Bonds Explained

Today I am explaining bonds. Something I have a keen eye on as I consider a career in Debt Capital Markets. I'll run through some key terminology and then the importance of bond yields in global markets.

What is a bond?

A bond is a type of loan. Companies issue bonds to raise capital. The bond gets issued for a certain price, investors then buy the bond for that price. They'll then receive interest from the issuing company until the bond matures (expires) at which point they'll receive the same amount of money they paid for the bond originally. To put it simply, imagine you take out a loan from a bank. You are the company(raising capital) and the bank is the investor who gives that capital in return for interest.

Key terms

Face/Par Value - the amount the bond pays out at maturity, i.e. the original amount the investor paid the issuer

Coupon rate - the annual interest rate (pay out)

Coupon payment - the annual amount paid out (face value x coupon rate)

Current price - the price the bond trades at today (if u sold that bond today)

Current yield = the current return of the bond (coupon rate/ current price)

Maturity – the time until the bond gets repaid at face value

Where are bonds sold?

Bonds are initially sold on the primary market, straight from the issuer to the investor.

Investors can then sell these bonds on the secondary market.

Buying on the secondary means you have paid a fellow investor for the bond and you will receive the coupon payments and face value payout from the issuer (if you hold onto the bond until maturity)

Think of bond selling as a game of 'pass the parcel'

Term Premia

This is the extra yield investors require for holding long term bonds due to the inherent extra risk of these long positions.

It's influenced by:

Central Bank Trust - the more credible they are the less term premia is

Volatility - if markets are currently volatile the premium is higher

Quantitative Easing - if active QE is in place this reduces risk as there are less long term bonds on the market

Market Sentiment - generally if markets seem stable investors may accept a lower premium

Credit Spread

In similar vein as term premia, this is the extra yield investors require to hold a risky bond over a safe one.

Credit spread= Corporate Bond Yield - Government Bond Yield (same maturity)

Market Conditions

Risk-on times (times of growth)

Spread narrows - investors have high confidence and chase higher returning corporate bonds

Risk-off times (times of fear)

Spread widens - investors want security so go to government bonds, corporate bond demand drops so yield rises

Yield Curves

These show the relationship between interest rates (yields) and maturities of government bonds

yield (y axis) maturities (x axis)

Treasury yield – shows US government bond yields against maturities, this is typically used as a benchmark

Remember yield and bond price have a inversely proportional relationship!

Normal yield curve

Slopes upwards

Forecasts economic expansion

Long term bonds are less attractive as there is uncertainty due to unknown inflation, interest rates etc.

Less demand = lower prices

Lower prices = higher yields

Inverted yield curve

Slopes downwards

Signals a recession’s expected

Investors want long term safety

Long term bond demand increases

Increases prices = lower yields

Yield curves are a key tool investors use to gauge market sentiment. While they can seem a bit circular, as investors affect the market then use the yield to aid their investment strategy. Yield curves are still a vital indicator of market sentiment. The most utilised curves are U.S. Treasury yields. Here are the key reasons they’re used:

1)        Interest Rate Predictions

Short term yields (up to 2Y) are a good indicator of what markets predict Central Bank rates will be in the immediate future. The general shape (inverted or upwards sloping) gives a sense of forward guidance and what they foresee for the next few years.

2)        Recession Indicator

Yield curves inversions are a key sign a recession is expected. Not only key to investor strategy, but they are also closely watched by economists and policy makers.

In fact, it’s known each U.S. Treasury inversion has been followed by a recession since WWII.

3)        Alter Bond Investment Strategy

If investors predict a future rate increase, they’ll invest in short term bonds to avoid getting locked in to those bonds so they can invest in the higher yield bonds.

If they predict rates will fall, they’ll invest in long term bonds to lock in these higher rates.

4) Hedging Interest Rate Risk

Investors use the curve to alter their exposure to various assets tied to interest rates. They use a tool known as derivatives to capitalise/prevent losses on changing rates (article explaining their uses coming soon!)

I hope this was useful, check out the rest of my work here!