United Kingdom Government Bond Market - Case Study Example

Report on the United Kingdom Government Bond Market Author Course Tutor Date The United Kingdom Government Bond Market This report provides a description of gilt securities and the UK government bond market. The report pays particular attention to the main features of bonds and its basics, markets and explains why bond markets might be beneficial to certain types of investors. The report further explains how bonds are priced and explains the differences between dirty and clean prices. In addition the report explains the kinds of risks that bond investors face. Gilt securities A gilt security is a UK government liability that is issued by HM treasury and has its listings on the London stock exchange. Gilt securities are of two types namely, index-linked gilts and conventional gilts. Conventional gilts form the largest share of government liability. It guarantees to pay the holder a fixed coupon after every six months during the currency of the security until it matures. At maturity the gilt holder receives the final payment of coupon and the principal amount. Its prices are usually quoted in £100 nominal although they can be transacted in smaller units. Index-linked gilts pay coupon and the principal in line with retail prices index prevailing in the UK. The redemption amount and the coupons are adjusted to take into account the accrued inflation since the issuance of the gilt (Chaudhry & Gross 2003). A bond shows the date of issue, the maturity date, the interest rate and the yield rate. Gilts could be issued on the same date but have different maturity dates. Tr 5pc ’14 describes a UK gilt whose maturity is in 2014. The coupon interest rate on this bond is 5%, the purchaser of a £100 bond receives £2.5 every 7th March and September 7 from march 7, 2012 and ending September 7, 2014 (the maturity date of the bond). The purchaser will also receive £100 at the maturity date of the bond. The payment of £100 is the redemption value or maturity value of the bond. Determination of the price of a bond The Dept Management Office (2010) notes that purchasers of a bond take into account the levels of risk linked in the bond when determining its value. The valuation of bonds involves the concept of time value of money. This is captured by discounting the future value of the bond to determine its present value. The yield rate of the bond is used to discount it to the present. The payments will consist of a constant series of coupon payments (usually paid semi-annually) along with a large lump-sum payment (the redemption amount) at a time that the final coupon is paid (Blackledge 2009). A higher yield rate is required for a bond whose maturity date is long because of the risk inherent. Price of the bond is the present value of the streams of coupons plus the present value of the redemption amount. The regularly paid coupons form an annuity while principal amount will be paid once as a single amount (DMO 2010). Using Tr 2pc ’16 whose coupons are paid semi-annually (every six months). The present value of the coupons is £15.8339 and the present value of the redemption amount is £98.1592 therefore, the price of this bond is £113.9931. Dirty and clean prices The clean price of a bond is its quoted price without any accrued interest. Dirty price on the other hand is the price of a bond in between payment of coupons. It includes the quoted price and the coupon amount that has accrued. Dirty price is meant to compensate the bond holder if he intends to sell the bond before the time to receive coupons (Fabozzi 2001). Fabozzi (2007) explains that dirty price of a bond is calculated by finding out the quoted price, its rate for coupon payment and the days that have passed since the last interest payment. In the case of Tr 2pc ’16 we have determined that the price is £113.9931 and it has a 2 percent annual coupon rate. For the purpose of this demonstration we’ll assume that the last coupon payment was 40 days ago. After these have been established, the next step is to divide the quoted price which in this case is £113.9931 by 100. The result found here is then multiplied with the bond’s face value which for the purpose of this calculation will be assumed to be £1000. The calculation so far will be: Quoted price x Face Value of the gilt i.e. £113.9931 x 1000 = £1139.931 100 100 The gilt’s annual coupon rate is then multiplied by the face value which gives the annual coupon payment. In this case, the annual coupon rate is 2% and the face value is 1000 pounds. Therefore, the annual coupon payment is: 2/100 x 1000 = £20 The next step in this calculation is to divide the number of days since the last coupon payment by 365 (the total number of days in a year) 40/365 =0.1095 The results found here are then multiplied with the annual coupon payment to give the price of accrued interest i.e. 0.1095 x 20 = £2.19 accrued interest. To get the dirty price of the gilt, sum up the clean price and the accrued interest £1131.931 + £2.19 = £1134.121 Dirty price = £1134.121 Distinction between clean and dirty price is especially important when one is buying or selling gilts, this is because they help to establish the real value of the bonds and hence determine pricing