World bond markets have typically been less glamorous than their equity counterparts trading on the New York Stock Exchange, the Nasdaq or other stock markets, but this lack of cachet does little to dent a daily trade in debt instruments of hundreds of billions of dollars. Each day, governments, companies and other entities sell scores of bonds – i.e., borrow money for a fixed period of time – on world markets and these debt instruments are traded across continents and time zones. For investors, bonds offer the advantages of fixed, regular interest payments and the repayment of the amount borrowed at the end of a fixed term.
Bonds come in a range of sizes and flavors and their characteristics are generally tailored to meet the demands of investors and the conditions of the market at the time of the bond’s sale. Regardless of these ever-changing factors, bonds generally have a number of common attributes, such as yield, coupon and price.
When a company, entity or country sells a bond, it has to decide the term (or maturity) of the bond, or the length of time the bond will be outstanding before the debtor has to pay back the original amount it borrowed. This time frame can range from a few months or years to decades. When the bond finally expires and the borrower, also known as the issuer or debtor, has to pay back the principal, known as the par value or the face value, the bond is said to mature. Investors often refer to a bond’s maturity date as the date when it expires and the funds are due back to those who bought the bond (i.e.,lenders or creditors).
As is customary when borrowing money, the company, entity or country issuing the bond has to pay interest. The contractual interest rate on the bond when it is originally sold is known as its coupon, which is typically expressed in a percentage, like 4% or 8.25%. A new bond also has a price, or the value at which the bond is sold. For a new bond, the issue price is generally close to the bond’s face value and can be expressed as percentage of face value (such as 99.125).
Investors also talk about a bond’s yield to maturity, which is the total rate of return on holding the bond for the rest of its life. Obviously, at any moment in a bond’s life, the total rate of return (i.e., its yield to maturity) comprises two components: i) the stream of interest (i.e., coupon) payments expected to be made over the remainder of the bond’s life; and ii) the change in the price of the bond from its current level to the level at which it will eventually mature (i.e., par).
Which raises the following question: can the price of a bond differ from par? Of course it can. Once investors buy a bond at the initial offering, they can turn around and sell the bond in the secondary market, where the bond’s value will change to reflect investors’ views on the borrower’s ability to pay them back, on interest rates expectations, on the likelihood of inflation, on the broader economic picture and so on. A bond’s price and yield move in opposite directions – if the price moves up, the yield goes down, and vice versa.
Here’s a simplified example of how this works. Say company X sells a 5-year bond at a par value of $1,000 at an interest rate of 5%. If you buy the bond when it is issued and hold onto it for the life of the bond, you will get $1,000 back after five years as well as the $50 a year the bond earned over the course of the bond’s life, or a total of $1,250.
But what happens if the interest rate applicable to X goes up and you want to sell the bond? Investors will not pay you $1,000 for a bond with a 5% coupon when they can buy new bonds that pay higher interest rates. To entice them, you will have to sell them the bond at a discount, or below the $1,000 face value. (Obviously, the opposite scenario is when the bond sells above face value, or at apremium). Let’s say you sell the bond at $700 three years before it falls due. The buyer will get three years of interest payments of 5%, or $150, plus the original $1,000 back. But the rate of return is now calculated as 5% on a value of $700, which means the yield is 7.1% (interest/price). Since the bond is perceived to be less valuable than it was before, it will carry a higher rate of return to compensate the borrowers holding the bond – so the price goes down and the yield goes up.
As mentioned above, most bonds have regular, fixed interest payments, but there are a couple of other basic kinds of bonds to mention. Investors buying a zero-coupon bond do not receive interest payments during the bond’s term. They do, though, receive principal at the bond’s maturity. To be compensated for the no-coupon feature, a zero-coupon bond always trades at a discount. Floating-rate bonds, meanwhile, have coupons that fluctuate during the bond’s lifetime.
The world’s largest securities market is the U.S. Treasury market, home to debt issued by the U.S. government via its Treasury. This vast market sees daily volumes of more than $500 billion, according to the Securities Industry and Financial Markets Association, an investment industry group, and it serves as the benchmark for other bond markets. Treasuries are widely recognized as a safe-haven investment, or a place to invest when other assets and markets look turbulent and risky. Treasuries do not boast spectacular returns, but they are a slow-and-steady option for investing because the probability is almost zero that the government of the world’s biggest economy will default, or fail to pay its debts.
Treasuries are sold in a range of maturities. Treasury bills typically refer to U.S. government debt of a year or less, while Treasury notes have a life of between two to10 years. Treasury bonds are generally more than 10 years, although the government has typically only sold one bond – the 30-year, or long bond – in this category. Treasuries are sold in auctions to primary dealers, a group of banks and securities firms that have an agreement to buy and sell Treasuries directly with the Federal Reserve Bank of New York.
