Document Title



What is the bond market telling us about the future?

Sanjeev Sabhlok

Peliminary Draft 2 September 2013

[This is very preliminary. Do not use in any way]

Contents

1. Data sources 1

1.1 FT 1

1.2 Wall St Journal 1

2. Bond market forces 2

2.1 Overall trends 2

2.1.1 Bond bull market since 1981 2

2.1.2 Bond market ‘rout’ with the easing of QE 2

2.2 Key environmental factors 2

2.2.1 Discount rate and Federal Funds rate 2

2.2.2 Demand for safe assets 3

2.2.2.1 GFC 3

2.2.3 Demographics 3

2.2.3.1 Effect of retiring baby boomers on bond yields 3

2.2.4 Quantitative Easing (in addition to low interest rates) 3

2.2.4.1 Effect of Quantitative Easing on prices 4

2.2.4.2 Effect of Quantitative Easing on bonds 4

2.2.4.1 Effect of Quantitative Easing on bank balance sheets 4

2.2.4.1 Effect of QE on government deficit 4

2.2.4.2 Effect of the tapering of Quantitative Easing 4

2.2.4.3 Effect of loose money on bond prices 4

2.2.4.1 The Bernanke Zone 4

3. Background 5

3.1 Basic features 5

3.1.1 Important part of investment portfolio 5

3.1.2 Coupon 5

3.1.2.1 Amount 5

3.1.2.2 Rate 5

3.1.3 Maturity 5

3.1.3.1 Interest Rate Risk 5

3.1.4 Secured/Unsecured 6

3.1.5 Liquidation Preference 6

3.1.6 Tax Status 6

3.1.7 Callability 6

3.1.7.1 Prepayment Risk 6

3.1.7.2 Yield to Call (YTC) 6

3.1.8 Videos 7

4. Bond yield 8

4.1 Yield (to maturity) 8

4.1.1.1 Calculating Yield using excel 9

4.1.2 Current yield 9

4.1.3 Nominal Yield 9

4.1.4 Realized Yield 9

4.2 Price 9

4.2.1 Quality of bonds has fallen 9

5. What determines bond prices? 10

5.1 Interest rate 10

5.1.1 As interest rate increases, bond prices fall 10

5.1.2 As interest rate decereases, bond prices rise 10

5.2 Probability of default 10

5.2.1.1 Bond ratings 10

5.2.2 As the lender’s status (rating) falls, effectively the interest rate increases, so bond prices fall 10

5.2.3 As the lender’s status improves, effectively the interest rate falls, so bond prices rise 10

Data sources

[pic]

1 FT



– fixed spreads on all FX pairs [pic]

2 Wall St Journal



Bond market forces

1 Overall trends

1 Bond bull market since 1981

Over the past 30 years bonds have been in a bull market. This is partly because in October 1981 the U.S. 10 Year Treasury peaked at over 15% and has been on a steady decline since then. To explain, let’s assume you invested $10,000 in a 15%, 30 year bond back then. By midyear 1995 rates had fallen to around 6%. Because bonds have a market value like other investments investors interested in buying your bond would have paid a higher price because it offered a superior yield. Hence, if interest rates decline after you purchase a bond, generally speaking, the value of your “higher yielding” bond would rise. Of course, the reverse is also true. [Source]

2 Bond market ‘rout’ with the easing of QE

“bond market rout this year. Treasuries have tumbled on speculation the Federal Reserve will taper an $85 billion monthly debt-buying program designed to stimulate the economy amid signs output and jobs are growing.” [Source]

Treasuries declined for a fourth straight month, the longest losing streak in more than two years, as signs the U.S. economy is recovering backed the case for the Federal Reserve to reduce monetary stimulus. Benchmark 10-year note yields fell this week amid speculation possible U.S. military action against Syria may spur refuge demand. [Source]

The benchmark 10-year yield rose two basis points, or 0.02 percentage point, to 2.78 percent at 4:59 p.m. in New York, having increased 21 basis points this month, according to Bloomberg Bond Trader data. The price of the 2.5 percent benchmark note maturing in August 2023 fell 6/32, or $1.88 per $1,000 face amount, to 97 17/32. The 30-year bond yield dropped two basis points to 3.7 percent. [Source]

2 Key environmental factors

1 Discount rate and Federal Funds rate

The Federal Reserve sets interest rates by setting the discount rate (at which banks borrow from the Fed), and by targeting the federal-funds rate (at which banks borrow from one another).

