All about the bond market

It’s the biggest financial market in the world. About time you knew something about it

“Gentlemen prefer bonds” – Andrew Mellon (1855-1937)

They rock your markets

They rock your markets

Ever since the global financial crisis exploded a few years back, the bond market has been at the forefront of the media’s attention after decades of always playing second fiddle to the stock market. Be it sub-prime mortgage bonds which were tearing holes out of investment banks’ balance sheets in 2007 and 2008, or Greek sovereign bonds on the verge of default, people are finally waking up to the importance of the bond market within the global economy. But besides being the largest and most important financial market in modern capitalism, the bond market can tell us a lot about the current and future state of the economy in ways that the Dow Jones or Nasdaq could not. And despite the jargon, they are not so difficult to understand. So, without further ado, here’s all you wanted to know about the bond market, in a language you can read (which is English, a language seemingly lost to many economists).

What is a bond?

In the simplest sense, a bond is basically debt. What makes a bond different from other types of debt (say, a loan) is that a bond is tradable, just like any other security such as a stock. So for example, a company can go to a bank and get a $1 million dollar loan, or he can issue $1 million dollars’ worth of bonds (say, 1,000 bonds worth $1,000 apiece) to a potentially limitless range of investors. Bonds are generally preferred over loans as a form of debt because you can issue more of it at one go (no bank is ever going to give anyone a $10 billion loan!), and because it is generally cheaper than a loan. This is because there is less risk attached to it from the lender’s perspective. Whereas the risk of a loan defaulting is borne entirely by the bank that issued it, the risk of a bond defaulting is spread across dozens of bondholders, none of which owns the full amount of the issuance (i.e. no-one bought all those bonds). As a result, a bond will likely fetch a lower interest rate than an equivalent loan, which is clearly better for the issuer. The flip side is that bond issuance is only feasible for government and medium/large firms: a small and relatively unknown firm needs to convince dozens of investors who probably know nothing about the company to buy its bonds.

Why is the bond market so important?

Because it’s the largest securities market in the world. According to the Bank of International Settlements, there were roughly $70 trillion worth of outstanding domestic bonds ($42 trillion of them are sovereign bonds, issued by governments, the rest are corporate bonds, issued by private businesses and banks) and about $29 trillion in outstanding international bonds as of Q3 2011. In contrast, the market capitalization of the world’s stock markets is only about $53 trillion according to the World Federation of Exchanges. Despite this, bond markets tend to take a back seat to the stock markets in terms of publicity; in fact, you are likely to never see bond prices published on a daily basis in most newspapers. This is probably because bond prices tend to fluctuate less than stocks, and are therefore less exciting to journalists. When we think of markets, we think of frantic stockbrokers yelling their lungs out at the NYSE but bond traders on the floors of big investment banks have an equally frantic life (and are probably higher on the pecking order than stock traders). The Eurozone debt crisis, however, has changed this, and bond markets are undoubtedly more followed by the mainstream media than they ever have been in the past.

How is a bond priced?

A bond has three basic components: principal, coupon and maturity. The face value of the bond is known as the principal. This is the amount of money that the issuer will pay at the end of the bond’s life, which is called the maturity. The coupon is the interest rate attached to the bond, in other words, a fixed amount of money that the issuer will pay per year to the bondholder. So for example, a bond with a principal of $1,000 with a 5% coupon and a 10-year maturity will pay whoever holds it $50 per year, and $1,000 after 10 years.

Because a bond issuer will make these payments on a regular basis (and repay the principal at the end), bonds are said to be fixed-income securities: they guarantee a stream of income to the bondholder insofar as the issuer does not default. This is the main difference between a bond and a stock. A stock, for example, has no guaranteed income since dividend payments to stockholders are optional and the value of a stock can vary widely on a daily basis. If you buy the $1,000 bond mentioned above, you are guaranteed to be repaid that same amount in 10 years, and get a $50 coupon payment per year. But if you buy a $1,000 stock, it could drop to $100 in ten years and pay you no dividend during that time. Plus, even if the government or company goes bust, bondholders get first dibs on assets during liquidation. As such, bonds are generally seen as “safer” than stocks insofar as you simply use them a means to park money (as opposed to speculating). In the longer run, however, stocks do tend to outperform bonds which means that investment strategies which seek higher returns are likely to have a higher share of stocks in their portfolio precisely because they are riskier.