when a bond holder intends to sell them before redemption date. Current affairs Subprime mortgage crisis Tong & Wei 2008 explain that i the first half of the last decade, the United States was consuming more than its income. In order to get the balance, assets, including government and corporate bonds, were sold to foreigners. This led to a lot of money coming into the American economy from many countries in the world especially the fast growing economies in Asia. As a result, in the years leading up to 2006, banks in the offered many loan incentives to people applying for Adjustable Rate Mortgages. Since there had been a trend of increasing home prices, and decreasing interest rates, many people took up the mortgages hoping to sell the homes and make profits quickly. They were also hoping that the interest rates would fall and enable them pay for the loans at rates lower than those prevailing at the time they borrowed. Due to lack of a robust regulatory framework, the shadow banking system (Investment Banks and Hedge Funds) provided loans from money that was almost entirely borrowed; they did not have enough money to absorb losses incurred through Mortgage Based Securities which negatively affected their capacity to offer loans. The inability of banks to lend reduced the disposable income available to consumers, leading to a reduction of consumer spending. Consumer spending is a key driver of economic growth and its reduction led to a reduction of demand in a market that had a very high supply of houses (Tong & Wei 2008). Another reason for this collapse was securitization of mortgages. Traditionally, the risk of default in a mortgage was for the bank offering the mortgage to retain. In securitization, the banks offered the mortgages and then sold the mortgages to investors as Mortgage Based Securities; the banks themselves retained the transaction fee. The banks’ main focus was now to process as many mortgages as possible and then sell them off. This led to mortgages being offered without due regard to borrowers credit worth. In 2005 the average down payment for first time home buyers was only 2%, with 43% of buyers not required to make any down payment. 81 Lenders went to the extent of failing to ask for proof of income or ownership of assets before offering loans; this gave rise to what came to be known as NINA (No Income No Assets) loans.83 The United States Federal Reserve has been blamed for lowering of interest rates to 1% in the early 2000s which believed to have led to a lot of cheap loans which eventually led to the demand for mortgages that followed. Later, between 2004 and 2006, the Federal Reserve adjusted the interest rates significantly upwards affecting the people already holding ARMs Quantitative easing To counter this problem and the credit crunch that came as a result of the mortgage crisis, central banks in many countries reduced their interest rates to increase the amount of money in their economies. In the United States the Federal Reserve bought Mortgage Backed Securities increasing the amount it held from $800 billion in pre credit crunch period to $2.1 trillion in 2010. This was considered to be the first round of Quantitative easing (QE). The reserve instituted the second round of QE in 2011 through purchase $ 600 billion worth of treasury securities (Susino 2010). Euro zone crisis This phenomenon is also known as the European Sovereign debt crisis, this crisis was triggered by the inability of some countries in Europe to pay their debt. After a property bubble akin to the American bubble and its eventual bursting, some European countries instituted QE procedures. Like the US subprime mortgage crisis, the genesis of the euro zone crisis began with the availability of savings from fast growing Asian countries in the global capital markets which made a lot of money available for borrowing. According to Skidleby (2011) too much lending was the original cause of the crisis governments incurred huge debts while trying to bail out banks. Some of the countries that have largely been affected by this crisis include Greece which was one of the fastest growing economies in Europe in the period preceding the crisis. During the global financial crisis that came as a result of the subprime mortgage crisis. Drivers of the Greek economy which are shipping and tourism were particularly hard hit. Fiscal irresponsibility has also been blamed as a cause of the crisis (Skidleby 2011). Portugal is another country which was affected by this crisis; its problems are related to many years of overspending by the government. Its credit rating was cut to non investment grade by credit rating agencies, this meant that investors would found the country’s sovereign bonds unattractive making it difficult for the government to raise money. Portugal was forced to apply for a bailout package of €78 billion from the International Monetary Fund and the European Union. Susino 2010 explains that Ireland has also been affected by the crisis. The cause for this effect was the bursting of a property bubble under conditions similar to those that led to US subprime mortgage crisis. After the burst, the Irish government guaranteed deposits and bonds of the banks that were involved in the property