The Fed works toward its target fed-funds rate by buying or selling U.S. treasuries and other securities. By buying up securities, the Fed injects more cash into the banking system.

Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates. Lower interest rates encourage people to spend, not save. The Federal Reserve has had the fed funds rate at zero to a quarter percent since December 2008.

The interest rate on ten-year Treasuries increased from about 4% in the mid-1960’s to 8% in the mid-1970’s and 10% in the mid-1980’s. It was only at the end of the 1970’s that the Fed, under its new chairman, Paul Volcker, tightened monetary policy and caused inflation to fall. But, even after disinflation in the mid-1980’s, long-term interest rates remained relatively high. In 1985, the interest rate on ten-year Treasury bonds was 10%, even though inflation had declined to less than 4%.

2 Demand for safe assets

1 GFC

When panic struck in 2008 investors sold stocks and rushed into bonds with great exuberance. Over the past five years this extreme cash influx has pushed bond prices higher and yields lower. [Source]

3 Demographics

1 Effect of retiring baby boomers on bond yields

Retiring Baby Boomers to Curb Bond-Yield Rise. [Source]

[pic]

Treasury yields have gradually declined as the proportion of U.S. citizens over 65 years climbed. The age group will swell to 20 percent of the population by 2030 from 14 percent now, according to the U.S. Census Bureau. The chart tracks a similar trend in Japan, where 24 percent are over 65 years, the world’s highest ratio of seniors, up from 19 percent a decade ago. [Source]

4 Quantitative Easing (in addition to low interest rates)

When interest rates can go no lower, a central bank's only option is to pump money into the economy directly through quantitative easing (QE).

This involves paying INFLATED PRICES for already existing government bonds with the private sector (not individuals but institutions). The institutions selling those bonds (either commercial banks or other financial businesses such as insurance companies) will then have "new" money in their accounts, which then boosts the money supply. [Source]

The current QE-3 program is where the central bank buys $45 billion in mortgage backed securities (MBS) and another $40 billion in U.S. Treasuries every month. [Source]

The Fed announced its September schedule to buy as much as $45 billion in Treasuries. [Source].

Note that QE does not monetise government deficit. It merely pays more for the ‘normal bonds already available with banks.

1 Effect of Quantitative Easing on prices

By putting more money into the economy, the central bank is lowering the value of the currency, thus tending to push prices higher and avoiding deflation. [Source]

Quantitative easing can be used to help ensure that inflation does not fall below target [Source].

2 Effect of Quantitative Easing on bonds

The YIELD on long-term bonds has been kept abnormally low through QE. Increased demand for government bonds from private sector insurance companies, pension funds and High Street banks pushes up their price, thereby lowering their yield.

With these companies and banks having made a nice profit on these bonds, the idea is that they would now lend (using the money they got in return) for investment projects at a lower rate than they might have, otherwise.

Ten-year gilt yields had been as low as 1.7 per cent recently and are now at 2.5 per cent. To put that into perspective, they were close to 5 per cent in 2007. [Source]

3 Effect of Quantitative Easing on bank balance sheets

Quantitative easing increases the excess reserves of the banks (which now have higher assets, presumably?).

4 Effect of QE on government deficit

Quantitative easing makes US debts easier to repay by devaluing the currency they are denominated in. QE that buys government bonds (the latest round is buying mortgage securities) also helps soak up government debt. [Source]

5 Effect of the tapering of Quantitative Easing

Fed Chairman Ben Bernanke’s announcement in May that the Fed would soon start reducing its asset purchases and end QE in 2014 caused long-term interest rates to jump immediately (by increasing yields).

