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You are here: Home > Current Topics > Mind your Business > 01 May 2006 |
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In the past year, there has been a slow but gradual global movement in financial markets. To the average citizen, such movements have little direct effect and may not appear particularly interesting. Such movements rarely capture the front pages and could certainly not be described as sexy or sensational. Yet these global movements have a major impact on the wealth and welfare of millions of people throughout the world. You have no doubt heard of the 'pensions crisis'. This is a problem facing governments and businesses not only in the UK but also across Europe, the United States (US) and Asia. These global movements have a direct impact on funding pensions into the future. The global movement being referred to is being triggered by gradual tightening of monetary policy throughout the world. In the UK, the Bank of England has raised rates from 3.5 to 4.75% in the last two years although for the last seven months the rate has been stable at 4.5%. In the US, the Federal Reserve has raised rates by a quarter point every month for the last 15, rising from a low of 1% to the current (at the time of writing) level of 4.75%. In recent weeks, the Fed has hinted that there may be one more rate rise on the way but that might signal the end of the tightening of monetary policy. 
Dull day in the City? Not when the central banks are changing lending rates. © Photolibrary Group In Europe, the European Central Bank (ECB) has raised its interest rates, again in quarter point steps, to a current level of 2.5%. Analysts predict further rate increases will be seen during 2006. In Japan, meanwhile, there are rumours afoot that the Central Bank of Japan may be able to post positive levels of interest rates for the first time for many years as the country struggles to get out of a spiral of deflation that has left the economy in a slump. Why are global interest rates on the rise? Hopefully, any student of economics or business will be able to offer at the very least a simple explanation of the trend. The main reason is the fear of inflation. The global economy has lumbered back into some form of activity in recent years and with accelerated economic activity comes the threat of inflationary pressures and central banks tasked with keeping inflation under control respond by gradually lifting interest rates to stem the rate of economic growth and reduce inflationary pressure. Large parts of Western Europe and the US have seen inflation rates under a far greater degree of control than was the case in the 1970s and 1980s. Many analysts put this down to the greater degree of independence many central banks now have. A low inflation and (relatively) low interest rate economy provides the ideal conditions for stability which is what many businesses and investors like. For investors, the financial landscape has changed dramatically in the last 30 years. The developments in technology, the opening up of markets worldwide, the deregulation of global financial markets and the staggering range of investment opportunities have led to a far greater degree of complexity in markets. We hear of traders receiving six- and seven-figure sums in bonuses - many of these traders are acting on behalf of investors and their job is to 'make money'. When you start to get into the mechanics of financial markets, the jargon used can make the whole thing seem totally incomprehensible. In very simple terms, investment in financial instruments is about buying something at one price and selling it at another, and on the other hand, getting some payment for agreeing to forego consumption (that means lending someone else your money!) The rise in interest rates has had an impact on bond prices in recent months. Bonds are another form of investment opportunity and a way for businesses and governments of all kinds to raise funds. The selling of bonds in the US, for example, raised some 60% of the funds needed to pay for the First World War in that country. The willingness of an investor to put their money into bonds is therefore important in lubricating the wheels of commerce in a wide variety of ways. The purchase of bonds is also an element of the portfolio of investments held by pension funds and insurance companies, so their performance does have an impact on the pensions crisis. These unsexy global movements, therefore, have more of an effect on us than we ever realise. Many of you reading this might have a premium bond lying around somewhere! The theory section of this Mind Your Business will look in more detail at the jargon associated with bonds and how they work. |
A bond is a means by which one individual is able to lend money to a business, government or other agency. There are a number of key features about a bond and some terminology that we need to understand.
Investors may be looking to use their money for two main reasons. One might be to engage is a speculative risk to gain some financial benefit. This simply means you buy the bond at one price and hope to sell it for a higher price. The second reason might be to gain a regular income. A bond has an interest rate attached to it and throughout the life of the bond you will be paid that interest. For example, if a £100 bond has a 10% interest rate attached, you will be paid £10 a year in interest for the life of that bond. The bond therefore has a potential stream of income or income stream that is attached to it.
That might not sound like much but we are using simple figures here for illustration.
The organisation issuing the bond will do so with the intention of raising funds. The Financial Times (FT) publishes a list of bond issues (http://news.ft.com/markets/bonds/international) . A glance at this highlights the main features of a bond. For example, on Thursday April 20th 2006, the European Investment Bank (EIB) issued $1 billion worth of bonds with a coupon of 5.25% and a maturity date of May 2013.
Anyone buying these bonds therefore would be accepting that they are lending the EIB money at an interest rate of 5.25% and will be paid back their original investment in May 2013.
Bonds are but one way of investing your hard-earned money. In most cases, however, a professional investor will do this on your behalf through pension finds and insurance companies - part of the so-called 'institutional investors' who deal in billions every day. Copyright: Marcel Moura, from stock.xchng.
Let us assume that you decide to buy a bond with a face value of $50,000 from this issue. There are certain things we need to be aware of:
We always have to remember that any investment is a decision by an individual to apportion funds between competing uses. If I happen to be fortunate enough to have $50,000 available I can do lots of things with it; buy a car, a boat, spend it on clothes, put it into a bank, buy some shares, and so on. So there are a variety of competing demands for my money. As with any economic decision, there can be some assumption that my decision to use my funds will be a rational one. I will be looking to get the best return on my spending so spending my money on a bond has to give a greater return than all the other competing uses for my money.
