Holistically there are three asset classes: Equities, Bonds, and Alternative Investments. The article takes a simplistic look at the global bond market and understands the concept of the yield of a bond.
So why bonds?
# Market Size
The bond market is more significant than the equity market, both globally and in the US. According to SIFMA 2019 Outlook, the global bond market is around $100T and equity market $85T, wherein the US bond market is $39T or 1.8 times the nearest competitor EU ex. UK and equity about 38% or $32T.
T: Trillion. 1 T=1000B (B: Billion) 1B=1000M (M: Million) and $1M=7.1Cr INR (USD to INR)
Although bonds are also volatile, equity indices are more volatile if one average’s it over the years. Bonds are one of the most important ways of moving credit within the system — government, municipalities, corporates issue bonds for raising capital.
# Sovereign Bonds
Bonds are of various kinds, but in today’s series lets focus on sovereign bonds. Sovereign bonds are issued by the government to meet their expenditure. Governments meet their expenditure either through taxes or through issuance of debt.
Sovereign bonds can be both domestic and international. E.g., in the US, the largest bond market is the treasures i.e., those issued by the government. Ignoring money market instruments, treasury bonds can be of 3 months, 6 months, 1, 2,5, 10Y to long term bonds like 30Y or even 100Y. Recently Germany issued the first 100Y Zero Coupon Bond. So, what is a Zero-Coupon Bond? This will come in upcoming series. The most liquid bonds are always the 10Y bond. The yields of a 10Y bond are closely followed. So, what is a yield and why is it important. Remember sovereign bonds are the safest among all the bonds. Very simple it is considered governments will never default because they can simply print money. Alas its not so simple. LTCM learnt it the hard way. Russian default.
# Yield of Bond. Example 10Y Bond
Bonds are issued at a Face Value ignoring currencies let’s look at an example.
Consider a 10Y bond of 100 issued by a country called Middle Road. Bonds are issued either in primary or secondary market although sovereign will be issued more in primary market. Since bonds are debt instrument which will be redeemed at maturity, they must pay a compensation. There is no free lunch but then there is one.
The compensation is paid through interest payments also known as coupons. For simplistic case let the coupon be an annual payment. And for this example, we presume an annual coupon of 3.
Yield simplified = Coupon/Price of the bond.
The present 10Y yield on US treasuries is 1.722 and on the Indian 10Y bond is 6.78. So why are the yields different. Coupons depend a lot on inflation and interest rates.
As soon as the bond are traded, they become on the run bond. Investors don’t buy bonds to be held until maturity. Asset managers, foreign governments etc buy bonds for several reasons including managing duration risk, immunization, balancing their portfolio etc. And hence price of bonds change. Ignore all of them right now and we will come to it later.
There are many risks associated with a bond. Consider the economy is booming at Middle Road and interest rates are increasing. Therefore, new bonds issued will have higher coupon and hence an asset manager will be tempted to buy the newly issued bond and therefore sell the present bond in the portfolio. Now what do you think happens to the existing bond. Bingo the prices of the present bond will fall due to selling in the market.
Yield of the 100 bond at 3 annual coupon rate during the time of issuance is 0.03.
3/100=0.03. Now due to selling the bond price has fallen to 98, the present yield 0.030612245 so lets approx. it to 0.0306. and if the price of the bond falls to 95 the yield goes up to 0.031578947 or approx. 0.0316.
Now you know that yield going up signifies a selloff in that bond. On the other hand, if interest rates are going down, asset managers etc. would hold on to the present bond or buy the present 10Y bond driving prices of the present bond up. If you are a bond manager, you will always like yields going down. So now we known what we mean by yield of a bond. This is a simplified way of understanding yield of bonds without taking into account discounting method.
# Yield Curve
Yield curve is very simply plotting yields of different maturities on a graph. Take yields of 3M to 30Y or the highest duration bonds. Usually yields are flattening or steeping while an inversion signifies an onset of a recession. More on it at a later date.
This is an oversimplified example (does not include calculating bond price using discount cash flow analysis) and slowly we will look at concepts like different kinds of yield curve, YTD (Yield to Maturity), callable bonds, duration, modified duration, convexity and other concepts related with bonds. Going forward the knowledge series will be mailed through newsletters. And coming up tutorial on Structured Products. Keep looking at the tutorial section.