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SCMP Reporter

PUT simply, a bond is a debt. It is a method of borrowing money: no more, no less.

  Strictly speaking, it is a fixed interest rate debt security. So the amount of money raised, the repayment date and the interest rate are fixed throughout the life of the bond.

  A typical bond is issued for 10 years, although bond durations vary, and clearly the rate of interest a borrower offers is the lowest rate it thinks it can get away with.

   As soon as it is issued a bond becomes a traded security, just like a share. It is a huge market. The daily turnover in the bond market is at least three times that of equity markets.

  The total size of the world bond market is US$16 trillion, which compares with the capitalisation of world equity markets at about $9 trillion.

  The bond market is nearly twice the size of the equity market and yet most of what we read in the business pages is about the equity market.

  Of that $16 trillion, more than 60 per cent is issued by governments, government agencies, local governments or other issuers who are guaranteed by a government.

  The biggest borrower of money in the world is the US Government, with the next largest markets being Japan, Germany, Italy and France.

  There is virtually no bond market of any significant size in Southeast Asia.

  Four factors influence the price of bonds; actual and anticipated movement in the inflation rate, actual and anticipated movement in the interest rate, changes in the credit rating of the issuer and the obvious factor of supply and demand.

  The bond market is more concerned with the inflation rate than anything else. The reason is the principal return you get by owning a bond is the yield. Think of it as interest. Now, what is that interest worth after deducting inflation?   If you were living in the US right now, you could buy a bond which would yield you about 7.7 or 7.8 per cent. The consensus is that the inflation rate is not going to get much worse than three per cent.

  So if you deduct three from 7.7 you get the real rate of return, which is 4.7 per cent. Compared with an historical average, that is pretty high.

  Due to fears of higher inflation, central banks starting with the US Federal Reserve are raising interest rates to try to keep inflation down. That was the cause of last year's slump in bond prices, the worst in 60 years.

  Bond investors have been saying to themselves: if interest rates are going up, maybe the yield on bonds will go up, so I won't buy them today, I'll buy them tomorrow when the yield is better.

  Of course, it is not as simple as that. What the bond market does is to anticipate what is going to happen to interest rates, sometimes as much as 12 or 18 months ahead.

  The equity market is often driven by what is happening in the bond market because it sees the bond market as the best anticipator of the future direction of interest rates and inflation.

  Looking at the mechanics of the bond itself, it is issued as a piece of paper. What the issuer is in effect saying is: 'The market tells me I have to pay an interest rate of [for instance] 9.5 per cent to borrow money from you.

  'So, if you give me, say, $1,000, I'll give you this bit of paper and in return, I'll pay you $95 every year.

  'That is 9.5 per cent of $1,000 for each one of those bits of paper and, in 10 years, the issuer will give you, the lender, $1,000 for every one of these bits of paper you give me. This then becomes a traded security.'   The market puts these bond certificates together and they typically trade as a million dollar unit. An individual would find it extremely difficult to go out and buy a small number of bonds, which means that the best route into the bond market for small investors is to buy unit trusts which specialise in bonds.

  The yield of a bond is called the coupon. This is because in the days before paperless trading it was a coupon attached to the back of the bond.

  Most bonds pay interest every six months, so attached to a 10-year bond there would be 20 coupons. If it were a $1,000 bond with a 9.5 per cent yield, each of these coupons could be redeemed for $47.50.

  Now to the pricing. Let us suppose a government issued a bond a month ago, and the lowest interest rate it could get away with was 9.5 per cent.

  This month it needed to borrow some more money so its adviser took the temperature of the market and said: 'Well, things are going quite well, interest rates are coming down, bond yields are not so high, you can get away with nine per cent.'   The bond issuer would think that was great as it could get away with paying less interest. However, with the issue of the new bond at nine per cent, anybody who owned the one issued at 9.5 per cent last month would clearly be holding something more valuable as it pays more interest.

  The market would have adjusted for this by increasing the resell price of the first bond. This means that the return on the first bond would be the same as that on the new nine per cent bond even though a buyer would now have to pay more for the higher coupon. It is a simple mathematical calculation.

  If interest rates went up during the month and the borrower instead had to issue a new bond at 10 per cent, the one that only pays $95 is clearly going to be worth less.

  In 1991, 1992 and 1993, bond yields were coming down, so all the bonds that were already issued that were paying higher dividends became more valuable. But last year, bond yields started to rise, so a bond that was paying 6.5 per cent in January 1994 was not looking very good by July because new bonds were being issued offering 7.5 per cent. As a result the prices of the existing bonds fell.

  The trick is to buy when yields are not going to rise any more, so as to lock in the highest yield available. When the yield of new bonds falls, a high-yielding bond would be more valuable and the bond holder could achieve a capital gain.

  If the bond holder decided to keep the bond, that high interest would be earned through the whole period of ownership.



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