Bonds are debt instruments that allow governments to finance their fiscal deficits. In addition, their markets are strategic for global investors. Given that they are issued by governments, each country’s macroeconomic and political variables affect the interest in these securities. That is why, in this column, I will analyze their main elements and how they interact.
The starting point is the understanding that a bond is simply a loan, except that, instead of borrowing from a bank, the issuer borrows from market investors. By doing this, the issuer agrees to pay a periodic interest called a coupon and to repay the principal (the loaned amount) on the maturity date. Therefore, a bond’s value is no more than the sum of all the flows that compose it. However, given that they take place at different moments, they must be calculated at present value with a discount rate known as yield.
One element we must understand about yield behavior is that it is affected by the interaction of the forces of supply and demand, given that holding a bond does not necessarily mean that the holder will keep it until maturity. This exchange, known as the secondary market, is where investors buy and sell bonds that have already been issued.
Chart: Own elaboration. Data by Bloomberg
The graph illustrates these forces in a practical case. It shows the behavior of the yield rate of U.S. treasury bonds for the last five years. The rate has increased from 1.54% to 4.01%, but this trend has been accelerating in a pronounced way since August 2022. How is this relevant? First, because the yield rate has an inverse relationship with the price, so we are actually seeing a drop in the price and hence a massive sell-off. Additionally, because this increase will affect how much it will cost the U.S. government to finance its fiscal deficit. And finally, because this behavior concurs with a rise in both inflation expectations and the Federal Reserve rate, explained below.
The elements of a bond
The following four are some of the main elements of a bond:
- Yield to maturity or discount rate: Its behavior is inverse to the price and should reflect the values that affect the value of money over time, mainly inflation expectations and risk.
- Dirty price: Measured on a 100 basis, it reflects whether the bond has lost or gained value compared to the time of its issuance.
- Macaulay duration: This is a weighted average of the various coupon payment dates, weighted by the present value of each coupon. It is read in years and allows the definition of the bond’s term.
- Modified Duration: Measures the sensitivity of this type of financial asset to interest rate variations.
Which are the forces that interact with the markets?
Once the components of bonds have been considered, we need to understand how their relevant market is affected by different factors, both local and foreign, among which we can mention the following:
- Central Bank rates: These mainly affect short-term bonds, as they give a signal on the possible coupon rates of new issuances. That is to say, an increase in the central bank rate leads investors to sell short-term securities in expectation of higher coupon rates in the following bond issues.
- Inflation expectations: An increment in inflation expectations leads to lower demand for long-term bonds since having more exposed cash flows would reduce their present value.
- Government Policy Decisions: Since the government is the issuer of these bonds, any event affecting its stability or the economy will be another determining factor for investors’ decisions.
- Comparative analysis between markets: In addition to the internal events, another element to consider is how attractive one country’s public debt market is compared to another, particularly when they compete with each other. For example, an event in Colombia that leads to an outflow of investors might favor Mexico or Brazil, as they are located in the same region and would attract the same investors.
Finally, keeping an eye on the performance of different government bond markets serves as a measure of investors’ risk appetite and how it is affected by the decisions of governments, central banks, and economic variables. Understanding how they interact is a helpful tool for achieving a complete view of the global outlook.
This report was prepared by Gandini Análisis for Supra Brokers for informational purposes only and should not be construed as investment advice.