Asymmetric Information in the Bond Market, Thesis of Marketing

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Asymmetric Information ECO 316

Asymmetric Information

Hubbard & O’Brien (2017) define asymmetric information as “a situation in which one party to an economic transaction has more information than the other party.” The bond market, specifically corporate bonds, is a market that’s rife with asymmetric information. As corporate bonds are essentially promissory notes from the corporations that issue them, they are basically only as reliable as the company issuing them. When a company issues bonds it does so with information that the investor may not know, such as trends in sales, potential lawsuits, etc. This asymmetric information is just the nature of any business, if a company operated with full disclosure about how poor sales are, or that they have no viable plan to reverse course, institutional and private investors would be far more reticent to invest in that company. If all information were disclosed, it could potentially lead to many firms going out of business due to a lack of investment capital, so in my estimates these are key reasons why firms withhold information from investors.

Adverse Selection

Klein, Lambertz, & Stahl (2016) describe adverse selection as “when exploitative and careless buyers and sellers enter into the market and conscientious ones exit”.Adverse selection is a problem investors face in differentiating low risk borrowers from high risk borrowers prior to making an investment. Adverse selectionalso pertains to the bond market because investors can have trouble differentiating between good firms that are likely to honor the terms of the bond, and bad firms that are at higher risks of defaulting.

Restrictive Covenants further this concept by eitherlimiting the uses of the funds received or requiring that the borrower pays back the bond in its’ entirety in the event the borrower’s net worth dips below a certain amount.

Principal-Agent Problem

A principal-agent problem is the moral hazard associated with managers of firms pursuing their own interests instead of those of the investor. Situations like this are fairly common in financial markets when firms pursue interests that are opposed to those of shareholders. This applies to the bond market because in an attempt to generate profits, or a growth target that would get the manager or management team larger bonuses, the team could decide to involve itself in a risky proposition that leads to the company going bankrupt. This course of action is not in the bond investor’s best interest at all, primarily because increased profitability would not affect the investor as his bond principal and interest payments are fixed. The company going bankrupt is not in the investor’s interest because then the company would not be able to make its’ bond payments and fulfill its’ obligations to the investor(s).

Conclusion

As with all financial markets, the bond market is somewhat treacherous to navigate due to asymmetric information, moral hazards, and principal-agent problems.There are many solutions for large institutional bond holders to overcome these obstacles, chief among them would be installing their own proxies on the boards of these firms. Large institutional bondholders like a Berkshire Hathaway could insist that one of their employees be placed on a

firm’s board of directors in exchange for the hundreds of millions, or billion dollar bond purchase. This type of situation would ensure more transparency and access to the company’s operations for the lender. For smaller institutions and lesser investors these obstacles are not so easily overcome, and they can only make the best decision they can with the limited information that’s available to the public.