Buying bonds might be just one of many different ways to invest money - each investment has an opportunity cost associated with it. Copyright: T. Al Nakib, from stock.xchng.
Factoring in the effects of changes in interest rates, inflation and what I think might happen to the economy is therefore an important aspect of the decision making process. If I intend to keep the bond until maturity I am giving up potential consumption represented by $50,000 for the next seven years - I want to be adequately compensated for that sacrifice.
You might argue that I am being paid an interest rate for this sacrifice and that is indeed true. However, I am also going to have to be mindful that this income stream will stay the same for the next 7 years but $2,625 today is worth more than $2,625 in 2012 because inflation will have eroded its value. In other words, $2,625 will not buy as many goods or services in 2012 as it will do in 2006!
Yield = Coupon Rate / Market Price
It is important to remember that the yield and the interest rate are not the same thing. Changes to the market price of the bond will affect the yield and this in turn will be affected by what is happening to interest rates in general.
In the 'news' section, we heard how interest rates are rising. What then happens to the bond market as a result of this? Assume that I bought my bond for $50,000 in 2002 with a coupon rate of 3%. Any new bond issues have to tempt investors to part with their money - remember all the different ways I could spend my $50,000? Therefore any bond issue in 2006 has to reflect the interest rates in existence at this time. Let us say that a new bond issue (same nominal value, same maturity date) is made in May 2006. The coupon rate must be competitive with other possible investments and so is issued at 5.0%. Anyone looking to buy a bond at this time has two choices. They could either buy mine (assuming I wanted to sell it) or buy one of the new issues. Which would you choose?
Clearly the bond offering 5% represents a better investment than one offering 3%. Does that mean that you would not entertain buying my bond from me? Not necessarily. What I would have to do is to accept a lower price if I wanted to sell my bond. In this case the price would be bid down to a point where the yield from the two would be the same. In this case the yield would be at the higher rate of 5%. The buyer would be prepared to pay less than $50,000 to buy my bond from me. This reflects the fact that the coupon on my bond (3%) is less than they could have got from buying a new issue bond.
We can calculate this using the formula above. As an investor I am looking for a yield at least the same as that I can get on a new bond issue (5%). The coupon (income) from a $50,000 bond at 3% is $1,500. Substituting the figures into the formula we get the following:
5% = 1,500/Bond Price
Bond Price = $30,000
If interest rates were to fall then the reverse situation would occur. Now my bond with a 3% coupon might be more attractive than a new issue that might be being offered at only (let's say) 2.5%. I could expect the price of my bond to now rise.
What we have therefore is an inverse relationship between bond prices and interest rates; when interest rates rise, bond prices will fall; when interest rates fall bond prices rise.
If interest rates rise then the price of a bond is falling. What happens to the yield as a result? The yield will rise. Look back at the formula; if the denominator is a lower value and remembering that the coupon rate (the numerator) does not change then the yield must rise.
Bond prices and interest rates have an inverse relationship - when interest rates rise, bond prices will fall and vice versa. Copyright: T. Al Nakib, from stock.xchng.
What we are seeing on international markets, therefore, is precisely what the theory suggests is happening. As interest rates start to rise and if the expectation is that they will continue to rise, bonds become less attractive and their price falls. As their price falls the yield rises.
Given that some bonds might have many years to run before it reaches maturity, any investor will be considering income streams over a period of time. We have seen with our example of the $50,000 bond with a coupon of 5.25% has a yearly income stream is $2,625. That sum of money can be reinvested and so can these income streams generated each year until maturity. If you bought the bond at a lower price than the face value then there is also the fact that you will have that sum to consider when the bond matures.
In addition to this, investors will also have to take account of what is called the term structure of interest rates. This means that there is not one interest rate in the economy but many different ones relating to different types of investment. An investment that expected someone to lock up his or her money for 30 years would tend to have a higher interest rate attached to it than one where your money could be withdrawn instantly. To help in the decision of whether to buy short term or long term bonds, investors will use what is called a yield curve to help in that decision.
The yield curve is a graph which has the yield or interest rate on the vertical axis and the time on the horizontal axis. The longer the period of time the loan is tied up for the higher the yield expected. A yield curve can be used to show a range of competing bonds therefore to help make the decision. You can get some idea of this by looking at some market data - look at CNN's Bond Center or bondtalk.com and you get some indication of yield curves. Remember, though, that these will almost constantly change as bond prices change in the market. A good example of this can be gained by looking at this animation of the yield curve. (http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve)
A typical 'normal' yield curve.
The other major factor affecting bond prices is inflation. Take my $50,000 bond at 5%. If inflation was 2.0% when I bought it then I have a positive real income; I have to remember that inflation reduces the value of my income streams over time. However, if inflation rises to (say) 2.5% then my real income from the bond will fall. Because of the effect of inflation the price of a bond will vary inversely with inflation for the same reason that interest rates have an inverse relationship with bond prices.
Look at the following two articles:
