiency in terms of transparency and liquidity
In interviewee A’s opinion efficiency means that there is a possibility to buy and sell
with ease during the day at a relevant price, and the prices react logically to the news
flow. Interviewee D indicates that the bond market is efficient if the funding cost is fairly predictable and the market participants can access the market during most of the year.
If the bond market is relatively liquid, it’s possible to buy and sell with
ease during a day, way at least a few million euros of bond, and at a
somewhat relevant price, whatever that means, and it’s possible and even
easy to obtain bid and offer prices, and the prices react logically to news
flow. I guess that could indicate that the market is somewhat efficient.
Liquidity and possible ease to obtain prices, and prices react to word
around. (A)
Well it’s a situation where the funding cost is somewhat predictable and
you can access the market during most of the year. Problem with the
bond market is that it’s sometimes closed or there is like some Russian
invasion in Ukraine which closes the market. (D)
Interviewees have opposite opinions on whether the bond markets are actually efficient or not. Interviewee E presents that the bond market is fairly efficient at the moment, whereas, interviewee B argues that the bond markets are not really efficient and
that there is always somebody who is better informed than others. Efficiency is a complicated thing because it depends on who you ask, whether they advocate efficiency or
if they are in favor of inefficiency. The ones who benefit from inefficiency are in favor
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of it, for example, the institutional investors. Interviewee A also points out that the bond
markets can be efficient one day and inefficient the next. Every time new information
hits the markets movement happens. This fluctuation also refers to the fact that bond
markets are not efficient since the level on efficiency varies over time. As a matter of
fact, when we are talking about OTC-trading, the markets might never be truly efficient.
I think the bond market is fairly efficient as it is. (E)
I like inefficient market, because sometimes you create situations when
you have information advantage over someone else and you can buy
things cheap or sell something at a more expensive price. (B)
Efficiency might be there one day and not the other day, but I guess it’s
another story, if the market is truly efficient if it’s on and off, or should
efficient market be there every day, 250 days a year. I guess it would
have to be always there, but when it comes to OTC-market this is not the
case. (A)
Interviewee D continues that in the bond market there is primary and secondary market efficiency and these are two separate things. Primary markets can be only accessed
during a rather short period of time, whereas, secondary market is open until the bond
matures. However, because of the nature of the bond market, primary market efficiency
becomes more important than secondary market efficiency since trading in the secondary market can never become as active as in the stock market.
There is primary market efficiency and secondary market efficiency. Both
are important, but a bond is not a stock, so secondary market efficiency
is not that important than the primary market efficiency. (D)
The importance of post-trade transparency is pointed out by the interviewees, as a
way to give confidence, especially, to the small investors that they are trading at the
right price. Institutional investors might be better informed about the market prices anyhow. However, interviewee A and B argue that reporting post-trade information might
not be in the interest of all the market participants. They point out that the institutional
investors and even the dealers might have an incentive to keep transparency low. The
big investors might want to control the prices and make more profitable trades. They
might not want to reveal bigger positions, because when the markets are small, trades
might be traceable to certain investors and that might be harmful or at least uncomfortable for the big investors.
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The platform would give confidence to smaller investors that they are
trading approximately at the right price. Though, I’m not sure bigger investors would be happy to report everything. It would definitely be good
for transparency, but transparency is not necessarily in the interest of all
market participants. (A)
The problem is that the banks don’t like post-trade transparency. They
are trying to make money out of the trading and they wouldn’t want the
market to know that they have bought a big position in one particular
bond cause then the market could use that against them. (B)
Interviewee D is a little bit skeptical about the price transparency ever being as good
in the bond market as it is in the stock market. Trades do not happen very often and
when they do, they are made as OTC-transactions. Institutional investors’ and retail
investors’ needs are also different, and institutional investors are only interested in approximate daily levels, whereas, retail investors might appreciate active quotations they
can actually trade on. Because the institutional investors dominate the market, they are
also able to set the level of price transparency in the market.
There might be also benefits of increasing the transparency of pricing,
although, it’s never going to be sort of stock exchange type of market
where you would have continuous quotations, but it’s more over-thecounter market where certain bond houses are able to trade more efficiently than the others and there might be benefits of them disclosing
more openly where the trading takes place. From institutional investor’s
point of view they are able to execute the trade whether they have a good
daily record of price levels or not, but if you start having retail investors
they might appreciate this kind of stock market type of structure where
you have active quotations that you can actually trade on, but that’s hard
to implement in the bond market because it pretty much is an institutional
investor’s game and over-the-counter market. (D)
The interviewees have different thoughts on whether there could be such thing as too
much transparency in the market. Some feel that in some cases there could be even such
thing as too much transparency whereas others do not regard this as a problem.
The bigger fish, the more sensitive trading is. It could be even harmful to
have too much transparency (A)
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I don’t think so. Don’t get me wrong, that I would need much more
transparency. I mean, it’s ok but it’s not the biggest problem I have. My
biggest problem is to have bonds that I like. (B)
I guess if there is such harmful action which would put the company into
increased risk of bankruptcy if somebody tried to hostile trade and drive
the price down. That could happen, but it’s not very easy to manipulate
the market, even the bond market. So I don’t really think that there is
any reason to hide anything in the bond market. (D)
According to interviewee E, greater transparency means that issuers will have to inform the market better and spend more resources on disclosure. This might even lead to
preventing the market form growing, which is obviously the opposite of the original
purpose.
I think whether they call it too much transparency if the process as such
gets too cumbersome for the issuer who will then rather got to other
sources of financing then I think we’ve gone too far. I think I could perhaps make a comparison to the equity market, where issuers are seeking
alternative issuing venues instead of the normal main lists or regulated
venues. Given that especially for smaller companies a little bit too much
different disclosure work requirements might mean that they would actually not be able to handle that and this obviously goes into preventing the
market from growing. (E)
Liquidity means that the buyers and sellers meet on the market and actually create a
transaction. Usually finding a buyer immediately is not easy so the banks have to ease
the trading process. Interviewee A argues that formerly banks had large trading limits so
that they could buy and sell a lot of bonds on behalf of themselves, but that is not the
case anymore. Since the regulation has become tighter due to financial crisis the trading
books are only a fraction of what they used to be.
Today banks can indicate bids and offers, they can indicate prices, but
they are not able to actually trade the way they used to be – they need to
find a real buyer or a real seller, and just try to get them meet somehow.
(A)
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Interviewee A argues that the issue sizes of bonds have to be large, because if the issue sizes are small there are not enough sellers and buyers who want to trade every day.
The issues should be big so that the liquidity would also be better. Interviewee B continues that if the markets are hot and everybody wants to buy bonds there has to be
bonds in the market for sale. If the bonds do not exist, you cannot buy them. Liquidity is
something you need when things go wrong and then you do not have it. During more
turbulent times buyers and sellers just disappear and hide.
If the issue size is small, then there is just no sellers and buyers who want
to trade every day. The issues should be big to have liquidity every day.
(A)
Now that he markets are hot and everybody wants to buy bonds, it’s
about getting the bonds and you can’t get them anywhere. If the bonds
don’t exist how do you create them? You can’t create bonds from nowhere. Liquidity is a weird thing, because people say they need liquidity
but when you have liquidity then you actually don’t need it. You need it
when things are bad and then you don’t have it. (B)
Interviewee B continues that the market is so illiquid that if somebody wants to sell
a big block of a particular issue, it has a huge impact on the market price. The buyers
are able to push down the prices once they realize there is not enough demand for the
bonds. If a buyer wants to sell quickly, he has to lower the price. Once a particular position has been entirely sold, the prices will recover. In contrast, if the buyer is not willing
to reduce the selling price, he has to wait for a long time to be able to get rid of his
whole position.
There was a 500 million bond. For some reason there was one French
guy with 40 million of this beauty. And then people got to know that he
has 40 million and that he wants to sell. So what happened when everybody knew you wanted to sell, prices went down. And what happened
when the guy didn’t have any more bonds, nothing to sell, the prices went
up north again. That’s how illiquid the market is. (B)
Interviewee E emphasizes the importance of big markets because the more players
there are in the market, the more liquid the market will also become. Issuers, investors,
and intermediaries all attract each other to enter the market and the more players there
are in the market the bigger it will get.