How are bonds sold?

Bonds are generally sold directly by governments or businesses to a select number of buyers, usually large investment banks. This is known as the primary market. These banks then resell the bonds to their wider client bases, which can be other banks, pension funds, hedge funds, or private investors who can either keep the bonds or resell them over and over. This is known as the secondary market and is often found in the same exchanges where stocks are traded. The secondary market is where things get interesting because just like any other security, the price of a bond will fluctuate on the basis of supply and demand. For example, if a government or company runs into trouble, the price of their bonds in the secondary market will fall. Why? Because some holders of those bonds are likely going to try and get rid of them, and to do that, they must sell them at a lower price than what they bought them at. For example, a Greek bond that was bought at $1,000 in 2009 is certainly going to find no buyers at that price today, but maybe it can sell at $800 (in reality, they’re probably selling at way less than half these days). On the other hand, so-called “safe-haven” bonds such as US treasuries and German bunds will see bigger demand in times of trouble which means existing bondholders will likely find buyers willing to buy them at a higher price.

To simplify things, people often talk about the price of a bond in terms of a single unit so a $1,000 bond trading at $800 is sometimes said to be trading at “80 cents to the dollar”. Likewise, a $2,000 bond trading at $1,600 would also be at 80 cents to the dollar. Bonds trading at their original price are said to be at par, while those trading at more than a dollar are above par (or said to be trading at a premium) and those under a dollar are below par (or trading at a discount).

Is the bond’s yield the same as its coupon?

Unless the bond is trading exactly at the same price it was issued at, then no. If the coupon is the interest rate that an issuer pays directly to its bondholder, the yield is the actual rate that a bondholder is getting based on the bond’s price in the secondary market. This is better explained with numbers. Let’s assume that you bought that $1,000 Greek bond at $800 in the secondary market. Regardless of the fact that you got it at a discount, the Greek government will always pay 5% of $1,000 ($50) every year, and will pay $1,000 after 10 years. This is set in stone! Clearly, the person who bought it at $800 is making a profit out of this since they’re getting $50 out of an $800 investment, rather than $50 out of $1,000 had he bought the bond at its original price. $50 out of $800 is actually 6.25% rather than 5%, and this is what’s known as the bond’s yield.

The important characteristic of yield is that it is inversely proportional to price (i.e. demand): when the price of a bond goes down because the demand for it has fallen, yield goes up and vice versa. Looking it at from a different perspective, the price of a bond goes down when it is perceived as riskier than before, and an investor will therefore demand a higher yield from it than they did in the past. Let’s imagine that a German bund with a face value of $1,000 and a coupon of 2.5% goes up in price to $1,200 due to higher demand. Someone who buys the bund at this price is actually getting a lower yield of 2.1% since the coupon payment of $25 is divided by $1,200, rather than $1,000. In practice, the calculation of a bond’s yield is more complicated if estimating it to maturity, in which case yields tend to converge towards zero as the bond’s redemption date gets nearer (since at that point the bondholder would only have the principal paid back). However, the basic premise is the same: cheaper bonds have higher yields because they are riskier and the opposite also holds true. And because not all investors will want to hold the bonds to maturity, the way to profit from them is to buy them cheap and sell them once their price goes up (exactly the same as stocks).

It is worth mentioning that bond yields are also often given in reference to another “base” bond, with the difference known as the spread. So, for example, a bond trading at a 1.5% spread to a similar US Treasury bond trading at 2% means that it is actually trading at 3.5%. Because differences in bond yields are often so minimal, spreads are sometimes simplified by being given in basis points, banker jargon for 1/100th of a percentage point (1.5% would therefore be 150 bps).

