Why do financial institutions issue bonds?

For financial institutions, banks and insurance companies, the bond market is not only a place to find funding and capital for their business, but it is also a place both to find savers with different savings or financial needs and to invest.

The nature of financial institutions means that their funding requirements cannot be separated from their business activities, unlike the companies we discussed above. Financial institutions have broadly two activities: first, they act as financial intermediaries; and, secondly, they acquire and manage a diverse portfolio of financial risks. For example, a bank acts as an intermediary because it serves to move funds from those who have a surplus (savers) to those who have a need (borrowers). In doing so the bank acquires a portfolio of credit risks funded by savers: not all of the people or companies to whom it lends are likely to repay their borrowings in full. Banks find this an attractive activity and seek to profit by charging an interest rate commensurate with the borrowers’ credit risk.

However, banks do not have an appetite for all of the risks that they acquire when collecting deposits and making loans. For example, banks receive cash from savers in the form of deposits, which can be withdrawn at short notice, but their assets are loans not all of which are repayable on demand, some, such as mortgages, are only due to be repaid many years in the future. This mismatch is a risk for the bank and is generally referred to as either term or liquidity risk. Insurance companies and pension funds have the opposite risk to a bank: they have long term liabilities in the form of obligations to pay pensions in exchange for which they receive short term assets in the form of cash premiums. A bank will seek to mitigate its term risk in a variety of ways, one of which is to issue bonds. Pension funds and insurance companies can then buy these bonds and acquire a long term asset, which in turn reduces their risk by providing a better match for their long term liabilities (e.g. pension payments). In this example both the bank and the insurance company (or pension fund) act as intermediaries. The insurance company or pension fund receives cash from savers, which it uses to buy a long term bond from a bank; the bank thus secures funding with which to make long term loans. In the process the insurance company or pension fund on the one hand and the bank on the other have acquired or retained the risks that they want and diversified respectively their portfolio of investments and sources of funding.

As we have seen above, banks can attract funds by offering bonds that appeal to a pool of savers that is larger than simply depositors. Another such example, which appeals to very large and conservative savers, is known as a covered bond. This has a similar structure to a UK household mortgage. In the UK when someone takes out a mortgage, the bank lends the money to the individual, and takes a charge over the house. If the borrower fails to keep up the payments on the loan, then the bank can sell the house and use the proceeds to recover its loan. Covered bonds operate in a similar manner: the bank borrows the money by issuing the covered bond, but if it cannot keep up the payments on the bond the holders of the covered bond assume ownership of the supporting assets. Such a bond is attractive to certain investors, because the backing provided by the combination of the bank and the pool of assets makes the bond safer than one backed by either in isolation