The Broken Bond Market

Abstract

Valued at around $10 trillion, the U.S. corporate bond market is slow, expensive, and inefficient. This Article argues that the bond market – premised on contract – rests on a flawed regulatory design that delivers neither investor protection nor market quality. It makes three contributions. First, it shows that bondholders navigate a conflict between protecting themselves using a tailored contact – and being able to easily trade their bond. By tailoring a contract to match the riskiness of an issuer, bondholders end up holding a less standard claim that becomes harder and costlier to trade. Second, the Article develops the implications of this conflict for investor protection. Bondholders incur transaction costs that do not exist in equity markets. Activism is more difficult as investors cannot deploy the threat of exit cheaply to pressure managers. Monitoring costs are high as prices are incapable of performing a surveillance function. This Article thus refines the traditional notion of bondholders being passive, apathetic actors. Rather, the impossibility of achieving both investor protection and tradability limits bondholders in their ability to push back against managerial and shareholder misbehavior. Third, this Article sets out a three-part solution designed to create choice, control, and tradability. It proposes: (i) standardization through the creation of tiers of form contracts that enhance tradability while offering some tailorability in the choice of model contract; (ii) a stronger role for trading platforms in monitoring and enforcing contract terms; and (iii) maintaining a bespoke segment, offering maximum flexibility to contract, to accommodate those that want fullest tailorabilty even at a cost to tradability. Taken together, this solution aims to repair the broken bond market and to promote investor protection, trading, and efficiency as fundamental features of securities market design.

Keywords: Corporate Bonds, Credit Market, Equity, Securities, Investors, Bondholders, Indenture, Trustees, Banking, Liquidity, OTC markets, Dealers, Primary Dealers, Market Efficiency, Contracting, Trading Platforms, Exchanges