The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

Interest rates and bond prices

Interest-rate changes within the economy are the single most important factor affecting bond prices. This is because investors can profit from interest-rate arbitrage, selling certain bonds and buying others to take advantage of small price differences. Arbitrage will quickly drive the prices of similar bonds to the same level. Bond prices move inversely to interest rates. The precise impact of an interest-rate change depends upon the duration of the bond, using the basic formula:
Price change duration value change in yield Assume that an investor has just paid C$1,000 for a bond priced at 100, denominated in Canadian dollars with a 6% coupon and a term of ten years to maturity. This bond might initially have a duration of 7.66 years. If Canadian interest rates for ten year borrowings suddenly decline, investors will flock to the bond with a 6% coupon and bid up the price. Suppose that the market rate for ten-year borrowings in Canada drops to 5.9% immediately after the bond is issu…

Ratings of risk

Before issuing bonds in the public markets, an issuer will often seek a rating from one or more private ratings agencies. The selected agencies investigate the issuer’s ability to service the bonds, including such matters as financial strength, the intended use of the funds, the political and regulatory environment, and potential economic changes. After completing its investigation, an agency will issue a rating that represents its estimate of the default risk, the likelihood that the issuer will fail to service the bonds as required. This rating is normally paid for by the issuer, although in some cases an agency will issue a rating on its own initiative. Three well-known companies, Moody’s Investors  Service and Standard & Poor’s, both based in New York, and Fitch ibca, based in New York and London, dominate the ratings industry. The firms’ ratings of a particular issue are not always in agreement, as each uses a different methodology. It interprets the default ratings of the th…

Properties of bonds

Every bond, irrespective of issuer or type, has a set of basic properties.

This is the date on which the bond issuer will have repaid all of the principal and will redeem the bond. The number of years to maturity is the term. In practice, term and maturity are often used interchangeably. Bonds with maturities of 1–5 years are usually categorised as short-term, those with maturities of 5–12 years as medium-term and those with maturities exceeding 12 years as long-term. Few bonds are issued with maturities beyond 30 years, and in many countries the longest maturity is only 10 or 20 years.

This is the stated annual interest rate as a percentage of the price at issuance. Once a bond has been issued, its coupon never changes. Thus a bond that was issued for $1,000 and pays $60 of interest each year would be said to have a 6% coupon. Bonds are often identified by their maturity and coupon, for example, “the 6.25s of ’18”.

Current yield Current yield is the effective interest rate…

Electronic trading

Much effort and money has gone into building electronic trading systems. By 2002, 81 screen-based bond-trading systems were in operation, some belonging to a single dealer and others bringing many dealers together. The market was unable to support so many competitors and many of these nascent electronic bond exchanges have failed. Electronic trading has been extremely successful in the government bond market, where the number of different securities is small and liquidity – the amount available for investment – is high. Electronic systems accounted for about three-quarters of trading in European government bonds in 2004. Most electronic systems also offer online trading of commercial paper, emerging-market bonds and other fixed income products. Trading of corporate and municipal bonds has proven surprisingly difficult to automate because of three characteristics of these markets. First, institutional investors often pursue strategies that require near simultaneous transactions. For ex…

The changing nature of the market

Until the 1970s the bond market was principally a primary market. This meant that investors would purchase bonds at the time of issuance and hold the bonds until the principal was repaid. Their highly predictable cash flow made bonds attractive assets to investors such as life insurance companies and pension funds, the obligations of which could be predicted far in advance. The basic investment strategy  was to match assets and liabilities. An investor would estimate its financial requirements in a certain future year, often 10 or 20 years hence, and would then search for bonds of acceptable quality that would be repaid at that time. Successful bond investors were those who managed to buy bonds offering slightly higher yields than other bonds of similar quality.

Since the late 1970s, the reasons for investing in bonds have changed. Many investors now actively trade bonds to take advantage of price differences, rather than holding them over the long term. Two developments have brought a…

Types of bonds

An increasing variety of bonds is available in the marketplace. In some cases, an issuer agrees to design a bond with the specific characteristics required by a particular institutional investor. Such a bond is then privately placed and is not traded in the bond markets. Bonds that are issued in the public markets generally fit into one or more of the following categories.

Straight bonds 

Also known as debentures, straight bonds are the basic fixed-income investment. The owner receives interest payments of a predeterm inedamount on specified dates, usually every six months or every year following  the date of issue. The issuer must redeem the bond from the owner at its face value, known as the par value, on a specific date.

Callable bonds

The issuer may reserve the right to call the bonds at particular dates. A call obliges the owner to sell the bonds to the issuer for a price, specified when the bond was issued, that usually exceeds the current market price. The difference between the ca…

Setting the interest rate

The interest rate on a bond issue can be determined by a variety of methods. The most common is for the underwriter to set the rate based on market rates on the day of issuance. This, however, involves a certain amount of guesswork, and can lead either to excessive costs for the issuer if the interest rate is set too high, or to the underwriter being stuck with unsold bonds if the rate is set too low. Most syndicates prohibit their members from selling the bonds at less than the agreed price for a certain period of time, to keep the syndicate members from competing against one another. An alternative method of determining interest rates involves auctions. There are several auction techniques used in the bond markets. Competitive-bid auctions allow investors or dealers to offer a price for bonds being issued at particular interest rate (or, alternatively, to offer an acceptable interest rate for bonds being sold at par value). The offered price may go higher (or the offered rate lower)…

Bond futures

Futures contracts on interest rates are traded on exchanges in many countries. These contracts allow investors to receive payment if an interest rate is above or below a specified level on the contract’s expiration date. Large investors use such contracts as an integral part of their bond investment

The biggest national markets

Corporate bonds and some asset-backed securities are the main components of the private-sector debt market. This market has been growing rapidly overall, although in a few countries, notably Japan and France, the value of outstanding bonds has diminished . A disproportionate share of the world’s private-sector debt securities is issued in the United States. This is largely the result of deliberate efforts to retard the development of bond markets in many other countries. In Japan, the Bond Issue Arrangement Committee, a bankers’ group encouraged by the government, controlled costs and the timing of issuance until 1987, and a bankers’ cartel kept fees h…

The Bond Issuers

Four basic types of entities issue bonds.

National governments

Bonds backed by the full faith and credit of national governments are called sovereigns. These are generally considered the most secure type of bond. A national government has strong incentives to pay on time in order to retain access to credit markets, and it has extraordinary powers, including the ability to print money and to take control of foreign currency reserves, that can be employed to make payments. The best-known sovereigns are those issued by the governments of large, wealthy countries. US Treasury bonds, known as Treasuries, are the most widely held securities in the world, with $4.5 trillion in private ownership in mid-2005. Other popular sovereigns include Japanese government bonds, called jgbs; the German government’s Bundesanleihen, or Bunds; the gilt-edged shares issued by the British government, known as gilts; and oats, the French government’s Obligations assimilables du trĂ©sor. Governments of so-called e…