Knowing all this, congratulate yourself: you can now read the bond section of the Financial Times

Why do market prices determine the price of a new bond?

A bond issuer has to sell new bonds in the primary market with a coupon that roughly corresponds to the yield of similar bonds being traded in the secondary market. The logic is simple: why would a potential investor accept new Greek bonds at a lower interest rate than existing Greek bonds? Let’s say the Greek government offered a 3% bond in 2009 before the debt crisis hit. But now, the demand for those bonds has gone down and yields have risen to 10%. If the Greek government is to issue new bonds at 3%, nobody would buy them if they can get existing ones for 10%. So the government has to issue them at 10% (give or take a bit) to make them attractive. The implications of this are rather scary: in order to roll over old debt, a government (or company) in trouble is forced to issue new debt at significantly higher rates. If this spiral gets out of hand, the issuer will at some point default. So even though yields are generally small (in the single digits), small fluctuations have a huge impact: a bond yield going from 2% to 3% may appear meager but this means that the issuer is coughing up 50% more in interest payments (which could run in the billions). The problems that countries face when dealing with spiraling debt costs are called debt dynamics.

How is a bond rated?

You have surely read about ratings agencies such as Standard & Poor’s, Moody’s and Fitch, which assign a rating to many companies’ and countries’ bonds. Roughly speaking, bonds are rated as either investment-grade or speculative, depending on how risky they are perceived. The safest are generally rated AAA and include the largest and most financially stable economies such as the US, Germany and Japan (a handful of firms and banks are also rated AAA). The ratings then progressively descend alphabetically all the way to D which is generally considered only for a bond which is in default. BB is usually the boundary between an investment-grade and a speculative bond but just because the bond is speculative does not mean that nobody would be interested in them: riskier issuers need to offer higher coupons if they are going to get anyone to buy their bonds. There is actually a huge market for these high-yield or junk bonds by investors less concerned about risk (such as hedge funds) although many other institutions such as pension funds and local governments are required by law to invest only in safer bonds. Whether or not the ratings agencies correctly rate the bonds is, of course, another matter.

What types of bonds are there?

Bonds come in many flavors, tailored to such a large and diverse investor base. Perhaps the most important way of classifying a bond is by the origin of the issuer and the currency used to denominate it. Domestic bonds are those issued by a local entity in local currency: if the Mexican government issues a peso-denominated sovereign bond in Mexico, or Mitsubishi issues a yen-denominated corporate bond in Japan, those are both examples of domestic bonds. Things get a little confusing, however, when bonds are issued in other countries, or in different currencies. These types of bonds are called international bonds and there are three main types. First are the so-called eurobonds – quite a misnomer since they actually have nothing to do with Europe. Basically, eurobonds are bonds denominated in any currency that isn’t that of the country where the bond is being issued. So if Mitsubishi issued a dollar-denominated bond in Japan, that would be a eurobond (these usually have the prefix euro- followed by the suffix of the bond’s currency, so in this example it would be called a eurodollar bond). Next up are the foreign bonds: these are bonds issued in local currency by a foreign entity, for example, General Motors issuing a yen-denominated bond in Japan. In contrast to the confusing, generic names of eurobonds, foreign bonds are often given rather folkloric labels depending on the country where they are issued such as yankee bonds (US), samurai bonds (Japan), bulldog bonds (Britain), etc. Finally, you have global bonds, which is essentially a combination of the former; in other words, a bond that issued in many countries simultaneously (usually by a multi-national).

