Middleware & the infrastructure of the corporate bond market

Bottom layer: corporations seeking debt financing

Generally, companies can access two sources of financing: equity and debt.  Equity is an ownership interest in a company; equityholders own shares and have a right to the profit of a company after all other obligations have been paid.  Debt is a claim on a company’s assets; debtholders own bonds and must be repaid before a company’s equityholders.  Part of the role of the finance department in a company is to decide how much financing a company needs, and whether a company should access the equity or debt markets (or both) to meet its needs.  Generally, issuing debt is cheaper for companies than issuing equity, because debtholders are higher in the capital structure (i.e., in the event of bankruptcy, debtholders are repaid before equityholders).  Thus, lending to a company by purchasing its bonds is typically less risky than investing in a company by purchasing its stock.

Companies of all sorts and sizes have debt liabilities on their balance sheets.  A mom-and-pop small business might have a loan from the local bank.  A medium-sized company might have a syndicated bank loan – essentially, a loan that is too large for any one bank and is instead syndicated by a group of lenders.  For large, public companies, however, the need for debt financing is too large to be met by any one bank (or even a group of banks).  General Electric, for instance, was carrying about $400 billion in debt in June 2012.  To meet their debt financing needs, large companies like General Electric turn to the bond market.

Top layer: the over-the-counter (OTC) corporate bond market

Companies issue debt and investors buy and sell debt securities in the corporate bond market.  To break the structure down further, companies issue debt in the primary market, and investors trade debt securities in the secondary market.  Not surprisingly, the secondary market is where the vast majority of activity in the bond market occurs; a particular bond can only be issued once, but it can be traded a limitless number of times between issuance and maturity.  According to SIFMA, an industry trade group, the size of the market for U.S. corporate bonds is approximately $7.7 trillion.

“Over-the-counter” means that securities are traded directly between two parties.  Shares of stock are generally traded on an organized exchange, like the New York Stock Exchange or NASDAQ.  Conversely, corporate bonds are usually not traded on an exchange.  Rather, they are traded directly between a buyer and seller.  This is because while a single company may have only one or two classes of shares, which are easy to list, track, and trade on an exchange, the same company may have dozens of bonds outstanding, all with different maturities, coupon rates, capital structure seniority, etc.  Because there are so many different types of corporate bonds outstanding, the market for these bonds is relatively less liquid than the market for shares.  Over-the-counter securities are traded over the phone, generally between broker-dealers (large banks like Citi, Bank of America, or JPMorgan Chase) and investors (such as mutual funds, hedge funds, or high-net-worth individuals).

Middleware in the corporate bond market infrastructure: credit ratings

There are a vast number of essential elements that could be considered middleware in the infrastructure of the corporate bond market.  This list of intermediaries includes: accounting standards; investment banks; the rule of law, the bankruptcy system, and the courts; bond indices; tax regimes; and many others.  I’ll focus on one vital component: credit ratings.

Debtholders – investors who lend to a company – need to have faith that they will be repaid.  If bondholders have little confidence in a company’s ability to meet its future obligations, the company will be unable to access debt financing at a reasonable cost.  Before investors will lend to a company, they need to understand the amount of risk they are taking on.  This is where credit rating agencies step in.  These agencies assign credit ratings to bonds which measure credit risk.  Credit risk (also known as default risk) is, basically, the risk that a company will default on its obligations and not repay its creditors.  Investors rely on credit ratings for corporate bonds: a large mutual fund may hold thousands of individual securities, and even the most well-staffed investment manager would have difficulty tracking the creditworthiness of all those bonds on its own.

Credit ratings allow investors to ascertain important information about the riskiness of holding a particular bond quickly, easily, and cheaply.  Bonds are rated on a sliding scale (say, AAA to D), and investors can use that information to analyze their bond portfolios efficiently.  A hypothetical portfolio with, for instance, $100 million invested in AAA-rated bonds, $100 million in BBB, and $100 million in CCC+ might be said to have an average credit quality of BB+.  Because the company issuing a bond, not the bondholder, pays for the agencies to issue a credit rating, rating information is freely available to all investors.

In the U.S., credit rating agencies are designated as Nationally Recognized Statistical Rating Organizations (NRSROs) and are regulated by the Securities and Exchange Commission (SEC).  The largest NRSROs are Standard & Poor’s and Moody’s.  Following the 2008 financial crisis, credit rating agencies have come under fire.  Critics have accused the agencies of issuing ratings that were too rosy for particular types of debt instruments known as mortgage-backed securities (MBS).  As a result, Congress passed the Dodd-Frank Act, which requires the SEC to adopt a number of new rules regarding the credit rating agencies.  The ultimate outcome of these new rules has yet to be determined.

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