The bond market and the pension industry closely interlink to each other and to the economy. Businesses need long-term funds to invest in expansion, like buying new machinery and to create jobs. Borrowing directly from investors through bonds is often a viable and cheaper option than getting a bank loan. This is essentially because banks are intermediaries between investors and borrowers. Banks are also not the best intermediaries for long-term money because most of their deposits are held short term. They therefore deal with the challenge of using short-term deposits to lend long term by increasing the cost of borrowing, or declining to lend beyond certain periods.
When businesses borrow directly from investors instead of from banks, the cost of interest margin is eliminated from the transaction. Take the current margin of seven per cent, which is the difference between the interest cap of 14 per cent and deposit floor of seven per cent. Assuming it is shared equally between the investors and the borrower, an investor can get 10.5 per cent on their deposit and the borrower can borrow at 10.5 per cent. Granted, there is the cost of issuing the bond, which in this case should not exceed the benefit of 3.5 per cent. The investor also needs to be prepared to take a direct risk on the borrower.
Unlike banks that hold short-term deposits, pension funds have money on a long-term basis, usually an average of 10 to 20 years. This makes them a natural fit for investment in the bond market. A working bond market is a driver for a stable pension industry, and a growing pension industry drives the bond market. In fact, the traditional rule of thumb for pension fund investment is 60 per cent in bonds, and 40 per cent in the stock market.
The current decline in the bond market is, therefore, a risk to businesses and the economy. It leads to higher long-term borrowing costs for businesses at best, and lack of long-term funds at worst. This affects business expansion and employment creation. The impact goes further to the cost and availability of long-term funding in the housing sector as well, affecting individuals further. For pension funds, it means higher investment in the less predictable stock market, which affects their financial stability. Both affect the growth and stability of the economy. This makes the bond market a very important part of the financial market; for individuals, businesses and the economy.
It is no surprise that the rapid economic growth of Asian countries is closely linked to the developments in the bond market. It is, therefore, critically important that the current state of the bond market is resolved. There is no simple or easy way of going about it. But the solution must involve steps that allow investors to assess risks and build their confidence.