As noted on the bank’s website, the primary dealer system allows the U.S. Federal Reserve System, through the New York Fed, to implement monetary policy. In particular, the Fed engages in “open market operations” in which it (the Fed) buys US Treasury securities (in exchange for “money”) when it decides to engage in expansionary monetary policy and sells US Treasury securities when it wants to contract monetary policy.
Even for people who do not buy or sell Treasuries, monitoring the performance of U.S. government debt is crucial because it serves as the foundation for most bonds. Debt issued by companies, countries and entities typically trades at a spread over U.S. Treasuries, or the premium investors demand over (the effectively risk-free) U.S. government debt to compensate for carrying greater risk. Say for example country Z has a bond trading in the market. This bond’s yield is talked about as a value beyond the current yield of U.S. Treasuries. So if Treasuries are yielding around 3% and country Z’s bond is trading at 11.4%, the spread is 8.4%, which is also referred to as 840 basis points (1 percentage point=100 basis points).
Now let’s say country Z is having a financial crisis and investors are worried the government will not be able to pay back its debt, or it will default. This will undoubtedly drive up the yield on the bond of country Z, which in turn will widen its spreads. For example, if the bond of Z suddenly shoots up to 15% and Treasuries remain the same, the spread is suddenly 12%, or 1,200 basis points. Spread widening, therefore, signifies that a country’s borrowing costs have gone up, while a tightening in spreads means the country’s cost of borrowing is falling.
It is also important to understand that sometimes yields move while spreads remain unchanged. Let’s say investors are worried about a stagnant world economy. They might move their money en masse into safe-haven U.S. Treasuries, since they offer a sure return on their investment. But this increased demand is likely to lift Treasury prices, thus lowering US yields. So where the yields were 3% before, they may now drop to 2%. Country Z, meanwhile, has enjoyed a stable economic environment, so investors see the country no riskier or no safer than before, when spreads were 8.4% (or 840 basis points). In other words, there is no reason to expect spreads to change as a result of the change in US interest rates. However, because Treasury rates have come down, the yield on Z’s bond will also come down in order for the spread to remain the same – so now instead of a yield of 11.4%, the bond of Z will have a yield of 10.4%, all thanks to the move in Treasuries.
Other Debt Markets
There are scores of different kinds of bonds trading in the world, ranging from corporate bonds to emerging sovereign bonds to municipal bonds. Each of these kinds of bonds has their own market in a particular place: if the issuer is selling the debt in U.S. dollars, the bond may trade in one of the U.S. debt markets, while an issue made in euros would sell in European debt markets. Companies, countries and entities outside these markets may also sell debt in their local currency, meaning the bonds would trade on one of their country’s domestic markets.
Different investors have different tolerance levels for financial risk, which means some are willing only to buy safe assets like Treasuries, while others would gamble with higher-yielding assets. This is known as risk appetite.
The various bond markets each have their own peculiarities, which reporters will pick up as they talk to traders and analysts involved in that market. But here is a general rundown.
Corporate bonds – debt sold by companies; for companies, bonds serve as an alternative to bank loans for raising capital
Emerging sovereign bonds – debt sold by the government of a developing country. Emerging market bonds are viewed as riskier than developed country bonds and tend to carry high yields
Municipal bonds, or “munis” – debt issued by U.S. states, cities or counties; they are distinguished from other bonds in that they are generally exempt from paying taxes
Agency bonds – debt issued by quasi-government agencies of the United States, such as the Federal Home Loan Mortgage Corporation, known as Freddie Mac, and the Federal National Mortgage Association, or Fannie Mae; these investments were once thought to be nearly as safe as Treasuries since it was seen as unlikely that the U.S. government would let these giant agencies default on their debt if hit by financial trouble. The financial crisis of 2008 and beyond threatened to do precisely that, but the US government stepped in to rescue Freddie Mac and Fannie Mae, a move widely perceived as critical to preventing the financial system’s collapse.
Mortgage-backed securities – bonds created when a pool of mortgages is bundled together. Investors buy a share of this pool. These bonds, together with similarly bundled corporate bonds, are also known as collateralized debt obligations, or CDOs. These instruments were at the heart of the financial crisis and ushered in a broader global meltdown.
Bond Market Movements
When tracking bonds, official interest rates are one of the most critical factors to watch regardless of the kind of debt or its place of issue.
The decisions of the U.S. Federal Reserve – the U.S. central bank, commonly known as the Fed – have a far-reaching impact on bond markets around the world. The Fed holds a series of regular meetings to determine monetary policy and the fate of the U.S. federal funds rate, or the benchmark interest rate. The central bank can lower this rate in an attempt to stimulate the economy, as it did dramatically during 2008 to try to mitigate the effects of the credit crunch, or it can raise the rates if the economy is seen expanding too quickly. A fast-growing economy can lead to overheating and price increases, also known as inflation.
