Over the next couple of weeks, we’ll explore the money markets and bond markets. There’s a lot to cover in this topic! Let’s start with some terms and concepts used in the fixed income space. Reference for this post is ‘An Introduction to Global Financial Markets’ by Stephen Valdez.
The Rate of Interest
So far, we’ve talked casually of the rate of interest for borrowing and lending. Of course, there’s more to it that that…for one, the rate of interest is not fixed, it differs for different borrowers. Naturally, the rate of interest of borrowing for the government might be less than that for private companies. Additionally, the rate changed for a short term loan might be lesser than a loan of a long duration.
Put quite simply, a lender will feel more confident lending to a government than to a private company. After all, the government is unlikely to default on its payment (though it has been known to happen!). Thus, the government rate becomes the benchmark rate for other companies. For example, an American corporate wishing to borrow for say, 3 months, may be expected to pay ‘Treasuries plus 1%’ meaning 1% more than the current rate for US government Treasury bills. You might also here this referred to as ‘Treasuries plus 90 bps’. What does bps mean? Bps stands for basis points and a basis point is 1/100 of a percentage point. Therefore, 50bps = 0.5%. The difference between any given rate and the benchmark US government rate will be called the spread or ‘the spread over Treasuries’.
Theoretically speaking, lenders will expect a higher rate of interest for lending money for 5 years than for 3 months. This relationship between the rate of interest and time is called the yield curve.
Yield is a very important term in finance. Yield is the return on investment expressed as an annual percentage. We’ll get back to what yield is after tackling some related concepts.
Bonds have a par or nominal value. This is the principal amount on which the rate of interest is based and which will be repaid at maturity. Let’s take an example. You buy a bond with a par value of $100 with a maturity of 10 years and interest rate of 10%. You would think the yield on this bond would be 10%, right? You would be right only if you don’t consider the secondary market in this picture.
Suppose, 2 years later you decide to sell the bond as you need some money. However, the interest rate has changed in the interim. Now the interest rate for similar governments bonds is 12.5%. When you try to sell your bond with 10% interest rate in the market, no one would be willing to pay $100 for it, when they can get the same bond in the market with a higher return. They might be willing to pay you $80 because your bond pays $10 per year (10% interest) and $10 is 12.5% of $80 giving a comparable yield to that available in the market. The market price of your bond is less than the par value you paid for it to give the desired yield of 12.5%. So, when interest rates went up, the price of your bond went down.
Say you didn’t sell your bond then and now, two more years down the road are thinking of selling it. However, now things have changed again and the current interest rate for similar bonds is 8%. You will have no shortage of buyers now because 10% is very attractive if the market rate is 8%. The market price of your bond is more than the par value you paid for it to give a yield of 8%. So, as interest rates went down, the price of your bond went up.
In the above examples, we have calculated what is known as Interest Yield. Quite simply, it is the interest amount (coupon)/price of the bond. Interest yield is also known as simple, flat, running and annual yield. This is a good metric but not very useful.
Gross Redemption Yield
Unfortunately, in our above examples and calculations, we omitted one crucial factor – redemption. In the first example above, when the current market interest rate is 12.5%, an investor can do one of these two things –
- Buy the new government bond at 12.5% buy paying $100 par value – interest yield 12.5%
- Buy the existing 10% bond for $80 price – interest yield 12.5%
What we forgot, is that when the bond is redeemed at the end of 10 years, the government will pay $100 back. In case 1 above, there is no capital gain as the initial investment is also $100. In case 2, there is a capital gain of $20. This means we need a more comprehensive calculation that not only includes the interest yield but also the capital gain or loss at redemption. This is the Gross Redemption Yield or Yield to Maturity. The formula to calculate this is quite complication so we won’t go into that here. We are taking the future stream of revenue – interest and redemption – and calculating the yield that would equate this value to the bond’s current price. Alternatively, we could start with a desired yield and calculate the price of the bond that would achieve that yield. This is how bond dealers calculate the price of bonds which is why yield is so important.
We said the lower the amount of risk associated with a borrower, the lower her rate of interest will be. This is said to reflect the creditworthiness of the borrower, meaning she is unlikely to default. Some markets (for instance, the US) want the creditworthiness of the borrower to be officially assigned a credit rating that will help guide investors in their decisions. There are several companies in the ratings business with the most important being – Standard & Poor’s and Moody’s. The S&P Ratings go from AAA to D. A bond rated ‘D’ is either already in default of is expected to default soon. Bonds above BBB rating are of top quality – investment grade. Bond below BB rating are called junk bonds.
Stay tuned for more…