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The Fixed Income Markets

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What is the bond market? The average person doesn't follow it, and often doesn't even hear about it. Because of the bond market's low profile, it's surprising to many people that the bond markets are approximately the same size as the equity markets!

Until the late 1970s and early 80s, bonds were considered unsexy investments, bought by retired grandparents and insurance companies. They traded infrequently, and provided safe, steady returns. Beginning in the early 80s, however, Michael Milken essentially created the tremendous junk bond world, making a killing at the same time. And with the development of mortgage-backed securities, Salomon Brothers also transformed bonds into something exciting and extremely profitable.

Bond Market Indicators



The Yield Curve

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 shorter-term government T-bill are lower than Long Bond's yield, indicating what is called an "upward sloping yield curve." 

As with the stock market, the bond market has some widely watched indexes. The LGC index measures the returns on mostly government securities, but also blends in a portion of corporate bonds. The index is adjusted 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. Because they are virtually risk-free, U.S. government bonds, also called Treasuries, offer low yields (a low rate of interest), and are standards by which other bonds are measured.

Spreads

In the bond world, investors track "spreads" as carefully as any single index of bond prices or any sing .o 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 Company bond would compare it to a U.S. Treasury bond that has 1 D years remaining until maturity.

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. For example, IBM 30-year corporate AAA bonds in mid-1999 trade at a yield of 6.5 percent, which implies a 1 percent spread over the Long Bond (assuming the Long Bond yields 5.5 percent). Junk bonds, or bonds with a rating of BB or below, currently trade at yields ranging from 10 to 15 percent, depending on the precise rating, the company's situation, and the economic conditions at the time.

Companies continue to be monitored by the rating agencies as long as 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. 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 ensured by many different barometers 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 7 percent today, and that his rate represents a 1.5 percent spread over Treasuries. An increase in rates of 1 percent means that this said bond purchased now (as opposed to when you purchased the bond) will now yield 8 percent. And as the yield goes up, the price declines. So, your bond loses value and you are only earning 7 percent when the rest of the market is earning 8 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 7 percent and rates plunge by 1 percent, you now earn more than those who purchase the bond after the rate decrease.

How Interest Rates Affect Prices

The graph below shows hypothetical bond price movements of Treasury securities with increasing maturities. We show scenarios with both decreasing and increasing interest rates. To give an example, the chart car be read as, "A two-year Treasury note would fall from a price of $10 to a price of $9.81 if interest rates rose 1 percent. This is a 1.78 percent price drop." Obviously, if you own the security, and its price fell, you would not be happy.

Investors 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 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 moved 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.

T-Bill Yields - The yield or internal rate of return an investor would receive at any given moment on a 90 to 120-day Treasury bill.

LIBOR (London Interbank Offer 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 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.

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

Why Do Interest Rates Move?

Interest rates react mostly to inflation expectations. If it is believed that inflation will be high, interest rates increase. Think of it this way. Say inflation is 5 percent a year. In order to make money on a loan, a bank would like to at least charge more than 5 percent - otherwise it would essentially be losing money on the loan. That 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 expected continued high inflation). Today, many believe that the Federal Reserve has successful inflation and has all but eliminated market concerns of future inflation. This is certainly debatable, but the sound monetary policies and remarkable price stability in the U.S. have made it the envy of the rule 1998, the Consumer Price Index (CPI), a measure of inflation, grew at a mere 1.6 percent annual rate.

The Federal Reserve Bank, called the Fed and headed by Alan Greenspan, monitors the U.S. money supply and regulates banking institutions. While this role may not sound too significant, in fact the Fed's role is crucial to the U.S. economy and stock market.

Academic studies of economic history have shown that a country's inflation rate tends to track hat country's increase in its money supply. Therefore, if the Fed increases the money supply by 2 percent this year, inflation can best be predicted to increase by 2 percent as well. And since inflation so dramatically impacts the stock and bond markets, the markets scrutinize the week-to-week activities of the Fed and hang onto every word uttered by Greenspan.

The Fed can manage consumption patterns and hence the GDP by raising or lowering interest rates. The chain of events when the Fed raises rates is as follows.

The Fed raises interest rates. This interest rate increase triggers banks to raise interest rates, which leads to consumers borrowing less and spending less. This decrease in consumption tends to slow down GDP, thereby reducing earnings at companies. Since consumers borrow less, they have left their money in the bank and hence the money supply does not expand. Note also that companies tend to borrow less when rates go up, and therefore invest less in capital equipment, which discourages productivity gains. Any economist will tell you that the key to a growing economy on a per capita basis is improving productivity in the workplace.

The following glossary may be useful for defining securities that trade in the markets as well as talking about the factors that influence them. Note that this is just a list of the most common types of fixed income products and economic indicators. Thousands of fixed income products actually trade in the markets.
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