WHY BONDS ARE INTEREST-ing

The name is Bond. Just, Bond.

What do we know about the bond market? On the surface, bond markets look pretty uninteresting. Sombre even. Something for the corporate bigwigs with deep but risk-averse pockets to invest in. For a layperson, the bond market is this mysterious, dark arena only meant for the big players to play ball. It appears too calm and poised for the reckless day traders who splash away at the shallower end of the pool that is the stock market. However, beneath the tranquil surface of the bond market flows an undercurrent strong enough to float or sink an economy. While shares and debentures can cause minor shocks in an economy, bonds have the capacity to make or break the system.

Why do we need to know about bonds? Well, for starters, because the bond market is large enough to dwarf the world’s stock markets in its wake. So large that a bond market crash can bring the world economy to a complete standstill. In fact economic soothsayers have already begun forecasting the next big market crash that will most likely be caused by the bond bubble. So isn’t it best to get familiar with the workings of the bond market before the bears charge and it’s all too late?

SO WHAT EXACTLY ARE BONDS?

In simplest terms, a bond is an IOU, which you receive in return of making an investment. Just like a stock, it is a financial asset, one which gives periodic returns and which can be sold for capital gains. The difference between a stock and a bond is that a stock makes the stockholder an owner of the issuing company and thus entitles him to a share in its profits. A bond, on the other hand, is a legal contract that demands regular payments of fixed, predetermined interest (coupons), irrespective of the company’s profits and losses. Bonds yield fixed returns, irrespective of the issuers’ conditions or market atmosphere. Thus bonds are considered to be relatively stable in the short run and are thus favoured by risk-averse individuals like pensioners.

bonds 1

Unlike a share market, the bond market does not function through a designated stock exchange. Bonds can be bought in the Primary market i.e. directly from the issuer or in the Secondary markets, which are over-the-counter markets and lack any centralised, transparent system similar to the stock exchange. This is what makes it an obscure no-go for most investors. However bonds still form a large chunk of our total investments.

BONDS vs. INTEREST RATES

Bond prices depend on a number of factors. The most important factor is the interest rate. A thumb rule when dealing with the bond market is that bond prices and interest rates move in the opposite directions. When interest rates rise, prices of fixed-rate bonds fall.

We will try to understand this through an example. Lets say a Treasury bond offers the buyers a 5% coupon rate to be paid over a period of 10 years. This coupon rate is determined by the then prevalent market interest rate. Now if after 5 years, the market interest rate rises to 8%, the rate of return on every other financial investment will rise to the extent of the market rate. However, a bond being a fixed coupon rate investment, its rate will stay anchored at 5% and thus the holder of the bond would face the opportunity cost of having to hold a low yield bond when he could have invested the same money in a high interest rate investment. This works counterclockwise when the interest rate falls. For instance, if the market rate falls to 3%, the bond will continue paying the 5% coupon rate and will thus be a more favourable investment. Thus bonds are susceptible to interest rate risk.

bonds 2

Interest rate itself is influenced by factors like inflation and government policies. Higher the rate of inflation, the higher will be the interest rates and consequently lower will be the price of the bond. Furthermore, a high rate of inflation reduces the real value of the coupon rate and thus erodes the bond’s purchasing power.

Secondly, government’s fiscal deficit also influences interest rates. A higher borrowing by the government (for deficit financing), leads to an increase in interest rates due to the crowding out effect thus leading to a fall in bond prices.

Thirdly, high yield bonds may be heavily taxed by the government, whereby reducing their overall returns on investment. So we can see that there are several factors that affect the prices of bonds. However unlike factors affecting stock prices such as animal spirits and erratic speculations, the above-mentioned factors are relatively stable in the short run and so bonds are believed to be one of the safer avenues of investment.

As we can see, the bond market is indeed an interesting realm within the money market. Bonds have, for ages, been the favoured form of investments for many financial doyens, mostly because of the low risk associated with them. However many investors perceive them to be less lucrative as bonds usually give far less returns than stocks and, because of inflation, are about as risky in the long term. However, the greatest advantage of bonds is that they provide protection against one of the biggest risks in the money market, and that is our emotions, which are spurious, irrational and thus the most difficult to hedge against.

bonds 3

While the stock market is in perpetual upheaval, the bond market is relatively calm. With a comfortable amount of our capital safely tucked away in the relative hush of the bond market, a wise investor can stay unruffled when the market downturns raise the storms of irrational bear and bull runs in the stock market. In any case, bonds assure a steady stream of returns till maturity, which most stocks do not. Just like the ‘One True Bond’, bonds don’t stop (yielding) when they are tired, they stop when they are done.

-Naomi Satam

Links for further reading

https://www.google.co.in/search?q=bond+market+in+india&rlz=1CDGOYI_enIN712IN712&oq=bondmarket&aqs=chrome.2.69i57j0l3.7612j0j7&hl=en-GB&sourceid=chrome-mobile&ie=UTF-8

https://global.pimco.com/en-gbl/resources/education/everything-you-need-to-know-about-bonds

https://www.thebalance.com/why-invest-in-bonds-417083

http://www.projectinvested.com/markets-explained/bond-basics/

Photo Credits

glasbergen.com

colibritrader.com

 

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