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The more transactions there are the more players it will attract, both intermediaries and investors. I mean, as long as the intermediates are able
to fulfill their task and the investors are provided with possibilities to
trade the market will grow, and as the market grows the liquidity will
improve. (E)
Interviewee D separates primary and secondary liquidity and emphasizes the importance of primary market liquidity. He points out that everything possible is made to
improve primary liquidity, so that the companies would at least have a chance to issue
bonds. It is also important that when the companies issue bonds the issuing processes
get completed. There has to be enough professionals that care about the Finnish bond
market enough to be present here. Improving secondary market liquidity is hard because
most of the institutional investors are buying bonds in the hopes of holding the bonds
during their entire maturity. The institutional investors are not interested in active trading. This means that there should be more investors in the market who are willing to
trade the bonds more actively in order for the secondary market to be more liquid. However, according to interviewee D the retail market is never going to be very big, so the
private investors are not the answer, in his opinion, in making the market more liquid.
Instead, if there were more bond funds, that might help in making the market more liquid.
Secondary market liquidity is a harder goal to reach than primary market liquidity. It would require for there to be more of traders who want to
get in and out of positions frequently and that could happen if you get
more bond funds and fixed income investors into the market. (D)
In general, according to the interviewees, market transparency can be more easily
improved than market liquidity. Better market liquidity can be, however, achieved
through better market transparency which means that these two are strongly linked to
each other.
5.2 Comparison between Finland and Norway
5.2.1
Differences between Finnish and Norwegian market structure
The Finnish and the Norwegian corporate bond market are similar in many ways but
there are also some significant differences in the bases of these two markets. According
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to the interviewees the corporate bond market has become so significant in Norway because of the offshore business which was too risky for banks to finance and the companies were forced to come up with other kinds of funding opportunities. Bond financing
was excellent for this kind of industry and this is why the bond market started developing in Norway.
Oil and offshore bond market in the beginning it was not bankable.
Banks thought it was too risky to lend money to these companies. The
companies figured out that there was another way to get the money for
the investments and they started to issue bonds. The bond market has allowed this industry to boom in Norway. (B)
Today Norway is known for its oil and gas business and it has become sort of a mecca for offshore companies wanting to issue bonds. Even international issuers with no
other connections to Norway are willing to issue their oil and gas bonds in the wellknown Norwegian bond market.
The Norwegian market has a lot of oil and gas companies a lot of shipping companies issuing bonds, listed in the Oslo stock exchange, it has
become some sort of a mecca for this industry and there might be, for example, African companies issuing bonds in Norway and Oslo. They have
nothing to do worth Norway otherwise, but that’s where the investors are
looking for this sector. (A)
According to the interviewees also other factors, such as currency, can have an influence on the bond markets. However, when asked about the political status of the country, the interviewees feel that it is irrelevant regarding bond market efficiency. Interviewee D, however, points out that Norway’s independence and its own currency does
mean that Norway can never go bankrupt as a country, which might create more trust
among investors. However, all the Nordic countries are very similar in many ways, and,
for this reason, they are also trusted among investors.
Obviously Norway can never go bankrupt because first of all they have
their own currency which you can print an unlimited quantity via your
central bank and then you actually have the real wealth behind it. That
gives some kind of stability for the countries with their own currency,
while, in Finland we get to money from ECB so theoretically we could go
bankrupt in the government level. Overall all of the Nordic countries are
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sort of trusted and they have similar legal systems so there is no big difference between Finland, Sweden, and Norway. (D)
According to interviewee B, the issue currency determines what kind of investors the
issuers are seeking for. For example, the Norwegian companies might prefer to issue in
dollars to attract international investors, so that the international investors do not have to
worry about hedging their investments. Interviewee E brings up the benefits that euro as
a currency gives to the Finnish bond issuers and investors.
I don’t think anybody really cares about the political independence. They
care about the coupon and their risk. Currency is a much more important
in a sense that if companies want to issue a bond in NOK, then the buyers
are usually domestic, and if they want to attract international investors
they issue bonds in euros or dollars. (B)
Finland has the unique benefit in a sense that the currency is the same.
So every issue, as long as it’s a Finnish company is attracting both Finish and international demand. (E)
Interviewee A continues that euro is highly favorable for Finland because it enables
international investors to invest in Finland without taking any currency risk. However,
some investors might go to foreign markets just to benefit from the exchange rate in
addition to the attractive company prospects.
Many international investors would like to see the bonds be issued in euros or dollars or sterling. However, having Norwegian companies issue
in local currency opens up the possibility for investors to take a view on
not just the company and its credit quality but also the changes in the
currency. They might not hedge the currency and they could make an additional profit or loss. (A)
One thing that reflects the efficiency of the Norwegian market is that even international investors come there to issue bonds. Interviewee C argues that there are a lot of
international investors in the Norwegian bond market besides the domestic investors
because they trust the well-established market in Norway.
I think that the efficiency of the infrastructure is important. The international investors know how the system works in Norway. (C)
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In order to get the market function in Finland, the infrastructure needs to be in place
and the market has to be standardized so that the investors can have confidence in the
market. The more trustworthy, standardized, and transparent the market is the more international investors it will also attract. The presence on international investors is very
important in order to boost the economy.
The old way of doing things in Finland, was based on weak documentation, no rating or even shadow rating, no trustee, and no international
investors. And in that kind of world, you could sort of serve the investors
in the ancient way of doing things, but once you sort of need to meet the
demands of the non-domestic investors, you need to have the basic infrastructure in place. (D)
Functioning bond market attracts capital from outside because people
want to be in a transparent market. In a market where they understand
what it’s all about and how market functions and that will attract the
money and that money can be spend on investments to boost the economy. (B)
Standardization is obviously something that has helped out especially the
Norwegian high-yield market to grow. (E)
In Finland many of the issuers are Finnish companies, and it would be very unlikely
to have a non-Finnish company to issue bonds in the Finnish market. In Norway, however, there are also a lot of international issuers, and interviewee C points out that the
Norwegian bond market is actually divided into two: the domestic market and the international market. Usually the international issuers are somehow connected with the offshore business, but there are also other international companies issuing bonds in Norway. The international part of the Norwegian high-yield market is already as big as all
the other Nordic high-yield markets in together. The Norwegian bond market is truly an
international market since there are a lot of international issuers in addition to the international investors.
Half of the issuers in the Norwegian bond market are outside the Nordic
countries. And that part of the Norwegian high-yield bond market is as
big as the Swedish, Finnish, and Danish bond markets all together. And
in this market there are also a lot of international investors. In Norway
you have an international bond market and it is supposed to be the third
largest high-yield market in the world. That doesn’t mean that the Nor-
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wegian high-yield bond market is very big but we are the biggest one of
the small markets and then you have the US and the UK, the two big
ones. (C)
Interviewee A, however, points out that in the bond market it is difficult to define
which issues are regarded under which market, and that everybody has different justifications for the division. For this reason the statistics always look somewhat different
because people have different ideas on under which country each issue should be
placed. This is why it is hard to actually tell how many domestic or international issues
there are in a particular market.
Some include in the statistics only rated bond issues and some include
only issues under Nordic or Finnish law, and there are still many issues
that are unrated or issued somewhere else than in Finland, but the company is Finnish. It is not very clear – it depends on who you ask. (A)
All the interviewees argue that the reason the Norwegian market functions so well is
because they have established a very efficient infrastructure. In Norway it is easy to
issue bonds. The issuing process takes a short time and it is cheap. The process is quite
standardized and the enforcements have been well tested because of all the crises and
defaults there have been in the past.
I think that the efficiency of the infrastructure is important. The international investors know how the system works in Norway. (C)
I’d say the Norwegian bond market is by far the best in Europe and for
sure in the Nordic countries. Every bond issued will have the basic minimum level of standards so that the investors, whether they are Norwegians or outside Norway, they don’t need to spend time in reading and
worrying about will this issue have a trustee and will the documentation
be workable. Decision making costs and decision making time is much
lower for investors in the Norwegian market than it is in Sweden or in
Finland. (D)
Dealers, trustees and other intermediaries are an essential part of the bond market, in
addition to, a well-functioning, standardized documentation model. Interviewee D remarks that all of these different features are in place in the Norwegian bond market.
