Long Term Bond Markets and Investor Welfare

A simple framework is developed to analyze the important role of the bond market for the welfare of a long horizon small investor when both inflation and the real interest rate are stochastic. Closed form solutions for investor utility in different settings are used to show that the welfare loss due to the absence of long term bond markets increases with the investor’s horizon and risk aversion, and with the size and persistence of the shocks to the real interest rate, but decreases with the correlation between the stock return and real interest rate. Using parameter estimates derived from U.S. data, we show that the welfare costs of the lack of a bond market can be substantial. Long Term Bonds and Investor Welfare The last 20 years have seen increasing recognition of the importance of private capital markets, and particularly of equity markets, as a mechanism for achieving efficiency, allocating capital, providing appropriate managerial incentives. It is this recognition that in large part lies behind the wave of state industry privatizations that has swept most western economies, and led even the formerly communist economies of China and the former Soviet Union to develop stock markets. Gibbon (1998, 2000) reports that the cumulative value of proceeds raised through privatization programs by governments during the last two decades exceeds $1 trillion, and the amount of such revenue raised each year is now roughly $140 billion. Many countries experienced dramatic increases in market capitalization relative to GDP between 1990 and 1998. For example, China’s stock market capitalization rose from 0.5% of its GDP in 1990 to about 25% in 1998. However, if private capital markets are to be used to allocate capital, then the capital itself must be under private, rather than state, control, and since a major component of a nation’s stock of capital corresponds to the life cycle savings of individuals, the development of private capital markets presupposes a pool of private savings that are controlled by individuals. Therefore, the privatization of industry presupposes the privatization of savings. Countries as diverse as Chile and Sweden have modified their state pension systems so that a part of social security contributions are invested privately with some discretion of the individual over the type of fund in their retirement plans; and a similar proposal has been under consideration in the US. More D’Souza and Megginson (1999) point out that share issue provatization contributes the largest fraction of total proceeds raised by governments. Boutchkova and Megginson (2000) argue that “Although governments usually adopt privation programs to raise revenue, · · · , most also hope that privatizations implemented through public share offerings will develop their national stock markets.” Source: World Bank, “World Development Indicators 2000”.