Bonds as Financial Instruments and Their Functions - Essay Example

TOPIC: Bonds Submitted to (INSTRUCTOR’S NAME) (INSTITUTION NAME) (ADDRESS) March 23nd, 2015 By (STUDENT NAME) (INSTITUTION NAME) Bonds Introduction JPMorgan estimates that approximately $1.7 trillion of euro-region government bonds with long-run maturities exceeding a year are transacting at negative nominal yields (Shaffer 2015, p 1). After addition of the Swiss, Swedish and Danish bonds this figure increases to $1.8 trillion in negative-land bonds (Shaffer 2015, p 1). Another $1.8 trillion value of Japanese bonds were also transacting at negative yield at the end of February 2015 (Shaffer 2015, p 1). According to JPMorgan statistics, all-in-all, negative yields accounted for as much as 16% of the company’s Global Government Bond Index amounting to $3.6 trillion at the end of February 2015 (Institute of International Finance 2015, p 1). This trend is indeed very surprising that we still have people buying the bonds even at negative rates. Purchasing negative-yield bonds, which amounts to paying for the honour of lending money to governments indeed appears foolish. Bond yield is also inversely related to prices, hence when the prices increases fairy, entrepreneurs are paying for the honour of loaning money, which makes buying negative bonds looks more foolish. This paper looks at the issue of bonds with negative yields and the reasons why investors would still invest in them. The paper also examines economic theory that explains the motivation behind a buyer’s willingness to purchase bonds with negative yields. In fixed income, the convectional approach is to purchase shorter term bonds of highly valued governments in order to integrate low interest rate risk with low credit risk. The decision to buy negative yields bonds is thus attributed to the dilemma among conservative investors in the trade-off between bonds yields prospects versus interest rate risk concerns. Therefore, this paper attributes the decision of investors to buy bonds with negative bonds as contributed by the long-term concern of inflation impact in escalating the risks of bonds with long-term face value or premium maturity, which would result in the loss of purchasing power. Bonds as financial instruments and their functions A bond is an equivalent of a loan or an IOU (I Owe You) that is used by private and public institutions to borrow billions of money by selling the bond to individual, corporate or government creditors. The issuer of the bond (borrower) commits himself/herself legally to pay back the amount borrowed referred to as bond’s par, principal or face value to the bondholder on a specified future date referred to as the maturity or redemption date in addition to interest, coupon or coupon rate at a regular interval (Goyenko & Sarkissian 2014, p 1229). A bond’s interest or coupon is often paid twice per year and represents the cost of borrowing to the borrower as well as an income to the lender or issuer of the bond. Unlike other types of loan, bonds attract capital and retain the management autonomy of the borrower over his/her asset. Bondholders are also not entitled to dividends payment from the issuer company but instead receive only a fixed return on their investment in terms of an annual or biannual interest or coupon. Bonds are categorized as government bonds or corporate bonds. Government bonds are issued by central, federal or municipal government such as the United States government bonds. Corporate bonds are normally issued by financial firms, transportation companies, industrial corporations and public utilities. Corporate bond pay relatively higher interest or coupon compared to government bonds due to their relatively higher risk of default. However, bondholders have priority claim over stockholders in case the bond issuer goes bankrupt. Bonds are an ideal investment option for long term retirees due to their shelter from value fluctuations as witnessed in the stock market. Bonds are also best suited for shorter-term investment strategy (Goyenko & Sarkissian 2014, p 1231). Despite bonds’ relatively low financial performance over a one given period compared to stock particularly during prolific market conditions, bonds are useful financial investment tools due to their ability to circumvent market fluctuations and the usual ups and downs of the economy. Furthermore, bonds provides the means of diversifying investment funds by spreading them over different classes of bonds and stocks. As investment, bonds may offer a means of saving capital and generating a predictable income. Bonds investment generates regular income from interest or coupon payments before bond maturity. Bonds may also offer downside investment safeguards against the highly volatile mobility of the stock market. The buyers of the bonds A wide universe of individuals and institutions purchase bond including governments, insurance companies, corporations, pension funds, and banks. These customers buy bonds in order to create a stable cash flow income to pay for their predictable obligations. For instance, insurance firms use the steady interest payments from bonds to pay for their obligations from sales of insurance policies. Business and government with big funds from pensions purchase bonds to make sure that enough capital is available to meet obligations for beneficiaries and retired employees. International investors and mutual funds including central banks also invest in bonds. Bonds investors hence include insurance companies, individual investors or households, financial institutions, pension funds, mutual funds and international investors. What factors might prompt buyers of bonds to buy bonds with negative yields Yield refers to the return on the capital invested in the bond. The yield can be calculated as either coupon yield or current yield. Coupon yield refers to the annual interest rate return upon the issuance of