Fears of a sustained rise in global interest rates, apparently triggered by the surprise decision by the Reserve Bank of New Zealand to raise the official cash rate to 8%, caused bond yields to surge in the week ending 9th June 2007, which in turn became a dramatic sell-off in the US sharemarket as investors sold out of equities into bonds.
Bonds are tradable Interest rate securities and represent nothing more than a stream of regular income payments and then the principal payment at bond maturity. They are issued by companies and in the case of treasury bonds; governments, looking to raise capital without diluting ownership (as in the case of issuing shares). we have previously covered the relationship between bonds and infrastructure. Bonds carry less risk than shares for the holder and as such they normally offer lower returns. They comprise about 5% of the Australian investment assets compared to around 30% in the US where they are more widely used. They are increasing in usage in Australia as prior the ASX opening an exchange in 1999 they were traded by institutions Over the counter (OTC), they can now be traded by brokers over the SEATS system.
There are some concepts that you need to become familiar with to understand bonds / interest rate securities. The life of the security is known as the 'term to maturity' amount of interest paid is called the 'Coupon', coupons can be 'fixed' for the life of the security or 'floating' above a benchmark rate. 'Yield to maturity' is the return you can expect if you buy a bond now and hold until maturity, it is a calculation of the current price, all future coupon payments and the face value.
For example, a $100,000 30-year bond having a 7% coupon would pay the holder interest income of $7,000 every year and then $100,000 at maturity in 30 years.
Bonds are quoted in terms of $100 of 'face value' therefore the coupon is fixed to the face value, not the market (traded) price of the security. The market price of the security is expressed as percentage of its face value, i.e. $105 is 105, $95 is 95.
Market prices change as buyers demand a different rate of return. If investors desire a higher rate of return, then the price of the bond will trade at a price below par (100), for example, at 97. This raises the implied rate of return (yield to maturity), to a value of say, 7.2%. The bond's price fall (and the yield to maturity will rise) until investors find the price attractive. Conversely, if the bond's coupon seems attractive, then investor demand will raise price of the bond above par; for example, to 103. This will lower the yield to maturity (to around 6.7%) and will, in theory, therefore reduce the demand for the bond.
They are attractive to investors for several reasons, such as;
- hedging risk on a share portfolio; Economic shocks, such as the 9/11 attack have a huge adverse impact on stockmarkets, however bonds are relatively unaffected as the yields and return are fixed.
- hedging interest rate exposure on existing debt and profiting on interest rate movement; Bond prices and interest rates move in opposite directions, this is due to the rate of return that investors demand changing in response to new information on the economy. Falling bond prices mean that interest rates corresponding to that bond are rising while rising bond prices mean that interest rates are falling.