User:Nick Gardner /Sandbox
On The Pricing Of Corporate Debt: The Risk Structure Of Interest Rates* by Robert C. Merton 684-73 November 1973
And secondly, they have driven among investors a ferocious search for yield – a desire among investors who wish to invest in bond-like instruments to gain as much as possible spread above the risk-free rate, to offset at least partially the declining risk-free rate. Twenty years ago a pension fund or insurance company selling annuities could invest at 3.5% real yield to maturity on an entirely risk-free basis; now it would be only 1.5%. So any products which appear to add 10, 20 or 30 basis points to that yield, without adding too much risk, have looked very attractive. Financial market innovation The demand for yield uplift, stimulated by macro-imbalances, has been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments. Simple forms of securitised credit – corporate bonds – have existed for almost as long as modern banking. In the US, securitised credit has played a major role in mortgage lending since the creation of Fannie Mae in the 1930s and had been playing a steadily increasing role in the global financial system and in particular in the American financial system for a decade and a half before the mid-1990s. But from the mid-1990s the system entered explosive growth in both scale and complexity: • with huge growth in the value of the total stock of credit securities (Exhibit 1.5); • an explosion in the complexity of the securities sold, with the growth of the alphabet soup of structured credit products; and • with the related explosion of the volume of credit derivatives, enabling investors and traders to hedge underlying credit exposures, or to create synthetic credit exposures (Exhibit 1.6). This financial innovation sought to satisfy the demand for yield uplift. It was predicated on the belief that by slicing, structuring and hedging, it was possible to ‘create value’, offering investors combinations of risk, return, and liquidity which were more attractive than those available from the direct purchase of the underlying credit exposures. It resulted not only in massive growth in the importance of securitised credit, but also in a profound change in the nature of the securitised credit model