In a nutshell:

Issuer Currency Example
Domestic bond Domestic Local GM $-bond in US
Eurobond Domestic Foreign BMW $-bond in EU
Foreign bond Foreign Local BMW $-bond in US
Global bond Either Both BMW €-bond in EU & US

Aside from these, there are other bond types that deserve brief mention. Inflation-linked bonds offer an interest rate that is discounted from the inflation rate, thereby guaranteeing you a real gain. So, an inflation-index bond with a 2% coupon will give you 5% if inflation happens to be 3%. You never lose out on these insofar as the issuer doesn’t default. Some bonds have no coupon (zero-coupon bonds) or no maturities (perpetual bonds, or “perps”), others have a variable coupon linked to a reference rate, such as LIBOR (the rate at which banks lend to each other), which can go up or down. Bonds can also be issued by other public entities besides the central government such as cities (in the US, these are called municipal bonds or “munis”). Finally, a special type of bond which has gained notoriety in recent years is the mortgage bond. Actually, mortgage bonds are generally not bonds but derivatives: their value is derived from the price of certain underlying assets, which in this case are the mortgages. In practice, however, they behave exactly like bonds and will be therefore discussed as such.

Didn’t mortgage bonds cause the crisis?

Pretty much, which is why even the world’s most legendary investor, Warren Buffet, once called them “financial weapons of mass destruction”. Believe it or not, most economists (including this one) had only a passing knowledge of the incredibly murky world of mortgage bonds before the subprime crisis exploded. As mentioned before, this is mostly because mortgage bonds are not bonds, but derivatives which can be terribly complicated to understand (just watch Kenneth Rogoff, former chief economist of the IMF, struggling to explain Credit Default Swaps in Michael Moore’s Capitalism). In a nutshell, a mortgage bond – herein referred as a Mortgage Backed Security (MBS) – is built around a pool of mortgages. So, for example, one hundred $100,000 mortgage loans are taken, then re-structured (“securitized”) into one thousand $10,000 bonds and sold off. This basically allows a lender to take the loans off its books, transferring the risk to the investment bank which structured the MBS. The investment bank then transfers the risk of those MBSs by selling them to its clients. Everyone in this circle seemingly benefits: the lender gets the loans off his books which allows him to lend more, the bank collects hefty fees in structuring the MBSs and selling them, while the clients get high yielding and supposedly “safe” bonds, since the losses of someone defaulting on his mortgage are spread out across the pool of investors, who suffer less individually. If the mortgage had not been securitized, then the mortgage lender would have incurred the full loss.

Oh, it gets worse. Banks realized that they could structure the MBS into different tranches, each of them with different priorities in receiving the cash flow from the mortgage payments. The “safer” senior tranches would get the payments first, followed by less safe mezzanine tranches, and the even riskier unsecured tranches. So let’s say an MBS was structured in such a way that 70% of its bonds were senior, 20% were mezzanine and 10% unsecured. If 10% of the mortgage pool defaulted, then the unsecured tranches would be wiped out but the other two would be safe. If 30% of the pool defaulted, then both the mezzanine and unsecured tranches would be wiped out. If 50% of the pool defaulted, even the senior tranches would be suffering some pretty hideous losses which is exactly what happened in 2007. For some reason that defies mathematics and common sense, the senior tranches were often rated AAA even when many of the mortgages were classified sub-prime (in other words, sold to the riskiest borrowers), making them appear as safe as a US Treasury bond. There’s more to this story. Create a legal entity known as a special purpose vehicle (SPV), stuff it with MBSs then have it issue its own bonds with the MBSs and other assorted junk such as student loans, auto loans, credit card debt etc. as collateral and you have an even more extreme bond-like derivative known as the Collateralized Debt Obligation (CDO). Not enough? Make a CDO out of other CDOs and it’s a CDO-squared. Yes, there’s CDO-cubed too. Greed was the limit back in the good old days.

I think I’ll stick with some inflation-linked US Treasuries just to play it safe

Don’t forget the US almost (voluntarily) defaulted a few months back.

What can bonds say about the future?