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You need to have financial advisors who can sell the bond, you need to
have to issuers who are willing to do the bond and can do the bond. You
need to match the investors with the issuers by having good quality documentation. The law needs to be so that it supports the bond issuing and
you need to have a trustee to monitor the complexity of the documentation. And all of that is now taking place and it is very pleasing to see that
it is following the Norwegian model in most cases. (D)
Fortunately the Finnish corporate bond market is also being altered according to the
Norwegian example. The most important thing is to get the market participants to trust
the Finnish corporate bond market the same way they trust the Norwegian market.
5.2.2
Focal points towards increased efficiency
Norway has been sort of a forerunner in creating quality bond documentation, and according to interviewee C, Norway has had a standardized documentation for at least 20
years now and they have been improving the documentation constantly along the way.
There were a lot of defaults in Norway after the financial crisis and this is why documentation got a lot of attention in Norway and they decided to create a standardized
model for documentation. This standardized model consists of a standard template on
the bottom which is completed with all the commercial terms of the bond. When all the
issuers are using the same documents it creates trust among investors in the market.
The whole Norwegian market follows the same documentation. It is quite
easy. Most of the differences are because of the different terms of the
commercial sheet. Standardized documentation is an important part of
the issuing process because the investors always know that they can rely
on the noncommercial part of the bond and they don’t need to bring the
bond to a legal person. (C)
The demand for documentation has to come from the investors’ initiative. According
to interviewee A, investors have been sloppy regarding to documentation in Finland,
Sweden, and earlier also in Norway. The quality of documentation is important because
weak documentation might repel potential investors. Interviewee D emphasizes the importance of proper documentation as a way to attract international investors because
they might even have less information about foreign companies than the domestic investors do, and without a proper documentation the international investors will not
bother to invest in Finland.
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Many investors don’t have the knowledge, skills, time, or willingness to
read through all these thick and quite dull documents and they can be
several hundred pages long and quite difficult to read. (A)
Certain classes, especially international investors, don’t invest with the
old ten page Finnish or Swedish template which has no investor protection or sort of definition of special situations. In Norway in most issues
half of the investors are coming out of Norway regardless of the company
type, while in Finland and Sweden it is less than ten percent. (D)
The Finnish documentation has been under many alterations and the Norwegian
model has worked as a great example for Finland, and other Nordic countries. The idea
is to create a standardized documentation for the entire Nordic area, so that the content
of the documents will not differ that much from each other and the investors can trust
the market. Interviewee A argues that the biggest problem there has been with the old
Finnish documentation is that very risky companies have gotten away with too few covenants in the documentation.
Documentation has been made more from an investment-grade company’s point of view. Unfortunately too many companies have got away
with too light documentation – too few covenants in their documentation,
making quite risky companies able to issue bonds at terms that are not
what they should be for a bond investor. But that’s definitely changing.
The investors have become more aware of these risks and starting from
this year, there has been actually created model documentation for Finnish high-yield issues. (A)
Interviewee D continues that the biggest improvement of the new documentation is
that the new documents have incentives or even restrictions on what will happen if the
company engages to risk increasing behavior which is not compensated in rewards. The
investors cannot be sure what will happen in five or ten years and this is why documentation becomes very important. More specified documentation is meant especially for
high-yield issues, whereas, the investment-grade companies will not have many regulation clauses about special situations.
The new documents will include clauses about special situations, for example, if the company splits, it has been taken over, it defaults or it pays
a lot of dividends and its gearing goes up. These kind of special situa-
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tions were not regulated in the old template where the company could do
whatever it wanted. In the new documentation there are clauses about
what will happen if something unexpected happens. (D)
For the documentation being efficient it has to be reviewed and modified regularly.
Interviewee C points out that the Norwegian documents have been modified several
times in order to find the best kind of model, and this reviewing process will also be
ahead in Finland.
We’ve had a standard documentation for at least 20 years in Norway and
it has been reviewed many times. The latest review was finished last
week. (C)
The trustee model has its roots in the Norwegian history and it has been a very important part of the Norwegian bond market. According to interviewee C Norway did not
come up with the trustee model by itself, but rather copied the model from the AngloAmerican bond markets – in the US market there is a trustee Act which means that using a trustee is mandatory in the US, whereas, in the English market using a trustee is
not mandatory but still widely used. In the Norwegian market the trustee is not mandatory either, but according to the interviewees, it would be hard to issue a bond without a
trustee in Norway.
The Norwegian trustee-model was established late 1800. It was the first
time bonds were issued in Norway and they were issued with a trustee
model. I think the reason for that was that Norway had always had a
close connection to London and the US markets because of the Norwegian shipping market, so we adopted very early the Anglo-American way
of thinking when it comes to issuing bonds. (C)
The trustee, as it is today, started functioning in 1993, and according to interviewee
D, it has been the reason behind the success of the Norwegian bond market. Interviewee
C points out that the reason why the trustee was established in the first place was because first Norwegian bonds were issued with security and in order to have a security it
was necessary to have a trustee in the middle to hold the security. Interviewee E continues that the trustee model has become so big in Norway because even today the bonds
are organized in a way which requires a security, and in this sense differ from the Finnish bonds which seldom have a security.
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Nordic trustee is a big part of the functionality in the Norwegian market
and the agency functions are present in any kind of bonds except for government bonds and some kind of bonds issued by international companies. (D)
The first Norwegian issues were issued with security and it was mandatory for the bonds to have a security. In order to have a security, it was
normal and necessary to have a trustee in the middle hold the security.
(C)
In Norway the trustee is actually taking a little bit more active role, however, that is due to the format of the Norwegian bond issues, and perhaps
that’s actually a unique feature in the Norwegian market where the
bonds contain financial covenants which are more typical on the loans.
Norway is the only place in the world where bonds contain these kinds of
loan style covenants and such an active trustee does not really exist anywhere else. In normal bond issues the activity or the need to talk to investors is actually much less because the covenants are different in nature.
(E)
Interviewee E argues that the covenants are different in Norway because of the history and the background of the market. The investments needing to be funded are asset
based, and this is why the covenants can be made more precise.
I think that is perhaps little bit due to the background of the market. The
Norwegian market has evolved as an oil and offshore and shipping market where up to a certain point there has always been asset based financing so there is a certain fixed asset, either a vessel or oil rig that is being
financed, and given that there has been a fixed asset, it has been sort of
more easy to define if the value for the asset or the equity is about to be
wiped out. (E)
One reason that the trustee model has grown so big in Norway, as far as interviewee
C in concerned, is the fact that Norway has created a corporate bond market for medium
sized companies, whereas, in other Nordic countries medium sized companies are
counting merely on bank financing. All of the big Nordic companies usually go to bigger markets in Europe, like the English market, but Norway is the only one that has developed an independent corporate bond market for smaller and medium sized companies and built up a huge, efficient infrastructure for corporate bonds.
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I think that if you look at the Nordic countries you will see that Norway is
the only Nordic country who has had a corporate bond market for medium sized companies. If you look at other Nordic markets you will see that
in Swedish, Finnish and Danish markets the credit has been much more
controlled by the banks but in Norway you have built up an independent
bond market for corporate bonds, and I think that is one of the reasons
why we have this trustee function in Norway. (C)
The trustee is also the owner of the bond documentation in Norway and in this sense,
according to interviewee A, it is able also to be more closely involved in the monitoring
of the company and making sure that the company follows its covenants. Interviewee E
argues that the reason the trustee has such an irreplaceable role in the Norwegian bond
market is because of the fact that it owns the documents in Norway and in this sense
forces the issuers to use their services also in issues which do not include a security.
Nordic trustee is taking the role as a trustee for the bond holders and
they are including the bond documentation as they are doing this. Trustee in Norway is very closely involved in following of the company and its
covenants. (A)
In Norway a decent part of the documentation is actually outsourced to
the trustee who is having an active role, and that is the main reason why
all the companies are using the trustee in Norway, also the investmentgrade companies. The trustee is so big also due to the slightly different
mechanism of the market. I doubt that the trustee will ever become as big
in Finland. (E)
The trustee model has also been introduced in Finland and based on that a subsidiary
of the Norsk Tillitsmann has been founded in 2012. The trustee is functioning at the
moment and it has been used in a few issues already. Norsk Tillitsmann is, however, not
the only trustee in the market anymore, but it is still the original and the biggest one.
