Bond as a Financial Instrument and its Functions - Research Paper Example

International Business Finance Contents Foreword 3 2. Bond as a Financial Instrument and its Functions 3 2 Bond as Financial Instrument 3 2.2.Features of Bonds 4 2.2.1. Maturity 4 2.2.2. Coupon 4 2.2.3. Yield to Maturity 4 2.2.4. Quality of Credit 5 2.2.5. Market Price 5 3. Buyers of Bond 5 3.1. Individual Buyer 5 3.2. Institutional Buyer 5 4. The Factors That Prompt the Investors to Buy Bonds with Negative Yields 6 4.1. The Reason behind Bonds to Yield Negative Return 6 4.2. Factors Influencing Investors to Buy Bonds with Negative Returns 8 5. Examination Of Whether There Is A Case in Economic Theory for Buying Bonds with Negative Yields 9 Reference List 11 1. Foreword In finance, bond is considered as a debt instrument in which the investors lend money to the issuers of the bond for a definite period of time, with an obligation to receive variable or fixed interest rate after a specific interval and the principal amount at the end of the tenure of investment (Choudhry, 2010). Bonds are issued mainly by sovereign governments, municipality and large corporate for both institutional and individual investors in order to raise money for financing various public and private projects. In conventional financial terms, bonds are liable to pay the interest at the pre-determined rate throughout the tenure of the bonds and repay the face value at the time of maturity which means there is no question of incurring loss for the investors out of investing in such financial instrument (Burger, Sengupta, Warnock and Warnock, 2014). However, in recent times it has been noticed in Europe that in some countries such as Denmark, Germany and Switzerland, the government bonds as well as corporate bonds are yielding the investors a negative return. To be more specific, such negative yields are not inflation-adjusted returns; the bonds are simply yielding the investors less than their capital (Ivashina and Becker, 2015). Therefore, the research paper will aim to investigate regarding credibility of bonds as a financial instrument, their buyers and the factors that may influence such investor to purchase bonds even with negative returns in order to find out the rationale behind such negative return and to identify buyers’ motivation behind purchasing such bonds with negative yield. For the purpose of analysis, relevant economic theory that may justify the reason behind buying bonds with negative yields shall also be incorporated. 2. Bond as a Financial Instrument and its Functions 2.1. Bond as Financial Instrument Traditionally, bond is considered to be one of the most secured investment options among all other financial instruments available in the financial system. Dann (2005) has defined financial instrument as a mechanism that institutes a contractual right between the borrower and lender to receive and deliver some of money. Bond is a financial instrument that establishes a indenture between the two parties: bond holder and issuer. The indenture specifies that the issuer will pay a fixed or variable rate of interest during the whole life of the bond and will refund the principal amount at the time of maturity (Maginn, Tuttle, McLeavey and Pinto, 2010). Bonds can be of various types such as fixed and floating rate of bonds, zero coupon bonds, perpetual bonds, inflation-index bonds etc. In the next segment, the features of these financial instruments will be analysed. 2.2. Features of Bonds 2.2.1. Maturity In this financial instrument, the issuers are obligated to repay the nominal amount to the investor, at the time of maturity. Maturity period indicates the length of time during which the investors will enjoy a fixed or variable amount of interest receipt. The maturity period of bonds may range from one year to 30 years. Short term bonds mature in three years or less whereas the intermediate bonds mature approximately within three to ten years. Long term bonds take at least 10 years or more for maturity (Strumeyer, 2012). General conscience indicates that bonds with longer maturity period tend to yield higher returns; however, longer maturity also involves greater price volatility because of experiencing multiple interest rate cycles during the long tenure. Once the issuer repays the principal amount at the end of the tenure of the bond, they do not hold any further obligation related to the bond and its holders (Aboody, Hughes and Ozel, 2014). 2.2.2. Coupon A coupon rate is that interest rate which the issuer of bonds is obligated to pay to the investors over a certain time interval. Generally, the rate of interest tends to be fixed throughout the tenure of the bond; however, the interest rate can also be periodically adjusted or vary with the money market index in case of floating rate bonds. Coupons are generally paid semi-annually or annually. The coupon rate also influences the bond price. The higher the coupon rate is, the less price- sensitive the bond price will be, because of movements in interest rate (Dann, 2005). 2.2.3. Yield to Maturity Yield to maturity indicates the return received at the end of the tenure of the bond. It is also known as redemption yield that takes into consideration the current market price of the bond as well as amount of all kind of coupon payments due at the time of maturity (Stoffman, 2008). 