Don’t believe the hype: markets cannot predict the future. But in more ways than one, bonds can predict what markets think the future will be like. For example, comparing the yield of a regular 2-year US Treasury bond with the yield of an inflation-linked 2-year US Treasury bond will give you a rough idea of what markets expect the inflation rate to be in two years. Assuming that the risk of the issuer remains stable (a relatively safe assumption during good times, especially for governments), the single most important determining factor of a bond’s yield is inflation. This is because if inflation rises, bonds have to be offered at higher yields in order to remain equally profitable as before (a 3% bond under 2% inflation gives you a real return of 1%, so if inflation goes up to 3% it has to be offered at 4% or else nobody would buy it). In turn, inflation is influenced by the central bank’s monetary policy rate (i.e. the interest rate) which determines borrowing and lending rates throughout the entire economy. During boom times, inflation tends to creep up due to excess aggregate demand in the economy. Central banks respond by raising the policy rate in order to incentivize saving, which serves to cool down the economy. During slowdowns or recessions, however, inflation tends to be low since aggregate demand is weak (or in extreme cases, there is outright deflation). In this case, central banks lower the policy rate in order to incentivize consumption, thereby giving the economy a boost.

A veritable crystal ball?

A veritable crystal ball?

By making a chart of bond yields with their maturity on the bottom (y) axis and the yield itself on the left (x) axis, you obtain what is known as the yield curve which is believed by many to be one of the most powerful predictors of future economic conditions. During good times, the yield curve has a gently upwards slope which tapers off at the longer-end of the chart. Why is this the case? As mentioned above, when the economy is doing well investors believe that the central bank will eventually have to raise rates in order to cool down the economy so that inflation doesn’t get out of hand. This clearly means that those 2% bonds you hold today will be trading at a discount in the future, since new bonds will be offered at, say, 4% to cover the extra inflation (remember the inverse relation between yield and price: you are basically selling bonds today while they are expensive in order to buy them in the future when they are cheaper, something any sensible investor would do!). As time passes and all investors follow the same strategy, demand for those cheaper longer-term bonds rises, increasing their price and lowering their yields. So today’s cheap long-term bonds become tomorrow’s expensive short-term ones and the yield curve remains the same. Another reason why the yield curve is upwards-sloping in good times is that longer-term bonds are inherently riskier because of the greater uncertainties of the future. It’s a safe bet to assume that the US will not default within the next year, but can you say with the exact same certainty that it won’t default in 30 years? Clearly then the longer-term bond must be riskier, and therefore higher yielding.

On the other hand, an “inverted” yield curve means that short-term yields are higher than longer-term ones and consequently, the chart shows a downward slope. An inverted yield curve means that investors expect a slowdown or recession which will prompt the central bank to cut rates. In this scenario, demand works the other way around: compared to the 2% bonds offered tomorrow when inflation will be lower, those 4% bonds available today are will be trading at a premium. So you buy them up. This extra demand raises their price, dropping their yields and thereby gradually turning the inverted yield curve into a normal one (the implication being that an inverted yield curve is always a transitory phenomenon which markets eventually “self-correct”). From the risk perspective, an inverted yield curve implies that a recession is looming, so there’s a greater danger of a default in the short-term than in the longer-run, by which time it is assumed the recession will be over. Thus by pure common sense, the shorter-term bond must be riskier.

How accurate has the yield curve been in predicting recessions?

It has predicted all 7 of the last US recessions, including the recent one (the curve inverted on December 30th, 2005). However, it has also sent two “false positives”. Nevertheless it is of dubious value when central banks maintain near-zero interest rates for a long time, as is the (admittedly exceptional) case right now. This is because when you have interest rates that can’t go down because they are already at zero (or near it), then the only way bond yields can go is up. So you get a positive yield curve even in recessionary conditions as was the case in Japan during their “lost decade” in the 1990s or the Eurozone today.

I need some time to digest this all

Indeed you do. But I hear the bond trading desk at Goldman Sachs is calling your name…

3 thoughts on “All about the bond market

Leave a Reply

Your email address will not be published. Required fields are marked *