According to interviewee D, the trustee function in Finland will be mainly adapted by
the companies who want to have international investors or companies who want to have
a concrete security involved in the issue, so it might not be used in Finland as widely as
it is in Norway.
The trustee function is pretty much in place and it has already been used
in a number of issues and it is fully accepted. Now the final thing is just
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to get all the issues to use Finnish legal entity, Finnish law and Finnish
documentation, while as last year there were still some companies who
wanted to use Norwegian or Swedish law and documentation and trustee
for the issue. In Finland the companies who want to have international
investors are probably going to be the ones adapting the trustee or if they
have some concrete security, like we did a bond for VVO last year and
there was real collateral of the properties in the issue. However, it will
not become like in Norway, one bond in a week. (D)
The law has to support the trustee function so that the trustee has the right to represent the bondholders in the court if the situation requires it. The legislation in Norway
and Denmark has already been modified so that the trustee can act as a legal representative of the investors in the court. If the representation right was added to the law, it
would give the needed prestige for the trustee to become an essential part of the Finnish
bond market. The representation right has been discussed with the government, and according to interviewee D, the law will be rewritten so that the trustee has legal rights as
representative of the investors.
I’m in discussion with the Finnish government. The Danish government
changed their law in the beginning of this year to adapt fully the Norwegian legal situation which is to give ambiguous representation right to
the trustee if the bond documentation so requires. In Sweden and Finland
you have practically reached that same level but there is not the same
law based that the agent will have the right and obligation to represent
the bond holder. My understanding is that it is very likely that both Finland and Sweden will go this way over a short period of time. (D)
Two interviewees mention that making it compulsory for the banks to report posttrade transactions to the stock exchange would most likely improve post-trade transparency in Finland. Reporting post-trade information is not compulsory in Finland, whereas, in Norway the listed companies are obligated to report the trades to Oslo Stock Exchange.
Transparency could be achieved by making trades public afterwards.
That’s done in the Norwegian bond market. The bonds are reported to
Oslo exchange on daily bases. But it’s just Norway, and US market. Bond
trades in the US are reported to TRACE. Other than these two countries,
this is a very rare phenomenon. (A)
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The one thing you could do is the post trade transparency, where you’d
have full information about the market prices. You’d know the prices that
the bonds are trading at. That would be a more transparent market. In
the US market there is a system called TRACE, also in the Norway there
is a system. (B)
Interviewee E also mentions the post-trade information reporting recommendation as
something that is different between Finland and Norway. However, he does not advocate it as strongly as interviewee A and B, but feels that if the market collectively supports it, then post-trade reporting recommendation will be also introduced in Finland.
The difference in Norway is that the bond transactions are also being reported to the stock exchange and there is post-trade information available. There is a discussion over whether that is something that is going to
happen also in Finland – most likely at some point it will in the future. If
it can be truly adding value then the market collectively will make the decision to go for that. (E)
Although, three of the interviewees think that reporting recommendation to the stock
exchange might improve price transparency, interviewee C does not see this as groundbreaking as they do. He points out that, although this post-trade reporting obligations is
used in Norway, it does not improve the price transparency as efficiently as required.
There are three different factors that disturb the system from working. Firstly, only
some of the bonds are listed and only listed bonds have to be reported to the system.
Secondly, what also makes this system inefficient is that not all the brokers report their
trades because nobody is monitoring them – it is only a sort of a recommendation to
report. Thirdly, bonds are not traded constantly so the information in the reporting system might not be valid anymore at the time it is registered in the system.
First of all not all bonds are listed and secondly not all brokers report
and thirdly there is not that much trading in the bond market. So it is
very difficult to find a price and even if it is recorded to the stock exchange it might be three months old, and a lot of things happen in three
months. (C)
Instead, interviewees C and D mention the Stammdata database as a way of improving bond market transparency. Stammdata is a sister company of Norsk Tillitsmann, and
it contains most bonds issued in the Nordic countries. According to interviewee D the
Stammdata database is a trustworthy place for the investors to find information on the
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issues, and their documentation. Also corporate actions of the bonds will be all posted
on the database. This database is designed to improve pre-trade transparency in the
market. All in all, Stammdata can be seen as a source of pre-trade information, but it
does not contain price information about the trades. Interviewee C continues that in
Norway they have also established a company called Nordic bond pricing. The idea of
the company is to give daily information for investors about the pricing of bonds, and
by doing so, to improve the post-trade transparency in the market. The concept is not
yet entirely finished, but interviewee C estimates that hopefully it will be fully functioning in the second or third quarter of 2014. Interviewee C thinks that Nordic bond pricing
is a crucial factor in making the markets more transparent and is hoping for other Nordic countries to establish the same kind of function.
We have a Norsk Tillitsmann’s sister company called Stammdata, and it
contains most of the bonds issued in Nordic countries, all bonds issued in
Norway practically since 1993 and most bonds in Finland and Sweden
from the last couple of years. So you have a sort of trustworthy place
where you can find the information and also in most cases the documentation. So I think that’s really important that the investors can access the
documentation and the bond terms all in one place. (D)
In Norway we have established a company called Nordic bond pricing. It
is a quite new establishment and we are one of the owners. They will try
to give information on daily basis about pricing of bonds. Hopefully they
will do the same in other Nordic markets as well. (C)
Interviewee A suggests that by making traded amounts smaller the private investors
could also participate more in the bond market which might improve market liquidity.
In the Norwegian bond market there are much more private investors than in the Finnish
bond market, and by getting the private investors interested in the Finnish bond market
the liquidity might improve. Before the private investors can start investing in bonds,
the market has to become also more transparent and suitable for the private investors.
The investors’ attitudes will also have to change because most of the investors are only
interested in stocks.
Possibility to trade smaller amounts would create a market for smaller
investors which it would definitely improve market liquidity at least
somewhat. The bonds are now mainly targeted to institutional investors,
which makes it hard for private investors to take part in the market.
Bonds have to become more suitable for private investors before the
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market gets more liquid. It is also partly dependent on people’s attitude
and knowledge about the bond market. Private investors are usually interested in equities – they are somewhat more familiar with this asset
class. But I think the interest towards the bond market and especially
high-yield bonds is definitely increasing. And there are quite a few private investors active in the Norwegian market. It’s much more common
there than in here. (A)
Interviewees point out that there are also other ways of getting private investors interested in bonds, for example, through bond funds. In any case, it is important to get as
many investors as possible to invest in bonds for the bond market efficiency to improve.
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6
CONCLUSIONS AND IMPLICATIONS
Theory and empirical evidences both show that macroeconomic stability is extremely
important for efficient markets. Although, macroeconomic stability is extremely important for the entire financial market, yet, it becomes even more important when the
investment products are affected by interest rate fluctuation. Financial crises are extremely harmful for the bond markets and the markets have taken a big step backwards
after each crisis. Markets have now recovered from the crisis in 2007–2008 but the regulation has become tighter which might make it even harder for the bond market to pick
up where it left before the crisis. However, the tighter regulation will most likely be a
positive thing in order to keep another crisis from building up.
When talking about microeconomic factors Bao et al. (2011), Sarig et al. (1989), and
Alexander et al. (2000) argue that issue size is positively associated to liquidity, so the
bigger the issue the greater the volume will be. In this study empirical evidence is in
line with the theoretical suggestions, and it can be assumed that bigger bond issues attract also more investors and increase liquidity. This will lead us to the fact that the bigger the company, the better suited it is for issuing bonds. This sets a certain restriction
for the companies pondering on whether to issue bonds or not – the company has to be
big enough for bond issuing to benefit the company and to capture the investors’ interest. However, somehow the bond market would also have to be made more suited for
smaller companies to issue bonds in order to resolve the dilemma of tightening bank
regulations and to ensure the economic growth.
Corporate bond market is an OTC-market and for this reason the trades cannot be
executed without a dealer. Bond market trading has, as a matter of fact, taken place in
the exchanges more widely in the past, but the financial crises have killed liquidity, and
for that reason there is no point in trading in the exchanges anymore. There are also
many bonds out there and most of them do not have enough liquidity, and for that reason electronic trading would be almost impossible, at least, for all of the bonds issued.
