The changing shape of fixed income markets: a collection of studies by central bank economists

BIS Papers No 5
October 2001

The papers in this volume analyse recent changes in the world's major fixed income markets. The introduction of the euro, structural changes in governments' fiscal positions, traumatic events such as the global financial market crisis of 1998, and advances in the technology of trading platforms are reshaping fixed income markets in Europe, Japan and the United States. The first paper provides a broad overview of the changes under way, and the following four papers elaborate on some of the issues that emerge. These papers complement a report published by the Committee on the Global Financial System in March 2001 on the use of collateral in wholesale financial markets.

Taken together, the papers in this volume highlight the growing importance of private sector debt instruments. Falling supply and shifts in the mix of investors holding government securities are draining liquidity from some government securities markets, in particular the US Treasury and UK gilt markets. In contrast, non-government markets have seen issuance volumes soar, a greater diversity of instruments made available, and liquidity conditions improve at least for the largest bond issues. The paper by Mastroeni describes the development of one of the fastest growing segments of non-government securities market: Pfandbrief-style products in the euro market.

Investors have accommodated changes in the relative borrowing patterns of the government and non-government sectors by moving towards more diversified portfolios. A key challenge faced by portfolio managers is pricing and managing the credit risk that they thereby take on. The paper by Hattori, Koyama and Yonetani examines the pricing of credit risk in the yen corporate bond market. They find that default risk, the stability of the financial system and the level of new corporate bond issuance relative to government bond issuance are the most important determinants of credit spreads in Japan.

Demand for fixed income instruments in recent years has also been affected by changes in hedging and arbitrage activity. The 1998 crisis led to a reassessment of risk management practices, one outcome of which was a switch away from the exclusive use of government bonds as hedging vehicles in favour of a wider array of instruments. Other traumatic events, such as squeezes in German government bond futures contracts, reinforced this search for alternative hedging vehicles. Schulte and Violi examine interactions between cash and derivatives markets in the euro area, and assess ways to alleviate the risk of a shortage in the cheapest bond to deliver into a futures contract.

Each market participant who switches to using non-government instruments as hedges subtracts liquidity from the government market and adds it to other markets, in the process raising the incentive for other market participants to follow suit. As non-government instruments gain liquidity, they are increasingly being used to price and hedge other securities and perform other functions for which government securities tended to be used in the past. The paper by Cooper and Scholtes concludes that declining supplies of government paper have helped to depress US Treasury and UK gilt yields below risk-free interest rates and so diminished their usefulness as benchmarks. They then demonstrate that interest rate swaps appear to have become the de facto benchmark for pricing high-quality bonds.

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