The year of booming bonds

China and other developing nations have the potential to make bonds a new engine of economic and financial reforms

Booming bond issuance and investment have been the pervasive themes throughout the global financial markets in 2012. The bond market not only met the needs of investors in the midst of the global financial crisis, but also provided strong support to companies and banks, becoming an engine for the world's economic growth.

It thus makes sense that amid market uncertainty investors regarded bond investment as a safe haven and flocked to this area. Over the past four years, according to JP Morgan's estimates, more than $2 trillion has flowed into fixed-income funds globally while equity funds have suffered an outflow of money.

For the first time in more than 50 years, United Kingdom pension funds are holding more bonds than equities, because they need stable, fixed returns to pay pensioners. In the United States, and European and Asian countries, some of the biggest pension funds have been switching to fixed income.

Bonds have also been the asset class of choice for private banks that conduct wealth management businesses, because they want to focus on wealth preservation for their clients amid volatile global stock markets and business uncertainty.

Not surprisingly, the European sovereign debt crisis and banking plight partly contributed to the boosting of bond markets. Europe's companies have usually relied far more heavily than their US counterparts on borrowing from banks, rather than from markets.

However, the situation has now changed. Since banks in Europe undertook deleveraging after being hit by the crisis, shrinking their balance sheets, they now have fewer capabilities left for lending. Thus, companies are being forced to go directly to markets to raise funds. As a result, corporate bond issuance has surged. In the eurozone periphery countries, good companies can borrow money from bond markets at significantly lower costs than from their own banks.

Bond markets play a key role in refinancing manufacturers, real estate property developers, banks and governments. According to Dealogic data, the global corporate bond market nearly doubled from $5 trillion in 2008 to $9 trillion this year.

Given that commercial banks have reduced their real estate loans, many property developers are on a record year of bond issuance, disenchanted as they are with the traditional banks. In addition, the funding shortfall in the real estate sector is expected to grow when Basel III regulatory changes are imposed on global banks. Previously, many banks would lend long-term loans to real estate developers by obtaining short-term funding to make a profit on the spread. The new regulation will require banks to match funding and lending more closely, therefore, removing some of the incentives to lend to this sector.

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

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

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

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

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

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

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

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

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

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

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

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

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

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