SPECIAL REPORT From 'Nikkei Business' January 9 1995　Issue　Bond Prices Increasingly Differentiated According to Bond Ratings　Credit Risk Becomes Standard Controlling Corporate Financing　　By Mitsutake Yoshimura　　Managing Director in charge of Information Services　The Japan Bond Research Institute　　 　Interest rates on the secondary bond market are increasingly being determined according to bond ratings 　which assess the credit risk of issuing corporations. The market is now operating under the principle that interest rates should be higher the lower the rating (and therefore the higher the risk). Banks 　groaning under the weight of nonperforming credits 　can no longer apply flat financing conditions 　and this development is being spurred on by the coming of age of ratings as a mechanism greatly affecting interest rates on fund raising. In the autumn of 1994 　one simple graph attracted serious attention on the Tokyo capital market 　even at a secret study group involving banks 　securities firms and government officials 　where it became a principal theme of discussion. The graph is represented in nearly exactly the original form on the next page. The reason this single graph became so prominent was that it challenged the preconceived notions of market players regarding the bond market. 　The broken lines on the graph represent spreads against LIBOR (London Interbank Offered Rate) on the secondary bond market according to different bond ratings. (The firms whose bond ratings were used in the sample are general Japanese domestic business corporations other than electricity and gas companies.) As can clearly be seen from the graph 　there was a clear demarcation in spread differentials between the period prior to the summer of 1993 and the period since then. Until that point 　there was no particular distinction between AAA (triple A) ratings and other ratings 　but from the summer of 1993 onwards a pronounced differentiation has emerged between AAA and BBB (triple B) rated bonds. 　Interest rate differential of 1.2% between AAA and BBB rated bonds 　A recent spate of downgradings of ratings has resulted in a further increase in the differential of spreads between ratings. Although this differential disappeared briefly in the early spring of 1994 　this was a short-lived phenomenon and the divergence in interest rates has become even more striking since then. This confirms that ratings are at last becoming a key factor in the differentiation of bond pricing. This differential between AAA and BBB rated bonds now stands at 120 basis points (1.2%) with an average divergence between each rating level of around 40 basis points or 0.4%. For an issue of ten billion yen's worth of bonds 　this adds up to a total pricing differential of ｴ120 million between AAA and BBB rated bonds. (All the bond ratings used in this survey are supplied by The Japan Bond Research Institute.) 　The above data strikingly demonstrates the development of a market structure whereby interest rates on the secondary bond market are set in response to bond ratings 　which is to say in response to credit risk. Meanwhile 　the same graph uses symbols such as representing AAA ratings and representing AA+ (double A plus) ratings to demonstrate issuers' costs (including underwriting fees and commissions) on the primary market. Whereas it would be expected that these symbols would appear above the original broken lines on the graph 　it can be seen at a glance that this is in fact absolutely not the case. There have meanwhile 　recently been cases of negative spreads of issuers' costs. This suggests that costs for fund raising through bond issuance are lower than standard interest rates 　or in other words that bond issuance has become a cheaper fund raising avenue than borrowing from banks. Issuers' costs do not appear to reflect bond ratings at all 　and this difference between the primary and secondary markets has become even stronger recently. 　Does this mean that the primary market is obeying a different logic than the secondary market? In any event 　it is unusual that different costs should prevail on the primary and secondary markets. If this implies that investors have to assume the burden of credit risks but issuers are able to avoid these risks 　it would suggest that the market is malfunctioning. In Japan 　bond issuance was originally a substitute fund raising route to supplement borrowing from banks and like bank borrowings 　used to be subject to the principle that collateral was essential 　so that ever since the war bond issues were controlled under the so-called 'height and weight system' depending on the scale and actual offering amount of an issue. However 　demands from both Japanese and overseas issuers to be permitted to issue unsecured bonds became increasingly insistent 　and the introduction on the primary market of bond ratings signifying the degree of credit risk opened the door to the issuance of unsecured bonds. Initially 　numerical standards such as the scale of assets were still in use alongside bond ratings 　but gradually these standards have been displaced. Since the start of the 1990s 　the dull stock market has made equity-linked financing (i.e. 　fund raising attached to the issue of new stocks) extremely difficult 　and this has also contributed a burgeoning of fund raising through debt instruments. 　Issuance of Junk Bonds likely to be Authorized 　General business corporations were caught up in the 'bubble' period of the Japanese economy during the 1980s and paid little heed to potential problems in the future 　so their issuance of bonds was stuck at low levels 　not even reaching a total of ｴ6 billion in the 1989 fiscal year. However this figure had multiplied to ｴ1 430 billion by the 1993 fiscal term 　broadly the same level of bond issuance as was recorded by electric power firms in the term. In addition 　further progress has been made toward consolidating the regulation of the financial system 　as represented by changes in laws regarding bond issuance during 1993 　and it is expected that in due course the issuance of bonds with a BB rating signifying high credit risk (i.e. junk bonds) will also be permitted 　pushing the liberalization of bond issuance a stage further. 　Since the early days of the introduction of the rating system in Japan it has been assumed by market players that ratings were firmly established in the primary market. In fact however 　the market reality demonstrated by the graph on page 2 shows that the opposite was true. Ratings were of course firmly established as part of the bond issuance system (ratings were one of the criteria used to regulate the ability of a company to issue bonds). It appears however 　that this did not mean that they were firmly established as part of the market mechanism. 　Table 1: Rating Definitions (from JBRI) 　AAA indicates the highest overall degree of security. 　AA indicates a very high degree of security. 　A indicates a high degree of security with excellence in specific component factors. 　BBB indicates a sufficient degree of security as a general investment object but requires constant watching. 　BB indicates uncertainty as to the degree of security in the light of probable future developments. B indicates a low degree of security. 　CCC indicates that there is an element of anxiety concerning future fulfillment of obligations 　although no defaults have occurred. 　CC indicates that there is serious anxiety concerning future fulfillment of obligations 　although no defaults have occurred. 　C indicates that defaults have occurred. 　Note: ･ "Degree of security' refers to the ability of the issuer to repay principal and pay interest in accordance with the obligations made to investors at the time of issue 　･ A mark of plus (+) or minus (ﾐ) is sometimes added to provide a more precise indication of an issuer's creditworthiness. 　The summer of 1993 saw the start of a period of fierce competition for bond underwriting business 　partly because it also saw the creation of brokerage subsidiaries by long-term credit banks and financial institutions related to the agricultural cooperative system 　and issues with negative spreads therefore appeared on the market. The summer of 1993 therefore represents a clear demarcation in the history of the primary market 　but even so there is no visible evidence either before or after this turning point of any relationship between ratings and primary market coupon rates. The secondary market however 　has followed market theory more closely. Why then 　have divergences according to ratings appeared in the secondary market? 　Securities companies use the screens of the 'QUICK' service to supply market-making information 　advertising the prices at which they are prepared to buy or sell bonds. These screens therefore display current bond prices (although in fact very few bonds issued by general business corporations are displayed). In the case of straight bonds 　it is standard practice to show a spread against government bonds with broadly the same period remaining until maturity. The graph shows the spread of this against LIBOR since the Tokyo financial market uses the divergence from LIBOR in its transactions. These are transactions involving interest rate swaps. Recently the volume of such transactions has increased in Japan 　and interest rate swaps are one of the kinds of derivative which have recently attracted a lot of attention. 　The yen LIBOR rate is the interest rate used in interest rate swaps 　and business is conducted through the spread 　the divergence from standard LIBOR. These spreads reflect bond credit risk or in other words ratings. Of course 　the credit risk of the swap counterparty is also involved in this calculation. This means that if a financial institution's rating suggests danger the potential risk is greater 　so an even higher spread needs to be paid. This is because the creditworthiness of financial institutions is like that of bonds denoted by ratings. In short 　ratings have become essential in setting LIBOR spreads because of the character of swap transactions 　which are based on a calculation of risk 　Overseas banks and securities companies introduced swap transactions to the Tokyo market. Japanese securities firms at that time had not yet considered that ratings could have any influence on interest rates in bond transactions. They in fact appear to have thought that if they followed the advice of overseas brokerages a tidy distribution of spreads would emerge without any effort. 　It would be no overstatement to think that the creation of the standard form of bond prices was controlled by factors external to the Japanese market. The introduction of the rating system itself was of this nature. This is evidenced by the graph on page 2. This alone makes this an epoch-making graph and explains why the implications of the graph have been a crucial learning process for market players. However 　arbitrage arising from a wider recognition of the fact that bond prices are being based on bond ratings will mean that such large spreads as shown in the graph may not appear again. In addition 　with the issuance of junk bonds being permitted 　spreads for BB rated bonds will be even greater than those for BBB rated bonds 　so spreads on BBB rated bonds are likely to fall to a corresponding degree. Whatever happens 　securities traders will find themselves less able to conduct transactions without a firm understanding of bond ratings. Overseas securities firms and banks are already using data bases of bond ratings 　and automatically estimate a certain basis point spread in view of the rating in telephone dealings. It looks inevitable that the same trend will emerge among Japanese domestic dealers in the near future. In that event 　the present favorable conditions for bond issuers on the primary market are unlikely to change. In future 　in addition to the 'broken line graph' of secondary market prices determined as a result of the influence of ratings 　the fixing of coupon rates on the primary market in a way which reflects bond ratings can also be expected to emerge. In one sense this is what the market system means. 　