bubble to prevent them from collapsing. Ireland also received a bailout package from the EU and IMF. For some time, there was no apparent improvement to the economy, this led depositors and bondholders in the banks that the government had guaranteed to cash in, before the period for which the government had offered guarantee elapsed. The government found itself under enormous pressure to raise the necessary amounts in order to pay depositors and bond holders thus increasing its debt and pressure to the economy. In the meantime, credit rating agencies downgraded Ireland’s credit rating to non investment grade. The rating meant that the government bond was extremely risky and could only be offered at unsustainably high interest rates to make it attractive to investors. Ireland has put in place measures to ensure economic recovery and is now well on the way to full recovery. Spain’s debt problem came as a result of bailing out banks that had collapsed as a result of the property bubble. The amounts required for the bailout increased the country’s debt and led to downgrading of its credit rating. It received a bailout package from the EU and to increase the confidence of investors, the Spanish government instituted measures to cut spending and amended the constitution in 2011 to make it a constitutional requirement to have a balanced budget by the year 2020. Due to low credit rating of many European countries and the uncertainty that was there about the state of financial markets in many others, many investors sought certainty in the UK government bonds. As mentioned earlier, UKs credit rating has been high throughout the crisis (Susino 2010). The influx of investors into the gilt market has led to a phenomenon being referred to as the gilt bubble which according to some analyst is about to burst. Harley (2012) sees this as a great way to pick up low priced bonds at the burst and watch them grow and earn you capital. Benefits of investing in bonds Andritzky (2012) asserts that bonds are a highly beneficial investment to have in ones portfolio because. Unlike stock dividends, coupon payments occur, mostly biannually at regular, predictable intervals that the investor can count on. They also offer stability for people who are putting aside money for use in future e.g. college fees payment or purchase of an asset (Hurst 2000). Gilts are considered to be some of the lowest risk investments and among the safest government bonds in the world; this is because of UK’s AAA debt rating (LSE 2012). Risks Although bonds are stable, there are certain risks associated with them. The value of investment can be eroded by inflation. As a result potential investors will no longer consider the gilts a worthy investment, thus reducing their prices in the market. This problem is not experienced in index-linked bonds (DMO 2010). Another factor that makes gilts risky is high interest rates, when interest rates rise, gilt prices fall and when interest rates fall, gilt prices rise. Interest rates can be affected by the exchange rate, this occurs when the pound is doing badly against other currencies making it necessary for the Bank of England to increase interest rates in order to stabilize the pound (Fobozzi 2007). As noted earlier, high interest rates reduce the value of bonds. As a way of reducing risks, our clients are advised to buy their gilts when the interest rates are high but are about to fall when the interest rates fall the value of bonds increases giving the investor a capital gain (Subrata & Shantanu 2010). An understanding of markets, the mathematics of bond pricing and the current situation in the market are key to the success of any investors. Yield curve This is a graphical representation of different interest rates of bonds with equal credit quality but different maturity rates at different points in time. There are three different types of curves, normal, inverted and humped. In a normal curve, longer maturity bonds have higher yields than the shorter maturity ones. An inverted curve shows the shorter maturity bonds having higher yields which may indicate a future recession. A humped or flat yield curve shows shorter and longer term yields being almost similar and shows the possibility of transition between normal and inverted yield curve (Eckett 2009). Normal Yield Curve Flat Yield Curve Inverted Yield Curve References Andritzky, J 2012 Government bonds and their investors: What are the facts and do they matter? International Monetary Fund. Fiscal Affairs Department WP /12/158. Blackledge, M 2009 Introduction to property valuation. London: Routledge Publishing. Chaudhry, M 2004 Corporate Bonds and Structured Financial products. 1st edn Oxford: Butterworth-Heinemann. Chaudhry, M, Gross, G 2003 The gilt-edged market. Oxford: Butterworth-Heinemann.   Debt Management Office 2010 UK Government Securities: a Guide to 'Gilts'. 8th edn. U K: DMO. Eckett, S 2009 Online Investing: 200 essential Q & As for the internet investor. Hampshire: Harriman House Limited. Fabozzi, F 2001 Bond portfolio management. Hoboken, NJ: John Wiley & Sons. Fabozzi, F 2007 Bond Markets: Analysis and Strategies. 6th edn. Upper Saddle River, NJ: Prentice Hall. Harley, R 2012 Gilt yields: staying lower for longer Read More