Quarterly Review, June 2005

The BIS Quarterly Review released today is divided into two parts. The first analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity in derivatives markets. The second part presents three articles: one on currency choice in international bond issuance, another on complexity, risk and the use of ratings in structured finance, and a third on opening markets through a regional bond fund and the lessons drawn from ABF2.

Repricing in credit markets

Credit and equity markets fell starting in March 2005 as investors retreated from higher-risk investments. Credit markets experienced their largest declines since 2002, while equity markets gave up most of their gains from 2004. At the same time, long-term yields in the major markets fell close to or even below their previous lows, pushed down in part by the flight to quality.

Firm- or sector-specific news, particularly the troubles of US auto makers, played an important role in the retreat from riskier assets, as did weak economic news, especially during April. In May, stronger than expected data releases helped equity markets to rebound. Credit spreads continued to widen through to mid-May, due partly to unusual volatility in credit derivatives markets. However, owing to the low level of nominal yields, borrowing costs hovered close to historical lows at longer maturities.

The international debt securities market

Building on the pace of record issuance in 2004, gross issuance of bonds and notes in the international debt market was up by 7.3% in the first quarter of 2005 over the same quarter in the previous year, to $1.1 trillion. Global net issuance also rose during the quarter, from $426 billion to $492 billion. Issuance was boosted by favourable financing conditions in the first quarter. Both gross and net issuance were particularly strong in the euro area and emerging markets.

Long-dated issues with maturities of 40 years or above were prominent during the quarter, particularly in the euro area, reportedly to meet pension funds’ demand for long-duration assets. Another notable development during the first quarter was increased international issuance by emerging market entities in local currencies. However, the portion of local currency issuance from emerging market nationals in the international market is still quite small, and whether the recent pickup can be sustained remains to be seen.

Derivatives markets

Turnover of exchange-traded derivatives returned to solid growth in the first quarter of 2005, as the combined value of trading in interest rate, stock index and currency contracts rose by 19%, to $333 trillion. Activity was buoyant in all market segments, albeit stronger for interest rate products. Growth in the interest rate segment may have been related to increased hedging needs due to uncertainty over long-term rates, as bond markets sold off in late February and early March.

In the global over-the-counter (OTC) derivatives market, the most recent data show that positions expanded in the second half of 2004. Notional amounts outstanding were up by 12.8%, to $248 trillion at the end of December. Trading in credit default swaps (CDSs) has been gaining in importance; at the end of 2004, notional amounts of CDSs outstanding totalled $6.4 trillion, of which $2.7 trillion represented contracts between reporting dealers.

The international banking market

New lending to all sectors led to a relatively large expansion in BIS reporting banks’ cross-border claims in the fourth quarter of 2004. Interbank activity drove the overall increase, while a rise in claims on non-bank borrowers primarily reflected greater credit to non-banks in Japan and the United States. Emerging market economies experienced a small net inflow of funds, boosted by a repatriation of deposits by banks in China and Korea, and a noticeable rise in claims on all sectors in emerging Europe.

Over the longer term, BIS reporting banks’ balance sheets have shifted towards investment in debt securities, reflecting growth in euro area bond markets and the external deficit in the United States. In addition, there is evidence that the degree of foreign bank participation in national lending markets has edged upwards in recent years. While foreign banks continue to play a smaller role in domestic lending in the euro area than in the United States, cross-border claims account for a growing share of total credit to non-banks in most industrialised countries.

Special features

Currency choice in international bond issuance

The determinants of currency choice in international debt issuance are of increasing interest to market analysts and policymakers alike. Based on an analysis of the international debt securities database of the Bank for International Settlements, Benjamin Cohen of the BIS finds that there is more issuance in a given currency when it is strong relative to historical averages and when long-term interest rates in that currency are high relative to those in other major currencies. The author’s conclusions hold even when controlling for demand for investable funds in the currency, as proxied by the growth of investment, or the level of home country issuance. The evidence suggests that the preferences of investors and those of issuers both play a role in determining the terms and conditions of international bond issues.

Structured finance: complexity, risk and the use of ratings

Issuance volume of structured finance products, which involve the pooling of assets and the subsequent sale of tranched claims on the cash flows backed by these pools, has grown rapidly in recent years. After reviewing the principal features of structured finance products, Ingo Fender of the BIS and Janet Mitchell of the National Bank of Belgium analyse the complexity of structured finance markets and their risk-return characteristics. The authors argue that the credit ratings of structured finance products, though useful, have intrinsic limitations in fully gauging the multidimensional risk of these products. Market participants and public authorities need to take account of these limitations in their assessments of structured finance instruments and their markets.

Opening markets through a regional bond fund: lessons from ABF2

East Asian policymakers perceive a need for deeper and more liquid local bond markets. Guonan Ma and Eli Remolona of the BIS analyse one recent regional cooperative effort at market reform, the Asian Bond Fund 2 (ABF2). Explaining the structure and features of ABF2 in the context of other regional initiatives, the authors argue that policymakers drew myriad lessons about market impediments from the very act of setting up an actual fund. The authors argue that the ABF2 initiative has not only been unusually effective in accelerating measures for market reform but has also established mechanisms which provide incentives for policymakers to reduce impediments further.