Why Could Profit Taking Suffer on the Bond Market?
Date: 4 March 2016 Share on Twitter Share on Facebook
After stocks, bonds are probably the most popular assets among investors – but for non-experts, the complexities that surround them can be bewildering.
What is a bond?
A bond is a loan from the buyer to the issuer, which can be a private company or a government. The issuer agrees to pay back the full value of the loan (known as the principal) when the bond matures, which can be anything from a few months to fifty years.
Additionally, there is an interest rate attached to the bond known as the coupon, incentivizing the buyer to lend the principal. So a bond should give you a reliable income and the guarantee of regaining all your initial investment – unless the issuer defaults.
The bond market
Discussion of bonds, however, usually refers to the secondary market, where bonds are traded much like stocks between investors. Instead of quoting the price, though, the key number is the yield, which measures what your return will be given both the interest rate and the current price of the bond. Calculating the yield can be fairly complex, but for now one basic principle will be enough: the yield is inversely proportional to the price. This is because the less you pay for the bond, the more your overall return is – and vice versa.
Two main factors affect a bond’s price: how attractive the interest rate is relative to the market, and how high the risk of default is thought to be. This is why a smaller company has to offer a much higher coupon than a government or municipality to make its bonds attractive. It also explains why the Fed’s actions are so important – the higher it raises rates, the less alluring a bond with a fixed coupon.
Bond prices and profit taking
Bond prices are currently high because investors are on the hunt for somewhere safe to put their money, which can also generate a decent return. Around the world, central banks’ base rates are either negative or extremely low, so a bond with a coupon of 2% is far more enticing than it was ten years ago. High volatility in stock markets has also pushed investors towards bonds, driving prices up and yields down.
Recently some investors have been engaging in profit taking – cashing out of the bond market while prices are still high, in anticipation of a fall in prices. For example, the Dow Jones Corporate Bond Index saw a sharp yield rise in February – a slump in prices that could suggest fears of a crash in the bond market.
What happens in a bond market crash?
The prospect of illiquidity is spooking investors the most – if bonds are being sold en masse, soon enough there won’t be enough buyers, rendering the asset at least temporarily worthless. That scenario is worrying for large institutional investors, who simply can’t risk having the value of a huge swathe of their holdings effectively wiped out.
Moreover, new regulations have clipped the big banks’ wings in the debt market – they won’t be able to buy up all the bonds on sale, making the environment even less liquid.
Is a crash on the way?
Predicting a downturn precisely is almost impossible, but many expert investors feel that one could be on the way. Knowing what to watch out for is difficult though: weak economic performance could spark a sell-off in more risky bonds (known as high-yield bonds), while a strong recovery could suddenly make ‘safer’ much less appealing investments (like US Government bonds, or Treasuries). Many also feel that bond prices have risen to levels that are simply unsustainable thanks to the economic turmoil of recent years.
Given all this uncertainty, it’s unsurprising that some bond owners are choosing to cash out. Their biggest problem now will be deciding where to invest instead.