4. Bond Markets and Bond Yields

Advantages of Bonds

• Receive income through interest payments

• Hold the bond to maturity to get all of the principle back

• Profit by reselling the bond at a higher price

Disadvantages of Bonds

• Bonds pay lower returns than stocks

• Companies can default on your bonds

• Bond yields can fall

What is the relationship between yield to maturity and bond prices?

• They are negatively related; as price increases, the yield to maturity decreases

• Additionally, bond prices rise when interest rates fall

Facts about bond prices

• A bond with a higher coupon payment has a higher price

• A bond with a higher face value or years to maturity has a higher price

• A bond with a higher yield to maturity has a lower price

Which factors present a risk to the bond price?

• Credit rating or creditworthiness of an issuer

• Liquidity of the second market for bonds

• Time for the next payment of bonds

• Interest rates/Inflation rates

What is market risk?

• The risk of unexpected changes in the prices of goods in the market

What is credit risk?

• The increased risk of default or decline in value of a bond due to a change in the creditworthiness of issuers or counterparties

Default risk

• Possibility that a counterparty in a financial contract will not fulfil an obligation of the contract and thus default on it

Credit rating

• Evaluates the creditworthiness (trustworthiness) of an issuer to lend money to; often done by a credit-rating agency

• Quantifies the ‘probability of default’

• Given by three main companies who give ratings like AAA, AA, A, BBB, and so on to represent the credit-worthiness of a company

The Big Three Credit Rating Agencies

1. Moody’s Investor Services

2. Standard and Poor’s (the same S&P as the S&P 500)

3. Fitch Group

The two main factors affecting credit rating

1. Business risks

• Measures strengths and weaknesses of the operations of the entity including market position, geographic diversification, market cyclicality and competitive dynamics

2. Financial risk

• Measures the financial flexibility of an institution, looking specifically at total sales and profitability measures, growth expectations, liquidity, funding diversity and so on

Determinants of sovereign (national) credit ratings

• A high capita per income, lower inflation and external debt are both consistently linked to higher ratings

• GDP growth, fiscal balance, and external balance lack a clear link to ratings

Yield curves

• Show the interest rate associated with different contract lengths for a debt instrument, summarising the relationship between the term (time to maturity) and the interest rate

• The gradient gives an indication of the market belief about future interest rates

• If financial markets expect the short-term interest rates to rise over the next three years then the 3-year rate will be higher than the current 1-year rate

The US Treasury Yield Curve

• Fixed income securities with different maturities must be considered of comparable credit quality

• Consists of bonds, notes, and bills and is the most frequently cited yield curve 

Normal Yield Curve

• Upwards sloping, depicting higher interest rates for longer held maturities

• Considered normal because investors usually demand higher interest rate payments for holding a bond for a longer period of time

A steep yield curve means…

• The spread between long and short-term rates rises (better to hold long-term bonds as they have much higher rates)

• Occurs during periods of economic expansion and signals positive economic sentiment

A flat yield curve means…

• There is very little difference between having short term bonds and long term bonds

• It might signal uncertainty in the market; investors are reticent to commit to either short or long term bonds 

• Could signal a transition from a normal curve to an inverted one

• The Central Bank might be maintaining a steady inflation rate while gradually changing MP

An Inverted Yield Curve means…

• Securities with longer maturities yield less than short term securities

• Can be influenced by CB MP, investor uncertainty, and global events

• The main determinants of the yield curve are changes in monetary policy and inflation expectations

• It might signal a recession; often the yield curve is inverted before a recession occurs