“Bond markets and rates are the grease of the financial plumbing system and for that reason central banks are very sensitive to how the liquidity is working “ Greg Foss
There are a few important concepts here that we have to go through in order to fully grasp the wide-scope nature of the "‘financial plumbing system’, as Mr Foss likes to put it. Before I introduce you to these complexities, I’ll begin by deconstructing the instruments (anatomy), which will lead into their functioning role in the system (physiology), and lastly, connecting the two together to understand the systemic mechanism at its entirety.
I feel like it is necessary to understand each modality here to get a full comprehensive understanding of market behavior and the powerful signals this individual market can convey. Understanding these truths will provide a great deal of opportunity like: risk management, timing risk-adjusted capital allocation, and understand the systemic money channels.
My goal in this paper will be to here is to introduce the technical aspects of fixed income instruments, which should provide you with the understanding of their functional purpose.
Anatomy of Fixed Income Instruments
As the name implies, a ‘fixed’ income instrument is a contractual agreement that provides a fixed stream of payments (yield) from the borrower to the lender. Through this contractual agreement, a bond issuer is able to raise capital for self-serving purposes. However, the bond issuer carries the obligation of paying the bond holder semi-annual interest payments (coupon), as well as the principal (face value) at the end of the contract (maturity).
Maturity is the time of your contract. Face value, is a bonds initial worth at the time of purchase. Coupon is the fixed payments when the bond is first issued.
Lets use a few examples to solidify this concept.
In order to raise capital, company XYZ decides to issue 1000 bonds for $1,000, in hopes to raise $1,000,000. Unlike buying a stock, a bond issuer is obligated to pay back the borrowed funds, (principal and interest) - atyou can also think about it as a type of debt instrument.
The value of a bond, is held loosely by the fate of exogenous factors. Including the issuers conditions (credit risk), interest rates and other economic factors like inflation or the time value of fiat.
In principle, as a lender you are taking the brunt of the risk. Despite holding an instrument that carries yield, your capital is tied to the fate of the conditions mentioned above.
So why wet your feet in the fixed income market?
It is a condition for banks to own certain securities, for the purpose of portfolio rebalancing
They have a fairly liquid secondary market. This means there are actively traded after issuance
Banks considerer them great collateral
They offer a fixed steady stream of payments
Hedge against interest rate risk
It is important to note that not all fixed income instruments are accessible to the public.
If you buy a treasury security, it is the government’s liability - this is the closest risk free security you can have as a form of money. For the most part we can assume the U.S government won’t become insolvent by tomorrow, so lending our money there shouldn’t be a problem. In addition, we can determine the credit rating of individual bonds that are appraised by an independent credit service.
In principal a bond that is considered investment grade should provide better yield, but that is not always the case.
Bond pheromones - Attraction forces acting on the buyer/seller
A newly issued bond has a set contractual term (maturity) and fixed payment stream (coupon). However, after you acquire the issue, a bond is liquid and free to be exchanged on this secondary market.
Comparable to other assets, the relative attractiveness, or risk-adjusted returns are predetermined by exogenous market conditions, as well as the laws of supply and demand. Hence, market participants are constantly anticipating the potential for risk and valuation changes, and this is exactly what drives these large market moves.
Unlike stocks, securities have a fixed stream as well as a principal return value. This makes their composition differ slightly, especially since market players are always anticipating market moves trying to maximize their returns.
One of the key determinants of a bond’s coupon rate (the interest you receive) is the federal funds rate, which is the prevailing interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. 2
Let’s say you bought a bond a year ago with a coupon of 5%. Since that time, there were major changes in economic conditions: rising rates to combat heightened inflation. Today, that same company offers new bonds with higher coupons to match the prevailing interest rates, let’s say 6%. The bond you bought a year back is now less attractive to investors.
This means that the bond holder will have sell their bond at a discount to attract buyers. Since, the current yield is calculated as the bond's annual income, divided by the current price, it is therefore the YTM that drives buyers appeal.
This is how we get these interesting signals in the market.
When the bonds market moves we listen
Since bonds are influenced by the effects of the environmental conditions, they are very diligent in anticipating policy moves, forward looking market conditions and more.
Firstly, we need to understand the why.
Duration and convexity measure the sensitivity of a bonds price to interest rate changes. Generally, duration assumes a linear relationship between the bonds price and interest rate moves. Convexity on the other hand represents the approximate point of error between duration and the price moves - a better heuristic to assume price changes.
However for the example below we will measure the impact of duration - to get an idea of the impact rates can have.
Generally, the higher the duration of a bond or a bond fund, the more its price will drop as interest rates rise. This is important because these inherent changes will affect the behavioral choices these individuals make. As demonstrated below, a 6% drop when the interest rose 100 bps can be devastated for the holders.
I think I’ll leave you on that note today, its pretty dense and will likely take a few reads to fully grasp. If you have any questions please feel free to comment.
NeuroInvest signing off…