May 14, 2017    8 minute read

The Economics of Bonds

Reverse Trajectory    May 14, 2017    8 minute read

The Economics of Bonds

Along with stocks and commodities, bonds are a form of investment. They are debt, rather than equity. They are nothing more than debt issued by corporations or, in many cases, governments. When in need of money to expand into new markets, in the case of companies or, in the case of governments, to finance social welfare or healthcare policies, institutions often need sums of many that are far too big for a bank to provide.

In this case, they go to the bond markets, where they can raise the money that they need. In exchange for capital, they issue bonds to thousands of investors. The bond that is issued essentially serves as a guarantee that the borrowing entity will get the investment back by a specified time, known as the maturity date, and a rate of interest on that amount.

Therefore, the bond is a different investment because it comes in the form of a loan and the investor is, in fact, lending money. Since bonds usually have a fixed interest rate, also known as the coupon, the investors know precisely how much money they will receive for their investment.

The Ideal Investment?

A lot of investors prefer bonds over stocks, which are more liquid but also far riskier. As such, bonds are usually ideal for investors who are risk-averse and have long investment horizons.

Furthermore, if an institution goes bankrupt and fails to pay back the money, the investor, as a creditor, is entitled to the assets owned by that corporate or government.

There is no such thing as the ideal investment, but conventional wisdom dictates that investors should start out by putting their money in the stock market when they are young and move into bonds when they reach middle age.

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Setting the Price

The value of a bond is determined by many factors. The maturity date, for example, can alter the value of the bond in the sense that the shorter it is, the more predictable it is. If a bond matures in six months, the interest rate will be smaller and the investor will get a lesser return.

On the other hand, if the bond takes a long time to mature, the interest rate will also be higher because the investor is undertaking a riskier investment. It is harder to predict what could happen in, for example, ten years, and time might affect the issuer’s ability to repay the investment.

The issuing entity and its stability also affect the likelihood of the investor getting his or her money back. Government bonds are usually more secure and reliable than corporate bonds because countries can always raise taxes to collect the necessary sums before the maturity date. However, the interest rates on government bonds tend to be less appealing to investors looking for higher returns.

However, even in government bonds, there are disparities in the risk of default risk that each government presents. In Europe, for example, Germany’s government bond is less risky than the Greek government bond.

Assessing the Risk

Assessing the risk of a bond in the short, medium or long term is often a job for private and independent rating agencies. The most regarded ones are Standard & Poor’s, Moody’s and Fitch. Their job is to say how likely it is for certain entities to pay back the money they borrowed from investors in due time by analysing them financially.

When their analysis is done, they assign a rating to that bond. The ratings range from AAA, the highest quality investment, to C or D, which translates into being in default.

The ratings given are followed closely by investors who look for the bonds that best suit their investment goals. So, if a bond has a rating of C or CC, it is considered “Junk”, or a very risky investment, by the rating agencies. Therefore, it has to offer a much higher yield to attract investors.

These rating agencies are highly influential as they dictate the price of bonds and can dramatically change investor appetites. Yet, they do not always provide the best analysis as was proven by the 2008 financial crisis, when rating agencies failing to detect issues with the subprime mortgages that ended up causing the crisis.

Risky Bonds

For a long time, Greek government bonds have been seen as a risky investment. Rating agencies have given bad ratings to Greek debt for years and the country has had difficulties raising capital in the bond markets, even at high interest rates.

The Greek government had so much trouble raising capital that it had no choice but to ask for a bailout financed by the troika: the IMF, the European Commission and the European Central Bank.

These three entities lend money to Greece at a lower interest rate than the country would have to pay in the public bond markets, but the Greek government has to put in motion an austerity plan for the country.

Austerity measures, overseen by the three institutions, often include raising taxes and cut public spending to reduce the country’s deficit and slowly improve its credit rating so that it can finally issue bonds in the markets without facing very high interest rates.

35% Greece’s 10-year average yield between 2010 and 2012

Now, in the middle of another economically harsh austerity program, the Bank of Greece says that it can issue bonds with a 10-year maturity to creditors at a 7.85% rate, much higher than the majority of European countries. However, it is still nowhere near the staggering 35% it reached between 2010 and 2012, at the peak of the debt crisis.

According to the Financial Times, the price is not necessarily the problem in Greece’s case; it is how often the bonds are traded. Greece traded a total of €28m bonds in January. This is incredibly small when compared to the €19bn German bonds traded every day.

€28m Total Greek bonds traded in January

Solid As a Rock

Unlike the Greek bond, investors place incredible trust in German bonds. The most illustrative case is Germany’s two-year Schatz yield – one of the safest places for investors to retreat to in uncertain times. This bond, which has a two-year maturity, is considered to be such a safe investment that the bond buyers (investors or creditors) pay money to invest in it, instead of getting paid interest.

This means that the German government gets paid to borrow money from creditors because so many investors want to buy its bonds. It is a highly unusual situation, but it is becoming more and more normal and the yield is reaching record lows.

Lesser of Two Evils

In an effort to boost inflation and stimulate growth, the European Central Bank cut the deposit rate it paid commercial banks on the money they deposited there. The banks started charging their clients a deposit fee, instead of paying them interest.

In this sense, companies and investors started to place their money in other types of safe investments, like the aforementioned German bonds. They still pay to lend their money, but less than they would if they were to keep the money in the bank.

So, this central bank policy is indirectly rewarding certain governments, like Germany’s, for having a great credit score while punishing others, such as Spain or Italy, for having a lower credit rating.

However, these debt instruments have become too volatile. As fear of the unknown spreads from the political arena into the markets, the demand for safe havens is higher. In a way, it goes against the logic upon which the bond market itself is built.

Should policy-makers and regulators be allowed to have such a degree of influence in this? Should depositors be pushed into being investors? Bonds are, after all, an investment and investments are meant to hold a certain degree of risk, whereas deposits are supposed to be safe. Should bonds yields be so easily influenced by external political matters?

No one can know what to expect from future policies. The European Central Bank will likely continue with this policy, and while German bonds will increasingly be safe havens for fearful investors, the situation could become even more uncertain.

Until the Brexit negotiations are underway, the future of the EU remains in limbo. Will Germany still be a haven for fixed-income investors? Time will tell. For now, at least, investors who buy the German 10-year bond will likely continue to make good returns, even if politics is chaotic across the world.

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