{"id":886861,"date":"2013-05-06T14:01:09","date_gmt":"2013-05-06T08:31:09","guid":{"rendered":"http:\/\/stockviz.biz\/index.php\/?p=886861"},"modified":"2013-05-06T14:01:09","modified_gmt":"2013-05-06T08:31:09","slug":"the-money-and-bond-markets","status":"publish","type":"post","link":"https:\/\/stockviz.biz\/index.php\/2013\/05\/06\/the-money-and-bond-markets\/","title":{"rendered":"The Money and Bond Markets"},"content":{"rendered":"

Over the next couple of weeks, we\u2019ll explore the money markets and bond markets. There\u2019s a lot to cover in this topic! Let\u2019s start with some terms and concepts used in the fixed income space. Reference for this post is \u2018An Introduction to Global Financial Markets\u2019 by Stephen Valdez.<\/p>\n

The Rate of Interest<\/h3>\n

So far, we\u2019ve talked casually of the rate of interest for borrowing and lending. Of course, there\u2019s more to it that that\u2026for 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.<\/p>\n

Risk<\/h3>\n

\"The<\/a><\/p>\n

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 \u2018Treasuries plus 1%\u2019 <\/i>meaning 1% more than the current rate for US government Treasury bills. You might also here this referred to as \u2018Treasuries plus 90 bps\u2019<\/i>. What does bps mean? Bps stands for basis points<\/i> and a basis point <\/i>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 <\/i>or \u2018the spread over Treasuries\u2019<\/i>.<\/p>\n

Maturity<\/h3>\n

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<\/i>.<\/p>\n

Yield<\/h3>\n

Yield <\/i>is a very important term in finance. Yield<\/i> is the return on investment expressed as an annual percentage. We\u2019ll get back to what yield is after tackling some related concepts.<\/p>\n

Par\/Nominal Value<\/h3>\n

Bonds have a par<\/i> or nominal value<\/i>. This is the principal<\/i> amount on which the rate of interest is based and which will be repaid at maturity. Let\u2019s 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\u2019t consider the secondary market in this picture.<\/p>\n

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 <\/i>of your bond went down.<\/p>\n

Say you didn\u2019t 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 <\/i>of your bond went up.<\/p>\n

Interest Yield<\/h3>\n

In the above examples, we have calculated what is known as Interest Yield. <\/i>Quite simply, it is the interest amount (coupon)\/price of the bond. Interest yield<\/i> is also known as simple<\/i>, flat<\/i>, running<\/i> and annual<\/i> yield. This is a good metric but not very useful.<\/p>\n

Gross Redemption Yield<\/h3>\n

Unfortunately, in our above examples and calculations, we omitted one crucial factor \u2013 redemption.<\/i> In the first example above, when the current market interest rate is 12.5%, an investor can do one of these two things \u2013<\/p>\n