If investors expect the Fed to lower interest rates in the short- or even medium-term, bond prices will often rally because it means the bonds will become relatively more valuable since the prevailing interest rate will be lower than it was but the bond’s interest will be the same. If the market sees a likely interest rate increase on the horizon, bond prices will probably drop because bondholders will expect the returns on their current bonds to be less attractive.
The Federal Reserve is the most widely watched central bank in the world, thanks in part to the decisive role of their interest rate decisions on the Treasury market. But the European Central Bank, the Bank of England and the Bank of Japan are also important players in the interest rate context. Likewise, a particular country’s own changes in interest rates or monetary policy can also play a role in that nation’s bond movements or even the movements of bonds in nearby countries.
Inflation, closely linked to interest rates and monetary policy, is also an important consideration. When prices increase, investors’ money does not go as far as it did before, so inflation erodes the value of their investment. For this reason, inflation is the enemy for bondholders, and if a jump in inflation is expected, interest rates will have to rise to compensate for this (real interest rates are equal to nominal rates minus the rate of inflation). In a low-inflation environment, therefore, bonds are seen as good investments because inflation will not erode the value of the bond. In a high inflation scenario, meanwhile, investors’ expectations of continuing price increases will mean they are unwilling to buy bonds unless the rate of return is greater than the expected inflation. Note that the United States and Europe have relatively low, single-digit inflation, so a jump can be a small number, but in some developing countries, frequent financial problems can lead to big swings in a nation’s currency, which can trigger a large move in inflation.
Economic performance, at the global, regional or national level, is another factor that can influence bond performance. If an economy is growing quickly, investors often opt for higher-yielding but riskier assets like stocks, which means demand for safe-haven bonds will likely decline. In addition, a robust economy can raise the possibility of inflation, which in turn raises the prospect of central bank interest rate increases. If an economy is wobbly, investors tend to opt for the relative safety of bonds as they bet the central bank will lower interest rates in an effort to jumpstart the economy.
Fiscal performance can also have an impact on the bonds of a company, entity or country. If the borrower is seen to be in sound fiscal shape with relatively low levels of debt, investors will be confident that the debts will be paid back, so they will not demand high interest rates to buy or hold the borrowers’ bonds. But if the borrower has a heavy debt burden or is sliding into a financial hole because its spending exceeds its income and it is running deficits, investors will demand higher interest rates as compensation for the risk of holding the borrower’s debt.
Credit agencies and their debt ratings are also crucial to bond values. They are explained in more detail in the section below.
Companies, countries and even bonds themselves are usually assigned a rating by the world’s major credit agencies. This rating, normally a letter or group of letters (or even numbers) such as AAA or BBB, measures the credit quality of the company, country or entity that has issued or will issue debt. In simplest terms, the higher the credit rating, the better the entity’s ability to repay its debts.
There are two main classes of credit ratings: investment grade or speculative grade, also known as “junk.” When a ratings agency assigns a country or company an investment grade rating, it means it sees the entity in sound fiscal shape with a high probability of repaying the bonds. Debt issuers with a speculative rating, meanwhile, are seen as less financially sound – in other words, a riskier investment for the buyer of that entity’s bonds. This scale of ratings has a major role in determining the entity’s borrowing costs: in general, the lower the rating, the more the country or company can expect to pay to borrow money since it must compensate investors for the perceived risk.
In addition to governing borrowing costs, the distinction between investment and speculative grades is important because some pension funds, mutual funds and other investors can only hold assets with an investment grade rating. As a result, when a country or company moves up the ladder from speculative into the coveted investment grade ranks, it can gain access to a whole new class of investors and ensure greater demand for its bonds, thus lowering its costs of borrowing.
Because of ratings’ impact on borrowing costs and access to investment, any changes in an entity’s rating can be market-moving news. When one of the major ratings agencies – Standard & Poor’s, Moody’s Investors Service or Fitch Ratings – raises a rating, it can have a positive effect on the bonds of that issuer, while a drop in a rating has the opposite effect. It is therefore important to know the ratings agencies’ jargon when covering bond markets. An upgrade is the increase of a rating, while a downgrade is a drop in a rating. The agencies can also assign outlooks – positive, stable or negative – and this provides a clue to the future direction of the rating. A positive outlook signals the agency could raise the entity’s rating in the medium-term, although there are no guarantees this will happen, while a negative outlook means the country or company could see a downgrade. There are also a number of different kinds of ratings, including long- and short-term ratings (with long-term typically being more important) and local- and foreign-currency ratings, so it is critical that reporters read stories on ratings changes carefully to make sure they know which rating is being discussed.
