In the 2nd quarter of 2015, the value of the international debt capital market transactions amounted to 1 trillion USD – that’s 1000 billion USD in 3 months. This huge market is called bond-market.
In the financial world, a bond is a paper that determines a debt from the issuer to the holder.
If a company or a government issues a bond, there are 2 basic terms to consider: Time and rate.
Time: In bond markets we speak about maturity and this is the date, a debt will be paid back in full. Short bonds have a maturity of 2, 3 years, but 10 or 30 years are also common, even a 100 year bond was recently issued by the brazilian oil company Petrobras.
Rate: The issuer guarantees to pay a fix interest rate for this debt until maturity to the bondholder.
The offered rate reflects 3 mayor factors:
• The quality of the issuer concerning the ability to come up to the obligation. This quality is in most cases determined by a rating-agency.
• The currency of the debt
• The general rate situation
A government-issued bond often pays a smaller interest than a bond of a company, called corporate bond. The reason is, that the bankruptcy risk of s state is lower than for a company.
That said, there are still differences between countries, so Romania for instance has to offer a higher interest than Germany, because Romania is currently rated ‘BBB-‘ while Germany gets the top-mark AAA by the rating-agency Standard & Poors. With this rating, Romania’s debt-quality is the same as Italy, India or South Africa.
Now, if a government of a solid state issues a bond of 4 billion EUR, a maturity of 30 years and a fix annual rate of 2% – an investor who is interested to buy a part of this debt has to ask:
In today’s low interest world, the 2% in EUR from a solid debtor is fine, but what’s my fix 2% in EUR worth in the future since the bond is running till 2045. If the rates are changing or the EUR is falling apart, today’s good conditions could become much worse.
If you still buy the paper, you have two options: You can store it in your safe for 30 years, collect the taxable interest each year and get your initial investment repaid in 2045.
Or you can trade this paper on the bond-market.
What’s the difference between the stock- and the bond market?
First of all, if you hold a share of company xy, you are an owner, if you hold a bond of xy, you are a creditor. In other words, if xy goes down, owners get nada, creditors will take part in the distribution of a possible liquidation value. But since you are smart and never invest in a company that goes bankrupt, this is only to show the difference in the status of a stock- or bond investor.
Nobody is actually that smart to predict the level of interest rates for a longer period. And that’s exactly where the gap between stocks and bonds comes to light.
When interest rates are low (as it is the case right now), companies can cheaply borrow money to finance their operations, so the general stock market rises in expectation of increased corporate profits.
When interest start to rise, the stock market generally declines because corporations have to pay more money to finance their operations and this cuts into their profitability.
It’s the yield that matters
Well, the bond prices will fall too when interest rates are rising. But in bonds, falling prices are actually good for a bondholder. Why?
Because it’s not the price that counts, but the yield that matters. Or, to be more precise – the yield to maturity.
The yield shows the return you get for a bond. If you buy a bond to the price of the par-value of 1000 and a fix coupon of 5%, the return or yield is obviously 5%.
If the bond price is sinking to 800, the yield is climbing to 6,25%. Why? Because the par-value of 1000 (that’s the value you get at maturity) and the fix rate never change, only the trading prices in bonds are moving.
To calculate the new yield, take the price of 800, divide it with the rate of 5 – you get 160. Now divide the par value of 1000 with 160 and you have a yield of 6,25%.
If the bond price is rising to 1200 and you make this calculation you will see, that the yield has gone down to 4,16%.
Now, I hope you are not too confused. Important is actually only to know, that in general, bonds are more attractive, when interest are rising, stocks offer a better return, when interests are falling.
In plus, the bond market – who is by the way much bigger than the stock market – is often giving a pretty good picture for stock-investors too. Right now, it’s anything but a nice picture. The recent collapse in high yield or ‘junk-bonds’ could be a forerunner of a serious stock-market correction coming up soon.
What do you know about basic financial concept, each of us is faced with in business, as a saver, investor or a debtor? A global survey shows very poor results. Facts & figures in the next chapter: http://www.theleader.ro/financials-to-know-or-not-to-know/