The Fixed Income Markets

The Fixed Income Markets

What is the Bond Market?

To begin our discussion of the fixed income markets, we’ll identify the

main types of securities that comprise it. We’ll discuss some of these more

in-depth throughout the chapter.

• U.S. Government Treasury securities

• Agency bonds

• High grade corporate bonds

• High yield (junk) bonds

• Municipal bonds

• Mortgage-backed bonds

• Asset-backed securities

• Emerging market bonds

Bond Market Indicators:

The yield curve

Bond “yields” are the current rate of return to an investor who buys the

bond. (Yield is measured in “basis points”; each basis point = 1/100 of one percent.) A primary measure of importance to fixed income investors is the

yield curve. The yield curve (also called the “term structure of interest

rates”) depicts graphically the yields on different maturity U.S. government

securities. To construct a simple yield curve, investors typically look at the

yield on a 90-day U.S. T-bill and then the yield on the 30-year U.S.

government bond (called the Long Bond). Typically, the yields of shorterterm government T-bill are lower than Long Bond’s yield, indicating what is called an “upward sloping yield curve.” Sometimes, short-term interest rates are higher than long-term rates, creating what is known as an “inverse yield curve.”

Bond indices

As with the stock market, the bond market has some widely watched

indexes of its own. One prominent example is the Lehman Government

Corporate Bond Index (“LGC”). The LGC index measures the returns on

mostly government securities, but also blends in a portion of corporate

bonds. The index is adjusted periodically to reflect the percentage of assets

in government and in corporate bonds in the market. Mortgage bonds are

excluded entirely from the LGC index.

U.S. government bonds

Particularly important in the universe of fixed income products are U.S.

government bonds. These bonds are the most reliable in the world, as the

U.S. government is unlikely to default on its loans (and if it ever did, the

world financial market would essentially be in shambles). Because they are

virtually risk-free, U.S. government bonds, also called Treasuries, offer

relatively low yields (a low rate of interest), and are the standards by which

other bond yields are measured.

Spreads

In the bond world, investors track “spreads” as carefully as any single index of bond prices or any single bond. The spread is essentially the difference between a bond’s yield (the amount of interest, measured in percent, paid to bondholders), and the yield on a U.S. Treasury bond of the same time to maturity. For instance, an investor investigating the 20-year Acme Corp. bond would compare it to a U.S. Treasury bond that has 20 years remaining until maturity. Because U.S. Treasury bonds are considered to have zero risk of default, a corporation’s bond will always trade at a yield that is over the yield on a comparable Treasury bond. For example, if the Acme Corp. 10-year bond traded at a yield of 8.4 percent and a 10-year Treasury note was trading at 8 percent, a trader would say that the Acme bond was trading at “40 over” (here, the “40” refers to 40 basis points).

Bond ratings for corporate and municipal bonds

A bond’s risk level, or the risk that the bond issuer will default on payments

to bondholders, is measured by bond rating agencies. Several companies

rate credit, but Standard & Poor’s and Moody’s are the two largest. The

riskier a bond, the larger the spread: low-risk bonds trade at a small spread

to Treasuries, while below-investment grade bonds trade at tremendous

spreads to Treasuries. Investors refer to company specific risk as credit

risk.

Triple A ratings represents the highest possible corporate bond designation,

and are reserved for the best-managed, largest blue-chip companies. Triple

A bonds trade at a yield close to the yield on a risk-free government

Treasury. Junk bonds, or bonds with a rating of BB or below on the S&P

scale, currently trade at yields ranging from 10 to 15 percent, depending on

the precise rating and government bond interest rates at the time.

Companies continue to be monitored by the rating agencies as long as their

bonds trade in the markets. If a company is put on “credit watch,” it is

possible that the rating agencies are considering raising or lowering the

rating on the company. Often an agency will put a company’s bonds on

credit watch “with postive or negative implications,” giving investors a

preview of which way any future change will go. When a bond is actually

downgraded by Moody’s or S&P, the bond’s price drops dramatically (and

therefore its yield increases).

