CommonLounge Archive

Bonds and Fixed Income Markets

February 09, 2018

Bonds are debts from investors to either a government or private companies. A government may want to finance infrastructure projects for example, and for that purpose, it can issue bonds to obtain funding. Investors would then purchase the bonds for a certain price (principal amount). Then, depending on the maturity period of the bond the investor will receive his money back in different regular installments. In addition to the installments, the investor receives interest payments on the loan on a regular basis as well. This interest payment is what incentivizes the investor to lend the money to the government or private company.

Bonds are considered fixed income assets since the interest rate is predetermined upon the purchase of the bond. Therefore, the investor knows in advance the amount he will receive in return for his investment. Bonds are usually a better choice for investors who have a long term investment horizon, since it usually takes considerable time for the bond amount to be repaid in full.

Bonds and fixed income assets, in general, are considered low-risk investments since their return on investment is known in advance. But they are not entirely risk-free.

The bonds are usually issued in the primary market and then they can be exchanged in the secondary market. In the secondary markets, bonds can be sold at a discount (at a lower price than the amount that the investor would have made had he held on to the bond). Investors looking for liquidity usually offer their bonds in exchange for a discount on the bond’s price. For example, let’s assume the remaining payments for a $1000 bond is$348, the investor might accept to sell it for $300 in exchange for liquidity.

Bond Yield vs Bond Price

A bond’s yield is the effective interest rate on the bond and is calculated as the annual return on holding a bond for a year — it is usually a percentage. For example, if you make $500 on a$20,000 bond per year, then the yield is 2.5%.

There is an inverse relationship between the bond’s yield and the price of the bond. If the yield increases, the price decreases, and vice versa. The reason for this relationship is that the interest rate is paid on the principal value (par value) of the bond and not on the market value (price) of the bond.

Let’s take an example. If a bond has a price of $87, but was initially issued for$100 (par value) and a coupon payment of $5 (5% coupon rate or yield), then based on the selling price$87 and the coupon payment of $5, the yield is 5/87=5.74%. Therefore, as priced declined from$100 to $87, the yield increased from 5 to 5.74%.

Types of Bonds

There are mainly two main issuers of bonds: governments and corporations. Government bonds are usually called sovereign bonds and are considered the safest since the possibility of default by the government is low. Municipalities can also issue bonds to fund projects, and those bonds are called municipal bonds. U.S. long-term municipal bond issuance totaled $445.8 billion in 2016, for example. Another type of bond is the Mortgage-backed bonds and it is usually used to fund real estate projects and investments.

Credit Rating Agencies

Bonds are associated with the risk of default (the inability of the issuer of the bond to pay back his obligations). And different issuers have different levels of default risk. For that reason, credit rating agencies such as Standard & Poor’s, and Moody’s provide credit ratings for investors to assess bond issuers on a regular basis to help investors assess the risk in their investment. Ratings can range from AAA (the highest rating and least risky) to C (lowest rated class of bonds) to D (in default). However, credit rating agencies have been blamed in the past for their inability to predict the financial crisis in 2008 and for not giving institutions responsible for the crisis a lower rating.

Global Bond Market

The value of global bond markets outstanding reached $92.2 trillion in 2015, and global long-term bond market issuance totaled$21.4 trillion in 2016. As you can see, the global debt securities market is considerably large. In 2015, it was larger than the equities market in terms of market capitalization.

US Bond Market

The US bond market is the largest in the world. The US Federal government sells debt in the names of treasury bills (T-bills), notes, and bonds. T-bills are usually short term debt obligations with a maturity period of a year or less. The T-bills usually have no frequent interest payment but rather one final payment that equals the par value plus the yield amount. The amount paid to the investor eventually is higher than the par value of the T-bill. For example, if you buy bought a T-bill for $100 at a 2% yield, you will receive at the end of the year$102.

Notes and bonds, on the other hand, have longer maturity period and have a fixed interest rate associated with them. Notes are usually medium term securities (they range in their maturity period from 1 year up to 10 years). Bonds are long term investments and typically last for longer than 10 years.

Factors Affecting Bond Prices

Bond Prices and Interest Rate Relationship

The interest rates in the market have an influence on the bonds’ prices since they represent an opportunity cost. If the interest rate has increased from 3% to 4% then the price of the bond that has an interest rate lower than 4% will decrease, whereas the price of the bond that has an interest rate of higher 4% will increase since they will become more favorable.

Bond Prices and Inflation

Similarly, the inflation rate has an effect on the prices of bonds. If investors expect that there will be high inflation in the future, then the price of the bond will decline, and the yield and the interest rate will rise.

Since interest rate and inflation can affect the bond’s price they should be considered as risks for bond holders and should be managed on that grounds.

Central Banks

Central banks intervene in the financial markets through their monetary policy tools such as changing the interest rate. Expected policy decisions such as the interest rate have an effect on the bond’s market in that they lower or reduce bonds’ prices.

Federal Reserve

The Federal Reserve is a major actor in the financial markets since its decisions have implications on different markets including bonds, currencies, and equities. The Federal reserve can also implement programs such as providing stimulus to the economy which usually pushes bond prices higher. For example, the stimulus package to rescue the American economy following the 2008 crisis has pushed the yields of the 10-year bonds lower and the prices higher. This is the case because such stimulus programs entail purchasing bonds from corporations and other sources.

Money Supply and Asset Bubbles

Furthermore, the federal reserve handles the money supply into the economy since they have the authority to print money. Many economists believe that excessive money supply leads to assets bubbles since assets can absorb this excessive supply with inflated prices. With excessive money supply and high prospects of inflation, bond prices tend to fall. Furthermore, big asset bubbles can often burst leading to financial difficulties and large losses such as the case in the financial crisis of 2008.

Risk-on vs Risk-off Environments

Bonds can be bought and sold on the secondary market. Usually, investors tend to buy bonds more when the environment in the financial markets is characterized by risk aversion (risk-off mode), since bonds offer a stable income represented by the fixed coupon (regular interest payment). Therefore, the prices of bonds tend to rise in a risk-off environment with a flight from equities or other assets to bonds which are safer assets. On the other hand, in an environment where investors accept higher risk in exchange for a higher return (risk-on mode), they tend to go to other securities than bonds, such as equities for example. In a risk-on environment, the prices of bonds decrease.

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