Here’s an example of how ratings work. Say for example, Moody’s says it raises the rating of company X to Baa3 from Ba2. By looking at the lists below, reporters know that company X has just been raised two levels, or notches, to an investment grade category. This is big news for company X and can boost debt prices since it means the company will have lower borrowing costs, even though the statement from Moody’s may not mention all of this.
Standard & Poor’s
- investment grade ratings, in descending order of quality: AAA, AA-plus, AA, AA-minus, A-plus, A, A-minus, BBB-plus, BBB, BBB-minus
- speculative ratings, in descending order: BB-plus, BB, BB-minus, B-plus, B, B-minus, CCC-plus, CCC, CCC-minus, CC, C and D (or default)
Moody’s Investors Service
- investment grade ratings, in descending order of quality: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3
- speculative ratings, in descending order: Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C
- investment grade ratings, in descending order of quality: AAA, AA-plus, AA, AA-minus, A-plus, A, A-minus, BBB-plus, BBB, BBB-minus
- speculative ratings, in descending order: BB-plus, BB, BB-minus, B-plus, B, B-minus, CCC-plus, CCC, CCC-minus, CC, C, DDD, DD, D (D again generally refers to default)
The ratings agencies came under severe criticism as the financial system unravelled during 2007 and 2008 and it became apparent that they had given AAA investment ratings to CDOs containing so-called “sub-prime” mortgages. These investments soon became known as “toxic assets,” in part because investors found it difficult to determine the value of debt instruments combining loans to home owners with both good and bad credit.
Covering a Bond Market
When writing about a bond market, the first step is to identify the most important issuers in the market or markets you are covering. In the U.S. corporate market, this may be a list of giant companies that routinely issue debt; in the emerging sovereign market, it is likely to be a few sizable economies that have a number of foreign-currency bonds trading in international markets.
Once you have determined some of the basics of the market, the next step is to find some key market players. One of the best approaches is to identify a pool of traders at brokerages and investment banks who specifically handle the kind of debt you are writing about since they are the most familiar with the minute-to-minute movements of the bond market. Traders can be found by calling a brokerage or investment bank and asking for the trading floor or trading desk, where you can then ask to be transferred to the specific type of trader you are seeking.
It is important to note that many traders cannot speak on the record, so it can be a good idea to reassure them that you are seeking comments that will not be attributed to them (they are generally quoted as “a bond trader”). Traders can also be extremely busy, depending on the trading session and the orders they have from clients, so if they hang up on you or brush you off, don’t take it personally. It’s just the nature of their job.
Besides traders, it is also crucial to find a solid base of strategists, analysts and economists who are in touch with the bond market you are covering. Where traders can give you the instant movement of a bond, the rumors that might be driving it and a general flavor for the trading session, analysts and economists are critical for putting bond movements in context. They can tell you, for example, whether the company is in good or bad shape financially or if new economic data from a country fell within expectations or was a positive or negative surprise to the markets.
One note on rumors: Be very cautious when repeating rumors from one trader to the next and when including them in your stories. Sometimes traders and investors “talk their book,” which means they try and influence the market in favor of their own investments. If they own a lot of a particular bond, for example, they may be more apt to repeat rumors that help the bond’s value. For this reason, it is often good to talk to several players in the market to get a sense if a rumor has really taken hold or if someone is using you as a way to spread it further.
Before talking to any of these sources, it is also good to get a feel for the day’s financial headlines from web sites like the Financial Times (www.ft.com), the Wall Street Journal (www.wsj.com) or Reuters (www.reuters.com) or from television channels like CNBC or Bloomberg. That way you will not be surprised if your sources tell you a company’s bonds have plummeted because the firm filed for bankruptcy or that a country’s sovereign debt rallied because it secured a loan deal with the International Monetary Fund.
Once you have determined the day’s basic theme – and there may not always be one, it can sometimes be a combination of factors or just a push by investors to lock in a bond’s recent gains – you can start writing. As with any financial story, it is important to approach a market report as if you were explaining it to someone who is totally unfamiliar with the bonds or market. Avoid the technical jargon used by traders and give enough background and context so that even your grandmother might understand. The people reading these reports are often analysts or investors from the equities side or the currency markets who don’t necessarily know the intricacies of your particular market.
For coverage of new bond issues, meanwhile, it is vital to establish good contacts on the syndicate desks of the investment banks managing the deal. If an investment bank is managing a particular bond deal – also referred to as co-leading the deal – bankers on that bank’s syndicate desk can give you first-hand details on the new bond’s price, yield, coupon and spread, and possibly the kinds of investors who bought the bond and the geographical breakdown. If one of the deal’s lead managers does not want to give out this information, the issue’s details can be gotten from other syndicate desks who have likely heard the results in the market, but in this case it is best to talk to a couple of different desks to make sure the details are consistent. And again, in many instances these sources cannot talk on the record, so it is always good to ask how they want to be quoted – often it is nothing more than “market sources.”