Factors affecting the bond market

What factors affect the bond market? In short, interest rates. The general

level of interest rates, as measured by many different barometers (see inset)

moves bond prices up and down, in dramatic inverse fashion. In other

words, if interest rates rise, the bond markets suffer.

Think of it this way. Say you own a bond that is paying you a fixed rate of

8 percent today, and that this rate represents a 1.5 percent spread over

Treasuries. An increase in rates of 1 percent means that this same bond

purchased now (as opposed to when you purchased the bond) will now

yield 9 percent. And as the yield goes up, the price declines. So, your bond

loses value and you are only earning 8 percent when the rest of the market

is earning 9 percent.

You could have waited, purchased the bond after the rate increase, and

earned a greater yield. The opposite occurs when rates go down. If you

lock in a fixed rate of 8 percent and rates plunge by 1 percent, you now earn

more than those who purchase the bond after the rate decrease. Therefore,

as interest rates change the price or value of bonds will rise or fall so that

all comparaqble bonds will trade at the same yield regardless of when or at

what interest rate these bonds were issued.

Which Interest Rate Are You Talking

About?

Investment banking professionals often discuss interest rates in general terms. But what are they really talking about? So many rates are tossed about that they may be difficult to track. To clarify, we will take a brief look at the key rates worth tracking. We have ranked them in typically ascending order: the discount rate usually is the lowest rate; the yield on junk bonds is usually the highest.

The discount rate: The discount rate is the rate that the Federal Reserve charges on overnight loans to banks. Today, the discount rate can be directly changed by the Fed, but maintains a largely symbolic role.

Federal funds rate: The rate domestic banks charge one another on

overnight loans to meet Federal Reserve requirements. This rate is also directly controlled by the Fed and is a critical interest rate to financial markets.

T-Bill yields: The yield or internal rate of return an investor would receive at any given moment on a 90- to 360-day Treasury bill.

LIBOR (London Interbank Offered Rate): The rate banks in England charge one another on overnight loans or loans up to five years. Often used by banks to quote floating rate loan interest rates. Typically, the benchmark LIBOR used on loans is the three-month rate.

The Long Bond (30-Year Treasury) yield: The yield or internal rate of return an investor would receive at any given moment on the 30-year U.S. Treasury bond.

Municipal bond yields: The yield or internal rate of return an investor would receive at any given moment by investing in municipal bonds. We should note that the interest on municipal bonds typically is free from federal government taxes and therefore has a lower yield than other bonds of similar risk. These yields, however, can vary

substantially depending on their rating, so could be higher or lower than presented here.

High grade corporate bond yield: The yield or internal rate of return an investor would receive by purchasing a corporate bond with a rating above BB.

Prime rate: The average rate that U.S. banks charge to companies for loans.

30-year mortgage rates: The average interest rate on 30-year home

mortgages. Mortgage rates typically move in line with the yield on the

10-year Treasury note

High yield bonds: The yield or internal rate of return an investor would receive by purchasing a corporate bond with a rating below BBB (also called junk bonds).

Why do interest rates move?

Interest rates react mostly to inflation expectations (expectations of a rise

in prices). If it is believed that inflation will rise, then interest rates rise.

Think of it this way. Say inflation is 5 percent a year. In order to make

money on a loan, a bank would have to at least charge more than 5 percent

– otherwise it would essentially be losing money on the loan. The same is

true with bonds and other fixed income products.

In the late 1970s, interest rates topped 20 percent, as inflation began to

spiral out of control (and the market expected continued high inflation).

Today, many believe that the Federal Reserve has successfully slayed

inflation and has all but eliminated market concerns of future inflation, at

least in the near term. This is certainly debatable, but clearly, the sound

monetary policies and remarkable price stability in the U.S. have made it the

envy of the world.