a bond and it’s the same as the coupon rate or the interest rate of a bond. Coupon yield is thus calculated as the amount of income collected on a bond, which is expressed as a percentage of the original capital invested in purchasing the bond. For instance a bond worth $1,000 that earns $45 annual interest has a coupon yield of 4.5% (Goyenko & Sarkissian 2014, p 1233). The coupon yield of a bond does not change for the entire lifespan of a bond. On the other hand, current yield is calculated by dividing the bond’s coupon yield by its market price. For instance, a bond with a coupon yield of 4.5% and a market value of $103 has a current yield of 4.37%. Other types of bonds yield include Yield to maturity, Yield-to-Call and Yield-to-Worst. Yield to maturity refers to the aggregate interest rate received by an investor who purchase a bond at the market price and keep it until maturity date. On the other hand, Yield-to-Call is plugged in terms of the number of months to maturity indicated as a call date or the bond’s call price. Yield-to-Worst involves consideration of the bond with lower investment return between Yields to maturity bond versus Yield-to-Call bond. Some traders buy negative yield bonds a gamble for prospective appreciation in a state’s currency. For instance, traders who bought Swiss bonds by the end of 2014 paid a negative rate that was compensated by a 30% appreciation in the Swiss currency in 2015 following the termination of the franc’s peg to the euro by the Swiss National Bank (SNB) (Institute of International Finance 2015, p 2). Other investors purchase negative rate bongs under the speculation of further rise in bond price driven by additional cuts in interest rate from quantitative easing or central banks. Majority of such investors have already witnessed strong capital gains. For instance, the rumour that the Swedish central bank, Riksbank might lower its interest rates into negative-land is attributed to the current surge in demand for Swedish bonds. Some investors simply don’t have an option from buying negative rate bonds. Such investors include index funds investors. According to JPMorgan, approximately $150 billion of the bond exchange-traded funds (ETFs) valued at $350 billion invest exclusively in government bonds (Shaffer 2015, p 1). Financial institutions including insurers and banks might receive negative return on bonds as a result of bad investment choices or mismanagement. For instance, approximately 220 billion euros worth bonds reserve at the European central bank, Swedish national bank and Danish central bank are entitled to negative deposit rates (Shaffer 2015, p 1). Financial players faced by an inescapable loss might buy negative-yield bonds in order to minimize the negative yield on investment. In such a case the negative-yield bond is seen as a less-expensive evil over the negative yield on investment. For instance, the Swedish national bank’s deposit rate, which stands at negative 75 basis points may stimulate the purchase of the Swiss bond, which has a current seven-year yield value of negative 67 basis-points (Shaffer 2015, p 1). The aging population might also explain why investors are buying negative rate contrary to conservative classic economic principles. When old age is a potential concern households are reluctant to relocate their preferred consumption from the future to the present despite lower interest rates incentives. During such times, households are more concerned with saving a certain level of their income and hence increase their saving with decrease in investment returns. The risk of deflation has also forced governments to auction off bonds with negative yield. For instance, Switzerland became the first nation to auction off 10-year bonds with negative yield in order to contain the risk of deflation (Han, Moore, Shin & Yi 2013, p 294). Danish debt also bears a negative yield return for up to five years maturity date. Investors are then duped into buying such negative yield bonds due to deflationary fears and robust central bank action in form of a couple of monetization gimmicks. Whether there is a case in economic theory for buying bonds with negative yields Interest rate changes significantly affect bond return. Bond prices vary inversely with changes in interest rate and hence each bond carries an interest rate risk. For instance, the prospected significant rise in interest rates in the entire major currencies over the next 2-3 years is expected to cause valuation losses to high-grade bonds with a maturity date of more than five years. This would consequently results in delivery of negative or low total return from investment in such bonds. For instance, the low current yield of Swiss government bonds offer the least cushion against negative interest rate impact on bond prices and hence would result in as much as 7.6% total return loss to 10-year bond’s investors. Besides interest rate risks, bond prices are also subject to inflation risk or purchasing power risk in the case whereby the yield on a bond is unable to keep pace with purchasing power. For instance a five-year maturity bond with a coupon yield of 5% with inflation rate at 8% translates to a decline in the bond’s purchasing power. All bonds with the exception of Treasury Inflation-Protected Securities (TIPS) therefore expose their investors to some level of inflation risk. Inflation also affects exchange rate of a currency through its impact on the competitiveness of a country’s product in the international market (Dajcman 2015, p 109). For instance, the current higher inflation rate in United Kingdom compared to its European Union counterparts is expected to lower the value of pound. The prospected devaluation of United Kingdom pound is attributed to the inflationary increase in price of Britain’s product, which reduces their competitive in the international market hence reducing the demand for pounds as exports from Britain