FED…Bond Markets…A Primer

The FED recently came out with a plan to cut the asset size of its balance sheet. This article looks into the bond market with some interesting and insightful facts about the bond market. The credit crisis took its severe toll in 2008 and Ben Bernanke, whose Ph.D. dissertation was on 1929 recession articulated that the best way to avoid a severe recession in the market was to allow credit to move into the market. FED primarily regulates the liquidity within the system through the change in FED rate. FED rate is the rate at which banks are willing to other banks or financial institutions overnight without any collateral.  Depository institutions especially banks have to conform to a  minimum reserve ratio according to latest Basel III norms and manage the minimum threshold through the overnight lending mechanism. Source:Federalreserve.gov

FED rate will ultimately decide the rates at which banks would not only lend to each other but also the rate at which banks lend out to customers. The FED lowered the rates to zero post-credit crisis. Theoretically, you cannot cut the rate less than zero so to make lending even cheaper, the FED started buying longer-dated government securities. The FED would print about $4.4 trillion of cash over the next few years and lend this money to banks so the credit moves within the financial system. The purpose of these asset purchases is to lower long-term interest rates in the economy. The asset purchases are done through Open Market Operations by buying or selling bonds in the markets to expand or cut credit.  The idea is to make lending cheap to boost loans to businesses and increase consumption. FED stopped buying extra bonds in 2014 but it did buy bonds replacing those bonds which had matured.

Quantitative Easing popularly known as QE (like I am popularly known as Nish, would say rather lovingly) is the process of buying government or other as a monetary tool to lower long-term interest rates when all the conventional means have been exhausted like lowering FED rates. Remember, long-term rates are more influenced by the markets rather than FED. In order to supply cash in the market, FED buys bonds through banks, authorized dealers etc. By buying bonds, FED pays banks for these bonds with the aim to boost lending in the market. The aim is to make the market more liquid and increased cash in banks leads to multiplier effect resulting in increases lending. The $4.4 trillion bonds which FED bought needs to be sold through open market operations. The FED will sell these bonds by auctioning them in the market and slowly suck back the liquidity from the markets. The excess liquidity in the market resulted in asset bubbles and there are many reports which analyze the effect of the QE in the US.  So, this is the simple mechanism which the FED will use to regulate the liquidity in the market. FED usually uses FED rate to change liquidity in the market. Above Source: http://www.multpl.com/10-year-treasury-rate

Hey Nish, what are bonds???

Bonds or Fixed Income Securities are instruments which promise to pay an interest also known as coupons on the face value of the bond. For e.g. take a bond of face value $1000 with an annual coupon annual payment of 5%.  The payments could be annual, semi-annual, quarterly etc. To simply here let’s assume annual payment of &% for a 10 year US government bond. This means bonds would give an annual payment of $50 and on maturity pay $1000 and $50 as an annual payment. One the bond starts trading in the market its know as on the run bond. The price of the bond would increase with greater demand. And now we come to yield of a bond. Bonds are always designated in yields. Yield is nothing but coupon/ Price if the bond. As the price of the bond increases, the yield of the bond reduces. So when you read yields of the bond are rising, it means that the price of the bond is going down. The lesser the yield of the bond, the better. Bonds have many kinds of risk like duration risk, reinvestment risk, interest rate risk and this article is not going to discuss.

Bonds are for multiple durations. Short-term bonds like 3 months, 6 months are generally risk-free while bonds are of duration 1y, 2y, 5y, 10y and long-dated bonds like a 30y bond.  10Y bonds are generally the most liquid and the most traded in the market. Generally, large institutions including governments are major players in the bond market although retail participation is also there in the US, unlike emerging markets where its only among select High Net worth Individuals. When we plot all the different yields of bonds with various maturities, we get a yield curve. Bonds of duration equal or less than 5 years are termed as shorter end of the curve on the yield curve. The long-term rates are generally defined by the market i..e investment banks and other financial institutions which trade in bonds. Now let’s look at yield curves.

Yield Curve:   

Yield curve signifies the state of an economy. Yield curve also serves as a benchmark for mortgage loans etc. An upward steeping curve is usually normal. In an economy when the interest rates are going to rise, it’s obvious you will buy bonds in the shorter end of the curve and wait until rates have increased to park your money in longer-dated securities. The reason is very simple. Bonds on the longer end of the curve with a higher duration will always have higher yields compared to shorter-dated bonds due to higher coupon rates because you want a higher premium for holding bonds of longer duration. Also known as term premium, a higher coupon rate will be always offered since the risk of fluctuations is much higher with higher duration as well as compensation for parking your money as an opportunity cost. Remember Yield = Coupon/ Bond Price. A higher coupon results in higher yield so it’s not right to compare yields of bonds of different duration. An important point to be remembered here is that the discussion here is about government securities. (FED, State, Municipalities etc). Bonds are also issued by companies and there are different ratings depending on the health of companies. A rise in interest rates would lead to higher coupon rates in the bonds. An increase in interest rates would result in the price of existing bonds of similar duration to fall since it makes sense to buy bonds with higher coupon rates. Note: Usually financial institutions donot hold all bonds until maturity. They trade in bonds profiting from the change in the price of the bonds. In case of many pension funds which hold part of their bond holding until maturity, change of interest rates does not matter since you are locked into the bonds. This scenario results in a steeping of the curve signaling expansionary economy considering interest rates rise when the economy is buoyant and in sound shape. Source: Municipalbonds.com

On the other hand, in a recession when interest rates are likely to go down, it’s pertinent to hold longer dates securities.  The price of long dates securities will always be high. Therefore, yields on longer-dated securities will be very low while yields on shorter-dated securities will rise. Increased buying in longer-dated securities compared to shorter-dated securities results in higher prices of the bond and lower yields. Remember, lower the yield means higher the price of the bond. Let’s say the economic outlook is very gloomy and to boost the economy, FED is going to cut interest rates. As a bond manager, you know that 10 years bonds will have lower coupon rates i.e. interest rates. If a 10-year bond is yielding 6% coupon i.e. interest rates, then the new bonds will have even lower coupon rates. It makes sense to buy existing bonds which will increase the price of the prevailing bonds and selling in short-term bonds. This will result in yields of longer-dated securities going down while longer-dated securities going up. Remember the bonds are not meant to be held till maturity in case you want to trade with them. One can buy a 2025 10 year bond presently which means you are buying a 10-year bond issued in 2015 and is maturing in 2025. Part of the portfolio will always be held until maturity but profits in trading of bonds are generated through an increase in the price of the bonds.

The yield curve is flat usually when the market is in transition. So let’s look what happens when an economy is going from expansion phase to recessionary outlook. In a recessionary outlook, it is expected that future interest rates are going to go down so there would be increased buying in the longer end of the curve bring down the yields while selling at the shorter end of the curve, increasing yields.  The yield curve will look like a flattish curve.

Please do not confuse it with equities…But Seriously…But Seriously is also one of the best alums of Phil Collins…

So what does the present US yield curve look like ???…

Quiz Question Which is the largest fixed income fund manager?

Answer: PIMCO…And now we come to a concept of TED Spreads and Junk Bonds…Coming Up…

I attended Janet Yellen’s seminar at the University of Michigan, Ann Arbor. I admired her and it’s very sad I could not meet her in person. This article is dedicated to her…Should have taken a photo with her and inserted in my resume. Might have got a job by now…Just Kidding…Have a good one…

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s