2.2.4. Quality of Credit Before investing in any bond, the lenders prefer to evaluate the credibility of the issuer in order to determine the degree of default risk associated with their investments. For this purpose, the investors tend to examine the rating provided by the recognized credit rating agencies such as Moodys Investors Service and Standard and Poors. However, such rating depends on multiple factors. For instance, as high level of risk is associated with high- yield bonds, the credit rating agencies tend to provide a lower rating to such junk bonds (Faerber, 2001). 2.2.5. Market Price Market price is an important consideration for tradable bonds. First issue of such bonds are made available to the investors at a nominal price or face value. Subsequent to the issue, as the bonds are traded in the secondary market, the investors can avail the bonds at a premium or discounted price depending on its market price. Such market price depends upon the timing of interest payment, time of capital repayment, available yield to maturity of other bonds trading in the market etc (Gkougkousi, 2014). 3. Buyers of Bond Bond buyers are those who invest capital for purchasing a stake of the bonds issued by governments, municipalities or corporate with an aim to receive interest as well as principal after a certain period of time. Such buyers of bonds can be segregated into the following terms, depending on their size of purchase (Jones, 2007). 3.1. Individual Buyer Individual investors are also known as retail investors who buy a very small proportion of the total issue of bonds. The investment pattern of such investors highly depends upon their own characteristics. However, individual investors are generally risk averse. Therefore, they tend to invest more on zero coupon bonds and other bonds that yields moderate return and the underlying risk is comparatively low (Crescenzi and El-Erian, 2010). 3.2. Institutional Buyer Banks, insurance companies, mutual funds, pension funds and exchange-traded funds (ETFs) etc. are considered as institutional buyers of bonds that allocate a considerably large amount of money to purchase very large scripts of the issued bonds. Sometimes, such financial entities invest a part of their accumulated profit in the government or corporate bonds in order to enhance their net wealth. Because of such large investment, institutional investors are less concerned about riskiness of bonds since such investors generally hold large portfolios where risk can be easily diversified. In fact, if the issuer defaulted, only a part of their whole invested funds will be affected. Therefore, rather than giving much priority to risk factors they would prefer to maximize their return from bonds investment so that the aggregate wealth of such institutions can be enhanced. 4. The Factors That Prompt the Investors to Buy Bonds with Negative Yields 4.1. The Reason behind Bonds to Yield Negative Return Before analysing the factors that prompt the investors to buy bonds with negative return, it is important to understand why bonds yield negative returns. Negative yields of bonds have become a common phenomenon in the recent years. The government and corporate bonds of Switzerland, Denmark, Germany and many other European countries are showing a trend of trading at a nominal yield (Bloomberg View, 2015). The rationale behind such negative yield can be justified through four distinct reasons. First, the imbalances between bond supply and demand as well as activeness of monetary policy in order to stimulate economic growth. Economic slowdown as a consequence of economic recession and financial crisis in 2008 has resulted in many financial institutions or issuer of bonds to default. Combining with that, the effect of deflation has led the global economy to receive a much lower amount as compared to the nominal value of their bond investment (The Wall Street Journal, 2015). (Bloomberg View, 2015) Ecology of current market participants to avoid the government bonds as an important constituent of their active investment portfolio has decreased the demand for such bonds. Moreover, such bonds have an increased representation in multiple bond indexes. Therefore, holding the government bonds to remain close to the benchmark has aided the investors to carry the cost associated with such holding. All these reasons have also resulted in the bond market in aggregate to yield negative return (Forbes, 2012). (Bloomberg View, 2015) Investment horizon posed to be a reason for the bonds to yield negative return. As the investors with shorter investment are witnessing negative returns from their bond investment at the time of maturity, such investors are shifting their investment pattern towards a longer horizon. Evidences are there where high inducement to buy bonds with longer tenure from the major investors in Switzerland have pushed the bond market to yield negative demand due to excessive demand in the market (Bloomberg View, 2015). 