Bond market is basically doomed to be an OTC-market because of the large quantity of
different bonds and the lack of liquidity and for this reason, liquidity and transparency
in the market will never be as good as in the stock market. This is a complex issue because an exchange platform would bring liquidity but because of the lack of liquidity
exchange trading will not be possible.
The corporate bond market is divided into two different markets, the institutional investors and the smaller investors. These two different types of investors have different
investment philosophies and different money supplies, which means that it is really hard
for them to trade with each other. Institutional investors are usually constantly in contact with the traders so they are also better informed about the markets than the retail
investors, and they also have more resources which makes them more attractive as in-
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vestors for the banks and the issuers. Accordingly, the bond market is not that efficient
because the strategy of the institutional investors is to buy-and-hold, and, as a matter of
fact, not everybody is even advocating efficiency. Institutional investors benefit from
inefficiency, as well as the banks, whereas, private investors might be the ones that end
up suffering from the situation.
Risk aversion of the investor determines whether the investors are willing to buy
bonds and what kinds of bonds. Companies want to get funding as cheap as possible
and the more doubtful the investors are the greater compensation they will expect for
their investment. There are different ways of reassuring the investors about the reliability of the company, and listing is one of them. Listing in the bond market does not have
an immediate effect on liquidity, but it gives the investors reassurance that the company
will disclose according to the stock exchange rules. Listing is a good addition to the
bond market trading, but it is not necessarily as important as other factors in the bond
market, like quality documentation and trustee functions. Ratings are another way for a
company to indicate their value in the market. Rating agencies in general are a big part
of the bond market; however, the Nordic market as a whole is still a so called unrated
market. This is due to the fact that the companies are too small to benefit from the ratings, because the costs will become greater than the utility. In this sense, a trustee also
becomes a relevant option since it is able to create more trust between the market participants and assure the investors that the companies are worthwhile investing in, and that
their best interests will be looked after, whether the companies are rated or not.
Black (1971) describes the market efficient in case the market participants can buy
and sell with ease during any time of the day at predictable prices which react logically
news flows and follow a random walk. Also in the efficient markets all the investors
should be treated the same way, and trading should be possible without going through a
salesman. However, according to this study, the corporate bond market does not meet
Black’s criteria, because of the structural weaknesses of the bond market. In the corporate bond market it is not easy to sell positions and the prices do not necessarily follow a
random walk, but can be affected by market participants. All the investors are not treated the same way, and trading is also not possible without a salesman.
According to Fama’s (1970) market efficiency in the strong form test, no-one can
earn excess returns with hidden or insider information, and in the semi-strong form,
prices adjust to all kind of publicly available information. The strong form is a highly
theoretical concept even for the stock markets but the semi-strong form should be
achievable. However, in the bond market not all information is publicly available and
some parties are better informed that others. This is why the market cannot be classified
even as semi-strong, which means that a lot needs to be done to improve market efficiency in the corporate bond market.
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Additionally, one has to keep in mind that in corporate bond market it is not on only
about the secondary market efficiency but the primary market efficiency, at the same
time, and the primary market efficiency might be more easily improved than the secondary market efficiency. Infrastructure of the corporate bond market issuing has to be
in place so that there is a possibility for the companies to issue bonds. Issuing process
that actually works requires efficient intermediary functions. The more efficient the process is, the more issuers it will also attract to the market and other way around. In addition, the more investors there are involved in the primary functions the greater the possibility is that the investors will also participate in the secondary market, and accordingly improve secondary market efficiency.
Market efficiency is formed out of transparency and liquidity. Because there is a possibility of moral hazard, as a result of information asymmetry, the market has to be
transparent enough for the investors to trust their money into the hands of the issuers.
Both, the level of pre-trade transparency and post-trade are extremely important. Pretrade transparency is about the company and the issue; all the relevant company specific
information, the terms and conditions and the documents that are used in the issue. Posttrade information is more about the prices and the amounts of the trades that have already been executed.
Corporate bond market transparency has been a subject of many studies and these
studies have had differing views on whether increased market transparency really enhances market quality. If the arbitrage perspective of the institutional investors is disregarded, according to this study, most of the interviewees see increased market transparency only as a positive thing. However, some points about the transparency requirements are made – if disclosing requirements in the bond market are too strict, the issuers
might consider gathering money from other sources of financing instead of bonds. All
in all, corporate bond market transparency can be seen as something that improves market quality. As a matter of fact, according to this study, corporate bond market transparency is more easily improved than corporate bond market liquidity. However, corporate
bond market transparency is believed to generate also more liquidity to the market.
Increasing bond market liquidity is an important matter that will only happen through
bigger pool of market participants. The more players there are in the market the more
liquid the market will also become. This is why it is very important to expand the investor base and to attract international investors to the national markets, side by side, with
international issuers. Tighter bank regulation makes it harder for banks to trade today,
because they actually have to match the buyers and the sellers and they cannot expand
their own trading books anymore. In fact, corporate bond markets are so illiquid that
when an institutional investor, who owns a substantial share of an issue, wants to sell
his position, he or she usually has to wait for a long time to get rid of his position, and
the market price might still go down significantly. According to Black (1971) market
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liquidity means that a large amount of securities can be sold over a long period of time
at a price not very different from the current market price or, similarly, an investor can
sell a large amount of securities immediately at a discount. However, in the bond market investors might have to give in to both of these terms at the same time, which indicates poor market liquidity.
Intermediaries, issuers, and investors are all needed for the bond market to be efficient. Intermediaries are helping the issuers and investors to find each other, issuers are
needed so that there are enough bonds in the market, and investors are the ones providing the money. All of these three market makers are connected to each other and attract
the others to participate in the market.
INTERMEDIARIES
ISSUERS
INVESTORS
Figure 11 Triangle of efficiency in the corporate bond market
In the figure above issuers are in the bottom left because everything comes down to
issuing of bonds. If a market has plenty of corporates willing to issue bonds it also has a
demand for intermediaries to take care of the issues and make the process efficient. Intermediaries are also the ones connecting the issuers and the investors, and for that reason they are in the middle. Ultimately, investors are needed – the more issuers there are
in the market and the more efficient the issuing process is, the more investors there are
willing to invest in bonds. The figure can be, however, interpreted by starting from any
of these three market makers and by going to any direction. If there are a lot of investors
willing to invest their money into bonds, it will increase the issuing of bonds, and there
will also be a demand for intermediary functions. On the other hand, a market with
plenty of intermediaries is a more trustworthy market, and appeals to both issuers and
investors. All of these three attract each other to participate in the market and the more
participants there are the more efficient the market is.
Norway and Finland are similar in a way that they are both Nordic countries and
their societies and economies are built the same way – public services count for a significant share of the economy in both countries. Industries in both countries are also quite
similar apart from the oil and gas business in Norway and video game and technology
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industry in Finland. However, GBD in Norway was almost twice as big as in Finland in
2012 which means that the country is extremely wealthy. Finland is part of the European Union, whereas Norway has maintained its political independence, which according
to empirical evidence does not affect the bond market in any ways. Although, Finland
could theoretically go bankrupt at a government level, whereas, Norway could print an
unlimited amount of Norwegian kroner, and even have the wealth behind it, investors
do not pay attention to this theoretical possibility too much. Countries have different
currency which might make the market participants treat the countries differently. In
most cases, however, Finland might be the one benefitting from sharing the common
currency euro, which should affect the bond market positively.
Norway has been a forerunner, in addition to the Anglo-Saxon countries, in developing their corporate bond market, especially for midsize and smaller companies, and
making it as efficient as possible despite all the restrictions the bond market has as a
built-in feature. A lot of foreign companies issue bonds in Norway, and the market has
also attracted many international investors. This rush to the Norwegian market has originally been due to the oil and gas business which is a very capital intensive industry.
Norway is today the mecca of offshore oils and gas bonds, but despite of this, the international companies would not come to the Norwegian market to issue bonds if the infrastructure was not in place, and the same applies to the investors. Norway has originally started developing their bond market because of the need of the capital intensive
oil companies to get funding, but ever since, the system has become better and stronger,
and it has had a spillover effect on the entire bond market. Furthermore, since any kind
of company can issue bonds according to this study, Norway’s success in the bond market cannot only be explained by their oil and gas business.