subsequently, reduces. Bonds are among a country’s export product capable of generating foreign currency and hence the weakening of a country’s currency has significant impact on bonds yield due to the market forces of demand, supply and prices. Therefore, exchange rate risk is also affects the bond yield in addition to interest risks and inflation risks. An increase in exchange rate volatility is generally associated with investor’s reluctance to purchase local currency sovereign bonds as the exchange rate risk increases unless the bond’s yield is higher enough to compensate for holding the high exchange rate volatility. Likewise, appreciation of local currency results in increased demand for local currency bonds by international investors due to the prospective higher yield return on the bond. However, this increased demand for local currency bond under the impetus of appreciation of local currency exchange rate is subject to the stability of the local currency. Therefore, the demand of local currency bonds would remain unchanged despite appreciation of the local currency exchange rate for an unstable local currency. Besides its direct impact on the market forces of demand, supply and prices in the local and international bond market, exchange rate risk also affects the yield return of local currency sovereign bonds in a number of ways. For instance, bond’s investors are subject to exchange rate risk on their bond status in the case where prospective changes in exchange rate could change the yields return of local currency bond. Likewise, large currency mismatches in banking, corporate or household industry balance sheets might raise default risks for government bonds (Bittlingmayer & Moser 2014, p 3). A prospect for higher exchange rate risks could also reduce liquidity in domestic bond and foreign exchange market. For example, an unpredicted depreciation of a domestic currency can prompt investors to exit from assets valued in that currency thereby reducing liquidity of foreign exchange market. The estimated 16% of global sovereign bonds with a negative yield are thus caused by central banks’ and other few monetary bureaucrats deft manoeuvring of the world’s economy through a several regulatory gimmicks. Such regulatory gimmicks involve disabling the entire pricing mechanism in financial markets and replacing market forces with central control and command. This central command and control system is characterized by manipulated bond yield curves, pegged money market rates, calling on speculators to champion massive central bank bond purchase programs and implied as well as explicit promises that increasing risk assets prices would be facilitated and favoured at all risks. The earlier case of Swedish national bank pegging of the Swiss-franc against the euro provide a typical example of the command and control contribution to negative bond yield. The regulatory manoeuvring of the financial market is justified on primitive Keynesian economic premise on the need to remedy the current worldwide insufficient aggregate demand and infinitesimal inflation in consumer goods and services through massive government deb monetization and other financial market regulatory tool. This monetization of debt is evident in the absurd financial arrangement between banks and the central bank for deposit of the surplus cash held by banks to central bank at a fee. The negative bond yield represents one of these absurd Keynesian economic premise, whereby bonds investors pay the government for the privilege of holding government debt (Bieńkowski, Gawrońska-Nowak & Grabowski 2014, p 33). For instance, the Swiss Federal Treasury sold 232.501 million Swiss francs on 1st April 2015 equivalent to $242 million worth of bonds with a 2025 maturity date at a yield of -0.055% at a coupon rate of 1.5% (Institute of International Finance 2015, p 2). Danish debt also carry negative yield for bonds with a maturity rate of short-term maturity date of five years. Conclusion The decision to buy negative yields bonds is attributed to the dilemma among conservative investors in the trade-off between bonds yields prospects versus interest rate risk concerns (Bansal & Shaliastovich 2013, p 2). Therefore, although investors would conservatively want to only invest in bonds that have positive yields, other reasons that would still make investors want to invest in the bonds even when they have negative yields. Such reasons include speculation, regulatory requirements among other reasons. Bibliography Bansal, R., & Shaliastovich, I. (2013), A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets, 26, 1, 1-33. Bieńkowski, W., Gawrońska-Nowak, B., & Grabowski, W. (2014), Comovements of Stock Markets in the CEE-3 Countries During the Global Financial Crisis, Eastern European Economics, 52(5), 32-55. Bittlingmayer, G., & Moser, S. (2014), What Does the Bond Market Know? SSRN Journal SSRN Electronic Journal, 49(1), 1-19. Dajcman, S. (2015), An empirical investigation of the nexus between sovereign bond yields and stock market returns – a multi-scale approach, EE Engineering Economics, 26(2), 108-117. Goyenko, R., & Sarkissian, S. (2014), Treasury Bond Liquidity and Global Equity Returns, Journal of Financial and Quantitative Analysis, 49(5-6), 1227-1253. Han, S., Moore, W., Shin, Y., & Yi, S. (2013), Unsolicited Versus Solicited: Credit Ratings and Bond Yields, Journal of Financial Services Research, 43(3), 293-319. Institute of International Finance. (2015, February 1), Capital Markets Monitor, Retrieved May 22, 2015, from https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=3&cad=rja&uact=8&ved=0CCgQFjAC&url=https://www.iif.com/file/8063/download?token=P_uf4OSD&ei=zxZfVf3HFuHLyAOlwYCgDQ&usg=AFQjCNHh4SnLQj71OPT0WEPaMQC1JWGVLg&sig2=SdM7MBeGQpWNP91f7X Shaffer, L. (2015, February 3), Negative yield bonds: Here's who's buying, Retrieved May 22, 2015, from http://www.cnbc.com/id/102391008 Read More