The Historical Evolution of Today's Bond Market
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This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Explorations in Economic Research, Volume 2, number 3 (Regional Stock Exchanges in a Central Market System) Volume Author/Editor: NBER Volume Publisher: NBER Volume URL: http://www.nber.org/books/conf75-1 Publication Date: 1975 Chapter Title: The Historical Evolution of Today's Bond Market Chapter Author: Sidney Homer Chapter URL: http://www.nber.org/chapters/c9226 Chapter pages in book: (p. 378 - 389) [ SIDNEY HOMER The Historical EvolutionofToday's Bond Market SIDNEY HOMER: In retirement since1971 Mr. Homer hasbeen acting as a consultant to SalomonBrothers and others. career in 1923, after graduation from He began h; Harvard College. Hewas presi- dent of Homer & Company,Inc., from 1932 to 1943; served withthe Foreign Economic Administrationfrom 1943 to 1945; of the institutional and ac manager department of Scudder,Stevens & Clark fr to 1961. From 1961 194 to 1971 he wasa general partner of Salonlon Brothers and was in chargeof its bond market research departmeni Mr. Homer is the authorof several books on the money market andisa member of the NationalBureau's advisory and associate editor committee on interest rates of the FinancialAnalysts lournal, I will start witha vignette of one phase 1910 as it was of the American bondmarket in described tome by my first boss. His first salesman foran old, well-known job was that ot Wall Street bond firm.His territory WdS Connecticut Theygave him a bicycle and were mostly a list of bonds to sell. The bonds second.grade 5 usually priced percent western public utilitybonds and were at par. Ourgrandjather numbers and itseenis,liked good round scorned fractionsOen the bonds writer, something cost that firm, the under- like tenpoints lower (plus young salesman, who some free stock), and so the operated on a 50-50commission basis, made $O for every bondhe sold. 378 EVOlUtR)1 of Today'sRond Mark't 379 IIitoriL-,ij days one bond aweek would keep a man alive, three bondsa In those be prosperity ten bonds a week would be affluence. So he %eek would peddlitig around the statelookmg tor prosperous storekeepers, to- went druggists, who might buy one or two IX)fldS, or country bacco farmers, might buy five or more. He did svell, and in live years of so he banks that accumulated enough capital to start his own firm. That is a picture of a had market, perhaps not entirely representative, but in the main retail bond valid. Those were nothigh-grade bonds and so had to be retailed in out-of- places to private investors. However, the record of those western the.way utilities wasexcellent, and twenty years later many of them were called and otherseventual!Y became legal. The prime bonds, in the decade ending in 1910, werethe rails, like the New York Central first 3½s of 1997 noncallable. Prime new issues were also underwritten on a negotiated basis, but these werelisted on the New York Stock Exchange, grabbed up by sophisticated investors,and if well priced they sold at quick premiums. Indeed, between 1880 and 1900,when prime yields moved from 41/z percent to 31/8percent, fortunes were made by capitalists carrying big blocks of such bonds on credit. They were usually 1 00-yearmaturities and noncaliable. One popular issue matured in 2361.The basic business was retailsmall, country investors or big-city investors. Underwritingspreads were so large as tomake methodical widespread distribution profitable to dealers even if unit transactions were small. This is not true today. a S THE 19205 I s'ill now jump to the mid-1920s when I began my career in Wall Street. From 1923 to 1930 prime, long-term bond yields were remarkably stable at about percent. I do not recall much interest rate speculation; probably the memories of the bond market collapse of 1920 were still green, when yields soared to 5'/2 percent and the old prime 3V2 percent bonds declined briefly to a price of 64. But there was a good active bond f business and lots of underwriting and distribution to private investors and S now also to institutions. Good bonds were mostly listed, and theprivate S investors bcught and sold on the exchange. e Institutions, however, liked round lots (in those days this usually meant a d hundred bonds, occasionally $1 million), and it was hard to buy such lots r- on the exchange except for a few very active issuesUsually relatively new e issues. So institutions often waited for new issues where they could buy in 0 s:ze. At times they could buy new issues at a lower wholesale priceand sometimes became underwriters. However, there were a fewbond-trading e S 380 firms that made it their bUsineSs to accumulate bonds üii the maybe one to five at a time, until they had collçteI lO0-bondexchange lo o more; and then they put theblock on their list at a worthwhilemark) sold the block to some savings bank or insurance company. It and was usually recognized that in a stable market a seasoned round lotwas worth than an odd lot. Such trades then began on the floor (accunirilation)more ended over the counter (distribution). and At this point I should mention a fact that is often overlooked. business obtains its external financing primarily in the American OVeNthe..counfer market through underwritings of bond and stock issuesor direct borrowing from institutions.It much less often looks to the exchanges for amounts of new capital and then mostly from rights issues. large The importance of our secondary markets, both listed and unlisted, is chiefly toprovide the initial investors with liquidity. If there wereno secondary markets many investors would buy new issues of either bonds not so or stocks Good secondary markets are basic to oureconomy, but are not primarily source of new capital. a direct THE DEPRESSION I will now pass to the 1 930s, a period which separated the sheep fromthe goats: in the panic, the yields on sound medium-grade bonds, say A rated. rose from 5 percent to as much as 1 5percent (a price decline of perhaps 70 percent), while at the verysame time prime corporate bond yields declined from 4½ percent to 2/4 percent (a price rise ofperhaps 42 percent if noncallable). Most of those bondissues that had been distributed to the public in earlier decades suffered one of four fates: they defaulted,or they lost caste and declined steeply, or if they did not losecaste rose steeply in price,or they were called ii callable. According to Brad Hickman's wonderful corporate bond studies,1x, tween 1900 and 1943, $71 billionpar value of straight bonds of American corporations were sold, of which1 8 percent defaulted, 12 paid in full at percent were maturity, 37 percentwere called, and 26 percent ss'ere outstanding at the end with a perfectcontractual record. These figures seem to reveal theprocesses by which private investors, of the corporate bond once the mainstay market, lost three-quartersof their bondholdings: by default, by call,and by maturity. During those depression years, indeed,private investors virtually aban- doned thecorporate bond market...discouraged ofcourse, by the calls, the defaults, the declines, the lowprime rates, and the income taxwhile Institutions grew rapidly and absorbed almostall of the small supply ol L. Evolution of Today's Bond Market HitoriC 381 new bondissues and also bought seasoned issues that were beingsold at depressed prices by other institutions and private investors. At that time 1onipctitive bidding for new issues became common, and sonic institutions experimented with bidding, often to their sorrow. There were alsoa few "best efforts" new issues. The corporate bond business became almost wholly an institutional business in the 1 930s.Often the dealers bought blocks of bondsat deeply depressed prices from deposit institutions that were forced by examiners to liquidate, and the dealers then sold the bonds to strong life insurance g companies. In those days, although most large corporate bond issues were e stilllisted, block transactions in high-grade bonds were mainly over the e counter while low-priced, active, si'eculative bonds traded partly on the e exchange and partly over the counter. The exchange tried hard to retain its bond business by means of a series of regulations requiring members to trade smaller lots on the exchange, or at least try to, but those efforts did not affect trades in large lots and without the public the small-lot business dried up, and the large-lot business came to dominate the market. In the worst part of the depression a great deal of round-lot bond business was done with institutions on an order basis without involving dealer capital, that is to say, a liquidating institution would give a dealer a firm order to sell a block of inactive bonds at a price higher than was obtainable from dealer bids, and the dealer would check his institutional customers in an effort to find a buyer and often succeeded. To large institutions the advantage of over-the-counter bond transactions became obvious. Imagine for a moment that you are the trader for a life S insurance company. One morning your boss walks up to you and says, 2 "We just approved $1 million X 7s at about 90." The bonds are listed, and d you could call your broker and find that on the board the bonds are quoted r 90-90Y2, ten up. You could buy the ten bonds and put him to work buying 990 more at about the same price.It might take a month, and your persistent buying would surely push the market up.