The infrastructure in Norway is in place so that he issuing process is fast and efficient and there are a lot of intermediaries involved in the transaction. The issuers in addition to the investors trust the market, and for this reason they are willing to invest in
Norway. Standardization is really the key to functioning bond markets. The reason why
international investors are so important for the market is that they bring liquidity to the
bond market accompanying market growth, and help the economy to flourish.
There has to be enough disclosure for the investors, and the documentation has to be
in place. In Norway they are utilizing a standardized documentation which has been
polished for over 20 years now. The documentation covers both investment-grade issues
as well as high-yield issues. In high-yield issues the documentation becomes extremely
important because if something goes wrong, the documents are the only thing protecting
the investors. Although, Zipf (1996) only mentions commercial terms that have to be
written in the documents, regulation clauses about conditions, for example, special situations like a merger are just as important.
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In addition to standardized bond documentation, Norway has a trustee model in
place. The trustee is closely related to documentation, and, in fact, the trustee owns the
documents, and it uses the documents to monitor the company. According to Tirole
(2006), monitoring is a time and asset consuming activity which is, however, compulsory for a rational investor. In Norway the trustee takes care of the monitoring on behalf
of the investors which is a big advantage. The trustee also works as a middle man if the
terms and conditions of the issue need to be reviewed, and in the worst case of scenario,
if the company goes bankrupt, the trustee represents the investors in the court and
makes sure that each investor gets what he or she is entitled to. Besides all this, in Norway transparency is more developed because of the post-trade reporting requirement to
Oslo stock exchange. And if this system is not working well enough, Norsk Tillitsmann
is developing new platforms for better pre-trade and post-trade transparency which
should be implemented in the near future.
Some improvements can be done for the Finnish corporate bond market to become
more efficient than it has been in the past, and the Norwegian bond market serves as a
good example. In fact, Finland has already started to copy some of the best practices
from the Norwegian bond market and, for example, the documentation standardization
has proceeded to the point where the new documents have already been used in some of
the new issues in Finland.
Seven different measures occurred in this study in order to improve the corporate
bond market efficiency in Finland. The first four of them are copied from the Norwegian market and the latter three arose in the general discussion about the corporate bond
markets. They all are on different level of importance as well as in different degree of
implementation.
Documentation came up as the number one priority for functioning corporate bond
markets, and luckily the implementation degree for the new documents in Finland is
also high. As a matter of fact, the implementation process in Finland has proceeded to
the point where the new standardized documents have already been released and utilized
in some of the new issues.
Trustee functions can be regarded as the second most important measure for efficient
corporate bond markets. Nordic trustee was established in Finland for a couple of years
ago but it started working more actively from the beginning of 2014. The trustee has
been involved in issues which have tangible assets as collateral that the trustee must
possess during the lifetime of the bond. Nevertheless, the trustee function in Finland is
growing all the time, and hopefully in the future, more people will be aware of the trustee and require trustees to be involved in bond issues.
In Norway, more than half of the companies are listed and in Finland this number is
also increasing. Better post-trade transparency is also related to listing as mentioned
earlier. If the stock exchange requires dealers to report the trades they have executed
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during the day to the stock exchange like USA and Norway, for example, have done,
post-trade transparency could be improved. Post-trade reporting requirements have been
discussed in the EU level, but nevertheless, Finland has not taken initiative to work towards this kind of development. As a matter of fact, even if EU decided on this kind of
procedures, implementation to the Finnish bond market could still take many years and
for that reason, post-trade reporting requirements of OTC-transactions will most likely
not be implemented in Finland in the near future. Furthermore, even though this kind of
system was implemented it might not improve post-trade transparency, and might be
rather useless, in a sense, that not all bonds are listed and not all dealers report their
trades
Nevertheless, there are also other ways of improving market transparency like, for
example, creating databases for all the bonds including both pre-trade information and
post-trade information on the trades. These kind of various databases like Stammdata
and Nordic bond pricing are under construction in Norway, and hopefully in the future,
Finnish bonds have also the possibility to be recorded into these systems or correspondingly to start creating their own system. It remains to be seen how widely information
about different bonds will be recorded into these databases and how extensively the
market makers will welcome the system and start utilizing the information stored in
there. Creating and maintaining these databases will require a lot of work and they have
to be promoted by somebody to establish their existence as a significant part of the bond
market.
First North listing as a place for eased listing, was introduced in Finland at the beginning of 2014 and a few Finnish companies have actually already listed to the First
North listing venue. This kind of shadow listing is, however, seen as contradictory because a more vulnerable target audience is combined with looser disclosure requirements, and the private investors with small money supplies might end up suffering. On
the other hand, this kind of eased listing possibility can increase the level of transparency depending on how the market participants begin to make use of the system.
Lighter domestic ratings have also been under discussion in the government working
groups. However, their necessity is still debatable because markets seem to function
quite well without them, and the reliability of shadow ratings can also be questioned.
Because of this, no measures have been taken towards a shadow rated bond market and
probably neither will any time soon.
Smaller traded amounts also emerged out of this study as a way of improving market
liquidity by making it possible for retail investors to participate more inclusively in
bond market trading. This suggestion might, however, be hard to carry out, and in fact,
it has not been under discussions extensively. For the retail market to become more significant there should be enough retail investors to buy the bonds that have large denominations cut into smaller pieces and sold to many different investors. Being involved in
99
the retail market also requires tighter terms and this might be unwanted in the eyes of
some issuers. If the bond market transparency was enhanced overall, the retail investors
would be in the same position with the institutional investors since the companies would
have to provide disclosure regardless of the investor type. The figure below demonstrates the level of importance of each measure and the degree of implementation at the
moment.
Figure 12 Measures to improve the Finnish corporate bond market efficiency
In the picture above measures on the top are more important than on the bottom. Also the degree of implementation is higher with the measures on the right side whereas
lower with measures on the left side. These seven different measures can also be each
placed into one of the four boxes. From the high importance & high implementation
section we see the essential measures that have fortunately already been implemented,
which are documentation and trustee functions. In the area of high importance & low
implementation, are the measures which should be paid more attention to in the near
future, because they seem to have a major impact on bond market efficiency, but have
not yet been developed enough according to this study. This means that Stammdata and
Nordic bond pricing and post-trade reporting requirements need to be reviewed carefully in the near future. The low importance & high degree box includes measures in
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which resources have been wasted too much considering the advantages gained. First
North listing falls into this category. Finally, the low importance & low implementation
box contains measures that are not priorities in making the Finnish bond market more
efficient. Lighter domestic ratings and smaller traded amounts are placed into this box.
Also, in this picture the measures on the right side were copied from the Norwegian
bond market and the ones on the left side arose from the general discussion.
Nevertheless, patience is required when wanting to improve the corporate bond market efficiency because it will not happen overnight. Documentation requires plenty of
revision and overall the market calls for dedicated individuals to advocate the different
improvements of the system. When looking at Norway as an example, they have had
plenty of practice for over two decades, and that will most likely be ahead in Finland
too. However, even small improvements might have a significant impact, and the most
important thing is simply to start paying more attention to the corporate bond market
functions, start becoming more aware of the insufficiencies, and start developing the
infrastructure step by step which will slowly pay off in the future.
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7
SUMMARY AND EVALUATION OF THE STUDY
Evaluation of the study is extremely important in resolving the credibility of the study.
The researcher has to discuss what was studied in the research and how the study was
executed. It is also important to detect the shortcomings in order to analyze what could
have been done differently. Also ideas for future research opportunities must be presented. Before the evaluation, however, the study is summarized.
7.1 Summary
The purpose of this thesis was to study corporate bond market efficiency and to compare Finnish corporate bond market to the Norwegian bond market in order to discover
what could be learned from the Norwegian market to develop the Finnish market. It is
extremely important to have a functioning bond market because the bank regulation is
tightening and soon companies cannot rely on bank loans as the only source of funding.
In addition, it is essential for the company to diversify their funding structure in order to
tolerate the risk. Corporate bond market efficiency has not been studied widely in the
previous studies and certainly not by using qualitative methods, and for that reason
there is an obvious demand for this study. The reason why these two countries were
compared to each other is that they are both Nordic countries, their size and economic
structure is about the same, and for this reason they are somewhat comparable. However, Norway has been able to develop a highly desirable and efficient corporate bond
market for also foreign issuers and investors, whereas, the Finnish corporate bond market has not been able to match the Norwegian market.