'Abandonment' of the Long-term Prime Rate 　As the market increasingly determines the distribution of funds within the macro economy according to bond ratings in such a way that high risk firms must pay higher costs and low risk firms a lower cost 　this will result in major benefits for the national economy in terms of boosting overall efficiency through spotlighting healthily managed firms. 　This process will heighten the safety and stability of management by encouraging management not to get involved in 'absurd' practices as was the case during the years of the economic 'bubble.' Moreover 　the open assessment of risk and return by the market will produce a system for distribution of capital resources through the pricing mechanism. In addition the victory of the principal (i.e. the bond holders) over the agent (i.e. 　management) will mean that agents have to bear the burden of risk so in terms of corporate logic 　benefits appear in the form of the monitoring of agency costs (institutional expenses) through ratings. 　The principle of the rating system is to achieve corporate governance by bond holders. In this way 　ratings are becoming in some sense an engine for the introduction of competition by driving down the agency costs of main banks 　whereas with bank borrowings the distinctly Japanese main bank system consisting of 'screening' and so on could be explained in terms of an agency cost approach. During the 'bubble' years 　the encouragement given to corporations by their main banks to invest in land and stocks created complications in terms of pushing up agency costs. 　The principle of a collateral-based system of corporate financing was founded on the experience of the 1930s when numerous banks foundered. However 　during the period of the 'bubble economy' this line of thought was pursued too far 　and the fall in the value of resources which could become collateral brought with it a massive outbreak of nonperforming credits 　so there is now an extremely high level of very risky credits. In addition 　since the extent of restructuring of claims through interest relief has not been made clear 　financial institutions hold a heavy burden of default risks. As a result 　each financial institution is setting up companies whose specific purpose is to dispose of collateral properties in order to write off nonperforming loans 　even if only on paper. On the other hand 　in order to ensure healthy financing in future 　there has been a 180 degree turn in financing methods from placing the main importance on collateral to placing the main importance on risk. Not only banks but life insurers liability insurers 　and securities firms are all making moves to change their ranking of transactions in terms of risk. Financial institutions with loans advanced to 10 　000 different firms are considering realigning their investment priorities by establishing new risk assessment systems. Until now 　long-term lending rates have been based on the long-term prime rate 　with a uniform rate for major listed firms. In the case of companies linked to a lender through 'keiretsu' ties 　premiums were offered in forms such as enhanced interest rates on deposits 　with mark-ups applied to other firms. It has therefore been a system heavily favoring keiretsu firms. Both lenders and borrowers have up till now acquiesced in this distinctively Japanese management system. However 　financial institutions now hold such a high level of default credits that they are reluctant to continue with this existing system any longer. It is probably now becoming inevitable that they should hope that the concept of risk will be built into interest rates. 　Spreads arising from bond ratings will probably in due course be reflected in interest rates applied to lending. In addition 　this development will probably be facilitated if financial institutions change to an assessment system focusing on risk. This promises to be the dawn of an age when keiretsu ties cease to obstruct the activities of banks. 　Financial institutions are already referring to spreads based on bond rating as definitive data in determining how far to differentiate lending rates 　even when they have set up new credit assessment systems. Both lending rates and interest rates on bonds are in other words now being determined by the market. The age of the uniform prime rate has been superseded. This is what the market demands 　and financial institutions which fail to embrace this transformation will be digging their own graves. In this sense 　the long-term prime rate has been 'abandoned.' The author: 　Mitsutake Yoshimura is a former senior staff writer of the editorial bureau of the Nihon Keizai Shimbun. His published works include 'Disclosure as a Force for Market and Management Renewal' (Chuo Keizaisha) which he edited 　and contributions to 'Osaka Economics' (Keieishoin). He is the director of the Japan Association for Business Analysis.