Fixed Income Investments - Bonds Overview

Fixed Income Investments (Bonds)

• Fixed income is a fancy term for borrowing and lending
• Bonds are tradable IOUs (I Owe You)
• Bonds involve a promise to pay regular fixed amounts of money (coupon or interest) and a large amount (principal) at a final date (redemption date)
• The world bond market is worth approximately $101 trillion, greater than the world GDP ($79 trillion) and the world stock market ($69 trillion)
• The US bond market is the largest in the world, comprising about 20% of the global bond market ($22 trillion)
• Bonds are categorized by ownership: corporate bonds (owned by companies) and government bonds (owned by governments)

The Fixed Income Market

• Governments use bond sales to fund things like wars, security, and justice projects
• When government spending exceeds income, it uses borrowing to cover the deficit
• This deficit financing is not necessarily bad news
• Bond markets allow governments to borrow from other countries

Government Bonds

• The government bond market (Sovereign Debt Market) is the largest portion of the bond market
• The US government bond market is worth $14 trillion, while the corporate bond market is worth $8 trillion
• The Bank of England was established in 1694 to finance the British Royal Navy

Government Debt

• Government debt isn't always negative; how it's managed matters more
• The US has a high amount of debt, estimated around $16 trillion as of 2008
• Other countries buy US bonds to protect their currency if the value decreases
• US bonds are the safest and most liquid financial asset due to the strength of the US dollar as the world's reserve currency, and the US's strong credit ratings

Bonds and US Dollar

• Bonds, like the foreign exchange (FX) market, are denominated in US dollars
• Countries use each other's bond investments to finance budget deficits or during periods of inflation and exchange rate fear
• US government bonds are sought after during exchange rate fear

Corporate Bonds

• Companies issue corporate bonds for two main reasons
• Debt is tax deductible
• Bonds serve as long-term financing

Bond Yield

• Bond yield is the current market interest rate on a bond
• It depends on supply and demand
• The initial interest rate (coupon rate) might not stay the same throughout the bond's life
• The bond's market value fluctuates with demand and supply, but the repayment amounts are fixed
• Bond Yield ≠ Fixed Price ≠ Fixed Interest rate

Bond Yield and Market Value

• When the yield is higher than the coupon rate, the market value of the bond is less than the face value
• When the yield is lower than the coupon rate, the market value of the bond is higher than the face value
• Bond yield and market value move inversely

Bond Valuation

• If a bond is issued during the middle of a year, the coupon amount needs to be adjusted/pro-rated
• The present value of the principal and periodic coupon payments is used to determine the bond's market value

Present Value of Principal and Interest

• The market value of a bond equals the present value of principal repayment, plus the present value of interest payments

Bond Valuation Drivers

• Credit Risks: The probability of the bond issuer defaulting on its obligations. Default is predicted to affect future returns negatively and this discourages investors to invest in the bond, thus reducing the value of the bond
• Macroeconomic Environment: Short-term interest rates and Inflation

Short-term Interest Rates

• Government actions to adjust short-term interest rates affect bond prices and thus yield. Increasing rates reduce bond prices, whilst lowering rates increases them.

Inflation

• Inflation usually shows excess money supply, and increases the interest rates to reduce the money supply and increases bond yield values

The Output Gap

• The difference between the potential output of an economy (ideal production) and its actual output
• A positive output gap signals inflation
• A negative output gap signals deflation

Statements about Interest Rate Policies

• Issuing statements about future interest rate policy changes can affect the market before the change actually occurs

Short-term Interest Rate Estimates

• To address inflation (+ output gap), Central Banks increase short-term interest rates. This is to make borrowing expensive and encourages cash deposit with the government, subsequently decreasing money supply

The Yield Curve and Why it Matters

• A graphical representation of yield to maturity (YTM) against the maturity period for a country's government and corporate bonds
• Generally slopes upwards (longer tenure, higher yield)
• Changes in the short-term side of the yield curve can have a knock-on effect on the larger economy (corporate & consumer impact)

Corporate Impact (of Yield Curve)

• Corporate borrowing costs are affected by changes in government borrowing costs. A wider yield curve spread indicates that corporate bonds are underperforming
• A smaller spread indicates corporate bonds are outperforming

Consumer Impact (of Yield Curve)

• Mortgage rates typically follow government bond yields
• This affects the cost of borrowing for homeowners and the level of housing market activity

Global Impact (of Yield Curve)

• Bond yields in different countries tend to move similarly, influenced by factors like investments, debt, and aid

Credit Risk Indicators (Measures)

• Credit rating agencies (S&P, Moody's, Fitch, DBRS) assess the creditworthiness of bonds, both corporate and government
• Investment-grade bonds have high ratings (e.g., AAA, AA); junk bonds carry low ratings
• Bonds with fluctuating ratings are less reliable

Credit Default Swaps (CDS)

• CDS measures the inherent probability of bond issuer default. It is more reliable than frequent credit ratings due to observable nature and earlier notification.

Bond Valuation Drivers (Continued)

• Short-term interest rates: Changes in short-term interest rates directly impact bond prices.
• Inflation: Inflation reduces the purchasing power of future bond payments

The Output Gap and Central Bank Toolkits

Central banks measure inflation and the output gap to assess the economic climate and use relevant policy tools to manage the situation

Investors' Predictions and The Yield Curve

• Investors' expectations about inflation and interest rates influence their decisions regarding bond purchases and sales, which can affect a country's yield curve.
• An inverted yield curve (short-term yields greater than long-term yields) is frequently associated with economic recession
• A flattened or steep yield curve indicates varying economic conditions