Note this does NOT mean the Fed is going to SELL bonds. It is still buying, but at a lower rate.

This, however, is enough to increase yields on bonds (and hence lower their price). If this happens in a big way, bond holders who paid high prices will find their holdings devalued.

6 Effect of loose money on bond prices

The greatest risk to bond holders is that inflation will rise again, pushing up the interest rate on long-term bonds. History shows that rising inflation is eventually followed by higher nominal interest rates. [Source]

7 The Bernanke Zone





Background

Bonds are basically an IOU with annual interest. Bond owner is a partial lender. Bond owners have priority in payment over stock owners. A bond is simply a type of loan taken out by companies. Investors lend a company money when they buy its bonds. In exchange, the company pays an interest "coupon" at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan. 

Unlike stocks, bonds can vary significantly based on the terms of the bond's indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing.

Although the bond market appears complex, it is really driven by the same risk/return tradeoffs as the stock market. An investor need only master these few basic terms and measurements to unmask the familiar market dynamics and become a competent bond investor. Once you've gotten a hang of the lingo, the rest is easy.

A government bond is a piece of paper, backed by future repayment through the tax system. Essentially the Fed is creating money out of thin air.

1 Basic features

1 Important part of investment portfolio

Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the market. Bonds are actually very simple debt instruments, if you understand the terminology.

2 Coupon

The coupon amount is the amount of interest paid to bondholders, normally on an annual or semiannual basis.

1 Amount

2 Rate

Coupon tells you what the bond paid when it was issued

The rate at which bonds pay

3 Maturity

When the principal is repaid.

The maturity date of a bond is the date when the principal, or par, amount of the bond will be paid to investors, and the company's bond obligation will end.

1 Interest Rate Risk

Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the investor faces the possibility of prepayment. If interest rates increase, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future. (To learn more, read Managing Interest Rate Risk.)

4 Secured/Unsecured

A bond can be secured or unsecured. Unsecured bonds are calleddebentures; their interest payments and return of principal are guaranteed only by the credit of the issuing company. If the company fails, you may get little of your investment back. On the other hand, a secured bond is a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation. 

5 Liquidation Preference

When a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all of its assets, it begins to pay out to investors. Senior debt is paid first, then junior (subordinated) debt, and stockholders get whatever is left over. (To learn more, read An Overview of Corporate Bankruptcy.)

6 Tax Status

While the majority of corporate bonds are taxable investments, there are some government and municipal bonds that are tax exempt, meaning that income and capital gains realized on the bonds are not subject to the usual state and federal taxation. (To learn more, read The Basics of Municipal Bonds.) 

Because investors do not have to pay taxes on returns, tax-exempt bonds will have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.

7 Callability

Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. (To learn more, read Callable Bonds: Leading A Double Life.)

1 Prepayment Risk

Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors, because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate environment. 

2 Yield to Call (YTC)

A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate this yield using Excel's YIELD or IRR functions, or with a financial calculator. (For more insight, see Callable Bonds: Leading A Double Life.)

8 Videos







Bond yield

When looking at an individual bond, it’s the yield to maturity, and not the coupon, that counts – because it shows what you will actually get paid.

Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations.

1 Yield (to maturity)

The yield – or “yield to maturity” – tells you how much you will be paid in the future. It is the discount rate which makes the present value of the future cash flows equl its purchase price.

For example, in 2012 the Treasury may issue a 30-year bond due in 2042 with a “coupon” of 2%. This means that an investors who buys the bond and holds it until face value can expect to receive 2% a year for the life of the bond – or $20 for every $1000 invested.

Fast-forward ten years down the road. In 2022, interest rates have gone up and new Treasury bonds are being issued with yields of 4%. If an investor could choose between a bond yielding 4% and the 2% bond from our example above, they would take the 4% bond every time. As a result, the basic laws of supply and demand cause the price on the bond with the 2% coupon to rise a level where it will attract buyers.

