Draft: June 8, 2003 Developing Efficient Market Infrastructure and Secondary Market of Government Bonds in Developing Countries

Capital Market Profile peculiar to Developing Economy

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2Capital Market Profile peculiar to Developing Economy

Some socio-economic conditions that are typically observed in a developing economy are different in many aspects from basic prerequisites for capital market development in a developed economy. The diagram in Figure 1 below schematically depicts a capital market profile generally peculiar to development economy.

The demand side of securities is where and how funds are accumulated in an economy. The demand side rectangular in the diagram below symbolically illustrates a distribution pattern of funds unique to a developing economy. Namely, the per capita income level is low and households are predominantly dependent on bank deposits for their savings. The aggregate size of a country’s economy is small. Among various kinds of contractual savings, pension funds are weak and often captive to government deficit financing. The insurance sector develops ahead of pension funds. In addition, the non-life insurance industry often overweighs the life insurance industry in the asset size. The informal economy is quite sizable.

The supply side of securities is where and how financing is needed for investments in an economy. The supply side rectangular in the diagram below schematically illustrates a distribution pattern of financing needs unique to a developing economy. As far as the supply side of securities in a developing economy is concerned, the government’s policy initiatives are central to the country’s capital market development through steady implementation of its privatization programs, and disciplined issuance of government bonds2.
Figure 1: Capital market in a developing economy

3Demand- & Supply-side Principles for Market Liquidity

Regardless of a developed or developing economy, certain conditions of the demand and supply sides of a bond market substantially determine a possible liquidity level of the market. They are prerequisites for bond market liquidity. A well-organized market infrastructure is often secondary to them.

The government, as the sole supplier of government bonds, needs to provide investors with a sizable, regular, and stable (predictable), transparent, and market-based supply of high quality and uniform bonds through public offerings. Generally, government bonds are regarded as being of the highest quality in the domestic market. On the demand side, investors should be many in number, incessant in trading needs, competitive in investment performance, and diverse in demand patters for the bonds.

It is outside the scope of this note to discuss implications of these demand- and supply-side characteristics and policy measures to create, reinforce, supplement or enhance each of them. Assuming that everything necessary on the supply- and demand-sides is reasonably in place, discussions in this note will focus on how to develop an efficient market infrastructure for secondary market trading of government bonds in developing countries.

4Why Does Efficiency Matter?

Trading per se is neutral to total returns, and never pays for trading costs without additional risk. Therefore, it is critical to keep trading costs low for market liquidity. Due to a public goods nature of capital markets, a public support is essential to bring down the direct costs of trading.

4.1Impact of trading on an investor’s return

Why does the market efficiency matter? “A market has to be efficient” appears a truism. Nonetheless, it is useful for market designing to know how efficient the market has to be. To answer these questions, the effect of trading on an investor’s return on bond investment will be examined.

What if an investor holding a 10-year zero coupon bond sells the bond at a market price in response to an interest rate decline halfway through the maturity, and immediately reinvests all proceeds in another identical bond? The proceeds consist of two kinds of capital gains: (i) accrued interests and (ii) a bond value appreciation due to the interest rate decline. Is the investor better off as a result of the bond price appreciation caused by the interest rate decline? In theory, the investor is required to reinvest all the proceeds from the sale of the original bond just to obtain the full principal amount of the substitute bond even in costless environments. The selling price of the original bond at a lower interest rate is the same as the buying price of the substitute bond. Therefore, the investor gains nothing from the trading in terms of total returns over the original investment horizon, despite of a temporarily realized capital gain thanks to an interest rate decline (see Figure 2). Most people can understand this fact intuitively without calculation.

Figure 2: Reinvestment of Zero-coupon Bond

What if we replace zero coupon bonds with current coupon bonds in the above case? An investor holding 10-year current coupon bonds sells the bonds at a market price in response to an interest rate decline halfway through the maturity, and immediately reinvests all proceeds in other current coupon bonds of the same quality and with the same maturity date at par. Since a coupon bond is theoretically decomposable into discount cash flows, the investor gains supposedly nothing from the trading in response to a seemingly favorable interest rate change in terms of total returns over the original investment horizon.

Impacts of trading were calculated on total returns of a 10-year 8%coupon bond in simple cases. The bond was assumed to be initially purchased at par under a coupon bond yield curve ranging from 3% for 1 year to 8% for 10 years, and sold at the end of 4th, 5th or 6th year as the yield curve made a parallel shift ranging from –1.5% to +1.5% with an increment of 0.5%, and all its proceeds was assumed to be reinvested in a new coupon bond with a maturity of 6, 5 and 4 years (the total investment time horizon remained unchanged at 10 years). It was further assumed that all coupon payments were reinvested in zero-coupon bonds maturing concurrently at the end of the 10th year, and that there were no trading costs. Under these assumptions, the future value of the bond investment at the end of the 10th year was calculated for each combination of a year of reinvestment and an interest rate change. Table 1 shows percentage gains or losses of the reinvestment at the future value under 21 (3 x 7) scenarios.

No significant impact was observed in the calculation. In fact, the calculated gains and losses came merely from a switch of the methodological assumptions for a yield calculation from a current coupon bond to a zero coupon bond in respect of the coupons.

From the above exercise, it is clear that trading of a bond in response to an interest rate change is basically neutral to the bond’s total returns over a given investment time horizon in no-trading costs environments unless the investor takes market risks. Even a capital gain brings about nothing over the life of an initially invested bond. To make matters worse, in the real world where trading always incurs costs, trading inevitably eats up some yield.

Table 1: Reinvestment of Current Coupon Bonds

Little impact on total returns of 10-yer bond


Rate Change

Yeas to Maturity
































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