In this thesis, corporate bond market efficiency was studied first from a more universal viewpoint to find out the factors that affect efficiency and the level of efficiency in
the corporate bond market in terms of transparency and liquidity. After that the similarities and the differences between the Finnish and the Norwegian corporate bond markets
were distinguished, and the reasons behind the success of the Norwegian corporate bond
market were discovered.
The theoretic framework of this study was introduced in the second and third chapter. The second chapter included general information about different kind of bond characteristics. The purpose of this chapter was to give general knowledge about bonds in
order for the reader to form a comprehensive understanding about the bond markets.
The third chapter went deeper in corporate bond market efficiency and introduced a
couple of theories on how to look at market efficiency. Efficiency was also explained
through market transparency and liquidity, and these terms and their significance in the
corporate bond market was introduced. There are different kinds of bond features that
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are determined on the commercial terms of a bond agreement. These different terms
give bonds their specific characters and determine the risk of a bond. Bonds are issued
in the primary market and traded in the secondary market. Bond market participants are
usually divided to issuers and investors who are connected by dealers. There are two
different kinds of investors in the bond market, retail investors and institutional investors. These two investor types have different kind of incentives – retail investors are
looking for more frequent trading of small traded amounts, whereas, institutional investors are following a buy-and-hold strategy with large denominations. Since the institutional investors constitute a majority of the investors, bond market liquidity suffers.
Although, stock market efficiency models can be also used to describe bond market
efficiency, some differences do arise, and these differences between the bond market
and the stock market are actually quite significant. Bond market is an OTC-market
which impairs transparency in the market. Transparency can be divided into pre-trade
transparency and post-trade transparency in the bond market. Liquidity level varies in
the bond market due to macroeconomic changes and more turbulent times increase illiquidity in the market. There are also so many different bonds in the bond market
which affects liquidity and makes counterparty identifying difficult.
The fourth chapter was focused on comparing the Finnish and the Norwegian corporate bond market to each other through market structures and charts about the Nordic
high-yield market. Norwegian specialties were also specified. Norwegian high-yield
market is by far the biggest out of the Nordic markets and has been also noticed on a
worldwide level. A bulk of the Norwegian high-yield market constitutes of offshore oil
and gas bonds, while the Finnish corporate bond market is more diversified. Norwegian
bond market has some specialties like the trustee system, standardized documentation,
and post-trade reporting responsibility. These specialties were examined to find out
whether they are the reason behind the success of Norway. Beside these factors, also
other suggestions were discovered on how to develop the Finnish bond market.
Empirical findings for this study were introduced in the fifth chapter. The data was
collected through five semi-structured interviews with bond market experts from Finland and Norway. The fifth chapter with the sixth chapter of conclusions and implications were designed to answer all the research questions and to match the theory with
the empirical part of the study, in addition, to broaden the view to other cases of bond
market efficiency. Corporate bond market is an OTC-market with polarized investor
base, and it was discovered that because of these built-in weaknesses bond market efficiency is not as good as stock market efficiency. Transparency is not in a sufficient level
in the corporate bond market; however, it is something that can be improved due to
tighter regulation and new developments in the market. Bond market liquidity is a harder goal to reach, but liquidity is thought to recover as a result of better market transparency. For this reason, improving transparency is to the first step towards better bond
103
market efficiency. Part of the reason why the Norwegian corporate bond market has
developed as one of the world’s biggest high-yield markets and attracted foreign issuers
and investors is the offshore industry, and as a matter of fact, Norway is known as the
mecca of oil and gas bonds. However, the success of Norwegian corporate bond market
cannot be entirely explained by the offshore business, and the other reason behind the
success is due to the functioning corporate bond market structure. Trustee functions and
standardized documentation are, at least, factors that have made the Norwegian corporate bond market a desirable option for bond issuers and bondholders all around the
world, and the Finnish corporate bond market should copy these best practices. Norway
has also created reporting systems that include pre-trade and post-trade information to
improve market transparency. These separate databases are developed in addition to
placing reporting requirements to the stock exchange. All of these measures are best
practices from Norway that the Finnish corporate bond market should copy. In addition
to these, some other measures can be taken including lighter listing and rating requirements and making traded amounts smaller.
All of these factors mentioned are something that should be paid attention to in Finland in the future for the corporate bond market to start flourishing. Although, improving bond market efficiency is not an easy task and needs somebody to take initiative, it
is possible by following the example Norway has given. Efficient bond markets are essential so that in the future more companies can start issuing bonds and growth of the
Finnish economy is guaranteed.
7.2 Reliability and validity
If the researcher is unable to show that the methods used are reliable and the conclusions made valid, there is little point in making a research dissertation (Silverman 2000,
175). Reliability and validity derive from the philosophy of quantitative study, but they
are the corner stone of each study.
A quantitative study can be defined as reliable if the same person is used as a research subject at two different occasions and both times the results are the same. A reliable study also requires two different researchers to end up with the same result. Another way of understanding reliability is to study the same subject with two different methods and end up with the same result.
Validity, in turn, means that it is possible to predict the results of future studies out of
a study that has been already executed. This is also known as the predictive validity.
Construct validity is related to the question does the study discuss the issues it is assumed to discuss and do the concepts used in the research reflect the studied phenomenon in the best possible way. Internal validity entails the idea that Y is really caused by
104
X and not a third factor. External validity means that the research results can be generalized also into different kind of situations and different kind of people. (Hirsijärvi &
Hurme 2001, 186–188.) However, in a qualitative study the definitions of reliability and
validity have to be viewed under certain mitigations, because, for example, a thematic
interview is also a unique situation, which cannot be entirely repeated afterwards
(Hirsijärvi & Hurme 1991, 129).
Although, the premises of reliability and validity cannot be entirely carried out in a
qualitative study, it does not mean that a qualitative study can be conducted in any possible way. The researcher has to aim to present the thoughts of the interviewees as realistic as possible, while at the same time being aware of the fact, that the researcher has
an influence on the studied subject and the results are based on the researcher’s own
interpretations. One way of approaching reliability and validity is making sure that the
quality of the study is good, and sufficient quality can be ensured by using quality control techniques.
First of all, the most important thing in a qualitative study is that the concepts used
are the most widely used in previous studies of the same subject. If the concepts chosen
for the theoretic part are not the most relevant ones, the construct validity of the study
might be considered weak. (Hirsijärvi & Hurme 1991, 129.) For this study literature
was widely explored and both the research articles and books were used to constitute the
framework of the most important concepts. When using thematic interviews as a research method, the interview structure has to be well-designed and the interviewer has
to think about how to deepen the interview themes beforehand and to come up with additional questions and alternative ways of representing questions. (Hirsijärvi & Hurme
2001, 184.) If the themes chosen for the interviews are not relevant, the internal validity
of the study will suffer (Hirsijärvi & Hurme 1991, 129). In this study the interview
questions were precisely formed and accurately designed to each interviewee individually. Also some specifying questions were thought about beforehand, although, it was
constantly kept in mind that the interviewer cannot plan the entire interview beforehand;
some questions take their shape during the interview. A test interview was also held to
polish the interview question for the remaining interviews.
One way of creating validity in a qualitative research is to make sure that the interviewees are a reliable source of information. This means that the interviewees have to
be qualified to represent the studied subject. (Hirsijärvi & Hurme 2001, 189; Hirsijärvi
& Hurme 1991, 130.) In this study the interviewees were chosen carefully to represent
the people who know a great deal of this matter and have been working in this field for
a long time. Also the technical equipment has to be in place so that the material gathered is easy to go through again after the interview. It is recommended that the interviews are transcribed as soon as possible after the interviews, and that the transcribing is
made carefully and correctly. (Hirsijärvi & Hurme 2001, 189.) All of my interviews
105
were recorded with two different recorders and the quality of the sound was good. The
interviews were also transcribed as soon as possible to get a better understanding of
what the interviews entailed, and to be able to form identifiable themes.