A move in the bond’s yield from 2% to 4% means that its price must fall. For it to yield 4%, its price needs to decline to $500 – or in other words, $20 / $500 = 4%.

But the actual yield is 5% because in addition to paying out the $20 each year, the investor will also benefit from the move in the bond price from $500 back to its original $1000 at maturity. Add the annual payment with the $500 principal increase – spread out over (the remaining 20 years) – and the combined effect is a yield of 5%.

This yield is known as the yield to maturity.

It works the other way, too. Say prevailing rates fell to 1.5% from 2% over the first ten years of the bond’s life. The bond’s price would need to rise to a level where that $20 annual payment brought the investor a yield of 1.5% - in this case, $1,333.33 (since $20 / $1,333.33 = 1.5%). Again, the 2% coupon falls to a 1.5% yield to maturity due to the decline in the bond’s price from $1333.33 to $1,000 over the final 20 years of the bond’s life.

To gain a better understanding of the relationship between coupon and yield to maturity, take a moment to study this page on the Wall Street Journal’s website, which shows all of the Treasury issues currently trading. As you will see, the high-coupon bonds have yields to maturity in line with the other bonds on the table, but their prices are exceptionally high. A look through this table will help elucidate the relationship between coupon, price, and yield to maturity.

Yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor's actual return will differ slightly.

1 Calculating Yield using excel

Calculating YTM by hand is a lengthy procedure, so it is best to use Excel's RATE or YIELDMAT (Excel 2007 only) functions for this computation. A simple function is also available on a financial calculator. (Keep reading on this subject in Microsoft Excel Features For The Financially Literate.) 

2 Current yield

Current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by dividing the bond's annual coupon amount by the bond's current price. Keep in mind that this yield incorporates only the income portion of return, ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only. 

3 Nominal Yield

The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual coupon payment by the par value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return. 

4 Realized Yield

The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel's YIELD or IRR functions, or by using a financial calculator.

2 Price

if interest rates decline after you purchase a bond, generally speaking, the value of your “higher yielding” bond would rise. Of course, the reverse is also true.

Over the past 30 years bonds have been in a bull market. This is partly because in October 1981 the U.S. 10 Year Treasury peaked at over 15% and has been on a steady decline since then. To explain, let’s assume you invested $10,000 in a 15%, 30 year bond back then. By midyear 1995 rates had fallen to around 6%. Because bonds have a market value like other investments investors interested in buying your bond would have paid a higher price because it offered a superior yield.

Now, though, with interest rates likely to rise, bond prices will FALL. if you are invested in bonds your concern should be the degree to which bond values will fall if interest rates continue their ascent.

1 Quality of bonds has fallen

as investors have plowed so much money into bonds since the Great Recession of 2008, bond prices have risen sharply and yields have fallen, forcing the investor to seek yield in lower credit quality issues.

What determines bond prices?

1 Interest rate

1 As interest rate increases, bond prices fall

2 As interest rate decereases, bond prices rise

2 Probability of default

Credit/Default Risk

Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. (To learn more, read Corporate Bonds: An Introduction To Credit Risk.)

1 Bond ratings

The most commonly cited bond rating agencies are Standard & Poor's, Moody's and Fitch. These agencies rate a company's ability to repay its obligations. Ratings range from 'AAA' to 'Aaa' for "high grade" issues very likely to be repaid to 'D' for issues that are in currently in default. Bonds rated 'BBB' to 'Baa' or above are called "investment grade"; this means that they are unlikely to default and tend to remain stable investments. Bonds rated 'BB' to 'Ba' or below are called "junk bonds", which means that default is more likely, and they are thus more speculative and subject to price volatility. 

Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm's repayment ability. Because the ratings systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are considering. (To learn more, read The Debt Ratings Debate.)

2 As the lender’s status (rating) falls, effectively the interest rate increases, so bond prices fall

3 As the lender’s status improves, effectively the interest rate falls, so bond prices rise

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