4.2. Factors Influencing Investors to Buy Bonds with Negative Returns Aftermath of recession and financial crisis that had occurred in 2008 crashed the investments of many individual and institutional buyers mainly in the US and European countries. Therefore, the return of money has become more important for the investors than return on money (Bhansali and Emons, 2015). Factors that have prompted the investors to buy bonds with negative yields are as follows: Risk-averse investors will accept bonds with negative yield in the form of insurance risk premium to keep their money in a relatively secured investment instrument as against investing in shrinking bank deposits or in collapsing equity market. In the economic situation of high deflation when prices of products and services are showing diminishing trend due to rapid disruption of production and distribution process, though the real return received from bond investment is negative, the investors can still experience a positive return, after adjustment with inflation. For instance, if a bond is yielding negative return by 1% but at the same time consumer price index is showing a fall by 2% then the purchasing power of the investor will become stronger, after adjusting with inflation (Greenwood and Vayanos, 2014). Another incentive of the investors to buy bonds with negative yield is that if the yield reduces further towards the negative side, the investor can take advantage of capital gain and adjust the negative return with their next year’s profit which is not possible in any other investments (The Global and Mail, 2015). If the investors speculate that the currency in which the bond is denominated will rise in the upcoming future, they will definitely opt for such bonds with negative yields. Institutional buyers such as insurance companies or pension funds can opt for bonds with negative yields when they are required to invest their large pool of funds in a relatively secured asset, regardless of the level of return from the instrument (CNBC, 2015). 5. Examination Of Whether There Is A Case in Economic Theory for Buying Bonds with Negative Yields (The Economist, 2015) Though there is no provision for bonds to yield negative return under the conventional economic theories, in the contemporary economics negative yield of bonds implies that investors who had bought bonds will receive a return, even lower than the nominal value of the bond, after taking into account interest income but without considering the provision for taxation. Such phenomenon has become obvious on the ground of the financial crisis of 2008. The crisis has exposed the financial institutions such as banks and other financial intermediaries to risk and pushed many of them on the verge of collapsing. As a consequence, the short term treasury bills of the US and European central banks are yielding negative return. Moreover, due to some economic uncertainties in the western economies such as the probable outcome of Greece to lease Eurozone has compelled the investors to accept a negative yield of 0.16% on 2-years German bonds. $1.7 trillion of euro- government bond and $1.8 trillion worth of Japanese bonds that will mature within next year are also showing negative yield. This indicates the philosophy of the recent investors is to accept a proportion loss rather than losing the whole of the capital employed (The Economist, 2015). However, economists are appointing various measures such as quantitative easing to recover the bond market from its present turmoil. If efficiently exercised, the bond market will definitely recover from its initial position in the upcoming future. . Reference List Aboody, D., Hughes, J. S. and Ozel, N. B., 2014. Corporate bond returns and the financial crisis. Journal of Banking & Finance, 40(1), pp. 42–53. Bhansali, V. and Emons, B., 2015. Why the Bond Market Is Yielding Negative and What Negative Yields Mean for You. [Online] Available at: [Accessed 14 May 2015]. Bloomberg View, 2015. 10 Things to Know About Negative Bond Yields. [Online] Available at: [Accessed 14 May 2015]. Burger, J. D., Sengupta, R., Warnock, F. E. and Warnock, V. C., 2014. US investment in global bonds: As the Fed pushes, some EMEs pull. National Bureau of Economic Research, 2(4), pp. 56-80. Choudhry, M., 2010. An Introduction to Bond Markets. New York: John Wiley & Sons. CNBC, 2015. Negative yield bonds: Heres whos buying. [Online] Available at: [Accessed 14 May 2015]. Crescenzi, A. and El-Erian, M., 2010. The Strategic Bond Investor: Strategies and Tools to Unlock the Power of the Bond Market. New York: McGraw Hill Professional. Dann, L., 2005. Common stock variables: an analysis of returns to bondholders and stockholders. Journal of Financial Economics, 9(2), pp. 113-38. Faerber, E. F., 2001. Fundamentals of The Bond Market. New Jersey: McGraw Hill Professional. Forbes, 2012. The Risk in Long-Term Bonds. [Online] Available at: [Accessed 14 May 2015]. Gkougkousi, X., 2014. Aggregate Earnings and Corporate Bond Markets. Journal of Accounting Research, 52(2), pp. 75–106. Greenwood, R. and Vayanos, D., 2014. Bond Supply and Excess Bond Returns. Review of Financial Studies, 27(3), pp. 663-713. Ivashina, V. and Becker, B., 2015. Reaching for Yield in the Bond Market. The Journal of Finance, 2(2), 2-18. Jones, C. P., 2007. Investments: Analysis And Management. New Jersey: John Wiley & Sons. Maginn, J. L., Tuttle, D. L., McLeavey, D. W. and Pinto, J., 2010. Managing Investment Portfolios: A Dynamic Process. New Jersey: John Wiley & Sons. Stoffman, N. S., 2008. Individual and Institutional Investor Behavior. Ann Arbor: ProQuest. Strumeyer, G., 2012. Investing in Fixed Income Securities: Understanding the Bond Market. New Jersey: John Wiley & Sons. The Economist, 2015. Accentuate the negative. [Online] Available at: [Accessed 14 May 2015]. The Global and Mail, 2015. Who would buy a bond with a negative yield? [Online] Available at: [Accessed 14 May 2015]. The Wall Street Journal, 2015. What Negative Bond Yields Mean for Investors. [Online] Available at: [Accessed 14 May 2015]. Read More