Reliability of the study can be ascertained by taking all the data collected under examination and by familiarizing oneself well in the collected data. The results have to
correspond with the views and attitudes of the interviewees and the analysis has to be
inclusive. (Hirsijärvi & Hurme 2001, 189.) All the data collected for this study was used
in the analysis and the transcriptions were executed with care. What is especially important in a qualitative study is that he researcher is able to document the execution of
the study and the results as accurate as possible, and make arguments to explain how
these conclusions were reached. However, it does not indicate a weakness of the study if
another researcher ends up with different kind on results. Researcher’s own attitudes
and sentiments are always present in a qualitative study. (Hirsijärvi & Hurme 2001,
189.) In this study the research process and the results were presented as precisely as
possible and arguments were made about the research results. The quality of the study
throughout the process is extremely important because it is the only way of ensuring
reliability and validity at the end.
7.3 Limitations of the study
Although, quality control measures were followed throughout the process, there are still
some shortcomings in the execution of this study. Although, the interviewees for this
study were chosen so that they would represent the people who have the most in-depth
knowledge about this subject, and several people’s views were taken into consideration
when choosing the interviewees, in the end, the interviewees were selected based on
who could be reached for this interview in between a certain period of time – the research schedule had to be stuck to. Overall, there could have been more interviewees to
create better validity and reliability, and especially, the Norwegian point of view could
have been better represented. A representative from the issuer’s side could also have
been a true addition to the mix of interviewees, but unfortunately such person could not
be reached for this study.
One has to keep in mind, that the interviewees might have ulterior motives when answering the interview questions. Although, the interviewees are individuals and present
their own ideas, they are also always representatives of the companies they work for.
For example, the trustee functions are also profit seeking companies, and some of their
ideas might be based on promoting their company’s services. For example, Stammdata
and Nordic bond pricing are subsidiaries of Norsk Tillitsmann, and since Norsk Tillitsmann was very strongly present in this study, these functions might have also ap-
106
peared more strongly than what they would have otherwise. However, by taking people
from different companies representing different market participants, the results should
be more valid than by taking just one aspect of the studied subject. Identities on the interviewees were kept hidden deliberately in order to get the interviewers to share their
views without reservations.
English as a research language was used throughout the whole study and it could
have also had an effect on the results. When the interviewees are not able to use their
mother tongue, some of their views might not be presented the way they would, if the
language was different. The same applies to the interviewer. However, all the interviewees are used to using English constantly at work, and most of them have also had
working experience abroad. Also most of the terminology related to bond markets
would have been hard to translate into Finnish so it was natural to carry out the entire
study in English.
According to Hirsijärvi & Hurme (2001, 189) the interviewees should be involved in
the analyzing process by evaluating and making corrections to the results the researcher
has presented. This technique is also known as the member check in the literature of
qualitative study. Also data triangulation is an adequate way of making sure that the
results derived are in fact valid. Data triangulation means that two or more methods are
used in validating the data through cross verification from two or more sources. In this
study neither data triangulation nor member check were used which might dilute the
reliability and validity of the study.
7.4 Further research opportunities
Many further research opportunities arose along this research process. It would be important to have a proper bond market efficiency model rather than modifying stock
market efficiency models, because they cannot be entirely applied to the bond markets.
Bond documentation was one the major themes of this study and it would be reasonable
to study what efficient bond documentation should be like. Experts in this field have a
pretty good understanding of the features that quality documentation contains, but research data in this field does not exist. What was also left unresolved was the true impact of post-trade reporting requirement to stock exchange and its influence on bond
market transparency. The efficiency impacts of increased transparency are also still left
to be resolved.
It would be also interesting to know what the issuers feel about the bond market infrastructure and what would make them to get more interested in bonds. Anglo-Saxon
markets were mentioned as a role model to Norwegian market, so it would make sense
107
to find out the reason why the corporate bond market is so significant in Anglo-Saxon
countries.
After a couple of years it would be interesting to find out whether the Finnish bond
market efficiency has in fact improved and what is the share of bond financing out of
the entire financial structure of the Finnish companies. A quantitative comparative study
about bond market efficiency would also deepen the knowledge received out of this
study. The two different types of investors and the complexity of trading they create
because of their different needs and expectations also surfaced as an interesting target of
research.
Some research opportunities that lean towards studying of law would be the legal
rights of a trustee to represent bondholders, or how and why does the Finnish legislation
protect the equity owners at the expense of the creditors. The last research topic was
suggested by one of the interviewees.
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114
APPENDIX 1: INTERVIEW QUESTIONS
Corporate bond market – a comparison between Finland and Norway
Background information about the interviewee:
1.
2.
3.
4.
What is your name and title?
What do you do here at work and for how long have you been working here?
What is your earlier working history like?
What is your specific area of expertise?
Corporate bond market issuing and trading:
1. What kind of companies should issue bonds and in what kind of situations?
2.
3.
4.
5.
What is relevant in the issuing process?
What kinds of bonds attract investors?
What kinds of investors should invest in bonds?
What is the role of different intermediaries (dealers, rating agencies, trustees) in
the bond market?
6. What kind of a role does documentation play in the bond market?
a. What kind of features does good documentation have?
7. Why are so few bonds listed?
Corporate bond market efficiency:
1. What does efficient bond market mean in your opinion?
2. What are most relevant features in efficient bond markets?
3. What would you say about transparency in the bond market?
a. What should be done to improve market transparency?
b. Can there be such thing as too much transparency?
4. What would you say about liquidity in the bond market?
a. What should be done to improve market liquidity?
5. Why is it important that bond markets function?
6. What might hinder the bond markets from functioning?
7. Which macro-economic and which micro-economic factors affect the bond markets?
a. Are macro or micro factors more important?
8. How does economy affect the bond market and how does bond market affect the
economy?
115
Finnish corporate bond market:
1.
2.
3.
4.
5.
6.
How many corporate bonds are issued in Finland in one year?
What kind of companies issue bonds in Finland?
What is the issuing process like for corporate bonds in Finland?
Who invests in Finnish corporate bonds?
How would you describe the Finnish corporate bond market?
What would you say about transparency and liquidity in the Finnish bond market?
7. How does EU and euro affect the Finnish bond market?
8. What kind of influence does the Finnish bond market have to Finnish economy?
9. Do you think Finnish corporations issue enough bonds? Why or why not?
10. Why do you think it is that the Finnish bond market has been so undeveloped?
a. Do you think something should be done to enhance the Finnish bond
market? What?
11. Should Finland learn something from the Norwegian bond market?
12. Do you think the Norwegian trustee model could also become a major part of
the Finnish corporate bond market?
a. At what stage is the implementation of the trustee model in Finland at the
moment?
b. What should be done to enable the implementation of the trustee model
in Finland?
c. To whom is the trustee model mainly targeted to?
d. In what kind of cases has the Nordic Trustee Oy already been involved
in?
e. Why are there two different companies in Finland taking care of the trustee functions Nordic Trustee Oy and CorpNordic Finland Oy?
13. What would you say about bond documentation in Finland?
a. Should it be developed? How?
14. Should the Finnish bond legislation be renewed somehow?
15. A team of officials has been established by the EK – what is the main purpose of
this team?
a. What has the team suggested to make the bond market function better
and have some of the suggestions been implemented?
16. Should post-trade transparency be introduced in Finland?
17. What do you think about First North listing?
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Norwegian corporate bond market:
1.
2.
3.
4.
5.
6.
How many corporate bonds are issued in Norway in one year?
What kind of companies issue bonds in Norway?
What is the issuing process like for corporate bonds in Norway?
Who invests in Norwegian corporate bonds?
How would you describe the Norwegian corporate bond market?
What would you say about transparency and liquidity in the Norwegian bond
market?
7. How does the political independence and Norwegian’s own currency affect the
bond market?
8. What kind of influence does the Norwegian bond market have to Norwegian
economy?
9. Do you think the Norwegian bond market functions well? Why do you think that
is?
10. Why are there much more private investors in the Norwegian bond market than
in the Finnish bond market?
11. Why does Norway dominate the Nordic bond market?
12. What do you think about the trustee model in Norway?
a. Why do you think Norway has been a forerunner in developing the trustee-model?
b. What is the main purpose of the trustee?
c. Do you think the trustee enhances the Norwegian bond market? How?
d. Norsk Tillitsmann is a profit-seeking company, how does it show?
13. How is bond documentation organized in Norway?
a. What do you think about bond documentation in Norway?
b. Do you think it influences the markets? How?
14. What could you say about post-trade transparency in Norway?