Travelling to my work place from home is by train. In the past couple of months, I have heard many passengers having lengthy conversation in respect of the Central Bank Bond issue. Hence I had an idea of penning down few lines in basics how it works.
Origins of Bonds
Bonds originated in Italy, where the city states, often at war with another, would force their wealthier citizens to lend them certain amounts in exchange for regular interest payments. British Government was issuing a Variety of Sovereign Bond the earliest - The Ton-tine, and the most popular Consol. During the first half of 19th century, Nathan Rothschild became one of the world’s richest men and arguably the most powerful banker by actively being in the bond market throughout Europe.
A few financial institutions, taking the opportunity from the window provided by the Government has already raised and others planning to raise funds from the International Bond Market as well as the local. Although this system prevailed in the global financial market, this is a new avenue for the Sri Lankan financial market when raising funds. Bond markets where companies and governments raise money are far less renowned and understood than their equity counterpart, the stock market. Yet in many respects can be more important and influential. By determining whether a country could cheaply raise liquidly or not, the bond markets have helped to determine the course of wars revolutions and political struggles, and had far reaching implications in almost every corner of life for centuries. Even during time of peace the ability of a government to raise money is of massive importance to a country’s Citizens. The higher the interest rates it has to pay, the higher are the borrowing cost all the way across the economy. So ignore the bond market at your peril. The price of sovereign bonds (see chart 1) reveals how creditworthy a government is, how easy it finds it raise cash, and how its policies are regarded. If a country no longer able to tap the bond market it will struggle to survive at all.
What is a Bond
A Bond is essentially a type of IOU which promises to pay the owner a certain lump sum at a point in future, as well as a stream of interest payments throughout bonds life usually at annual intervals. A typical government bond, for say U$ 100,000 will last for any thing like one to ten years, and will pay a nominal, in other words face value, interest rate fixed at around 4.5 percent. Once the bonds have been issued, they can be traded on the massive international bond markets. (Availability of bond markets) as Sri Lankan Bonds this can be traded in our secondary market.
The real power of bond markets lies in the fact that the interest rate the market determines for the bond can be quite different from that advertised on the bond itself. If investors believe a country is (1) at risk of defaulting or (2) likely to push up inflation (which in many senses is also a kind of default, since inflation erodes value). They will tend to sell off the bond which has the twin effect pushing down the price of the bond and pushing up the actual rate of interest it pays out.
This make economic sense the riskier an asset is, the less investor should pay for it, and the greater should be the compensation for holding it (the interest rate). To have an idea on the above consider this simple example, suppose there is a U$ 10,000 Treasury bond with a 4.5% interest rate (also known as yield) for a duration of 10 years. It will pay out US 450 to its share holders each year for any one who buys this in the market which offers a price this represent a 4.5% interest rate. But what happens if inventors get jittery about the creditworthiness of that particular country and starts selling their bonds. The price drops to U$ 9000 at this price U$ 450 yield in actually 5 percent to the new investor.
Hence the market rate of bond is highly important since it influences the rates at which a government can issue future bonds and still hope to find his buyers. If it is to get buyers as an when bonds are issued it must adapt the initial interest rates (coupon rate) to the market rate of the existing bonds the higher the rates it has to pay, the harder it becomes to borrow and the more it is forced to cut back. Not only Sri Lanka, other governments throughout the globe have to borrow in order to keep their budgets balanced items they are regularly issuing new bonds.
Ratings - A A to C Ratings
Bonds issued by a Company or a Country are regarded as a safest investments available. When the issuing Country or the Company collapses, the bond holders are closest to see front to get their investment paid back. However the possibility of default is a key consideration for investors, to be on the safe side investors look for the ratings of top agencies such as Standard & Poors Moody’s and Fitch. These ratings range from A A A, the best quality to C. Typically bonds rated a B A A or above are regarded as investment grade.
The Yield Curve
Perhaps the most telling sign of the Bond market’s importance is the fact that the way bonds behave can provide excellent clues about the future of the economy. The yield curve simply measures the interest rates on a variety of different governments bonds over time. All other things being equal, interest rates for bonds due to expire shortly should be lower than those which expire in a number of years - this reflects the fact that the economy is slowly to grow in the future, and the inflation will rise.
Occasionally, however, the yield of curve becomes inverted, meaning that to interest rate on bonds which expires soonest are higher than those expiring in the future years. This is fairly a reliable sign that the economy is heading for a recession, since it implies interest rates and inflation will fall in the coming years. Couple of phenomena usually associated with economy slump. It is another example of how everyone’s economic fate in inextricably tied into state of the bond market.
The article comprises Economic Ideas of Edmund Conway