Feature Stories | Mar 31 2021
It is fair to say most Australians don’t understand bond yields, or even know with certainty what a bond is. This article is a 101 lesson in what a government bond is, and why suddenly stock markets have been running away in fear of them.
-What is a bond?
-Why are bonds issued?
-What’s inflation got to do with it?
-Why are bond yields impacting stock markets?
By Greg Peel
What is an equity?
Few Australians do not know what an equity, or share, is, but to understand bonds it is best to begin with a comparison.
When you invest money in the stock market, by buying shares, you are entrusting in that company to increase the value of those shares. The end result is you might become rich, or might never see that money again.
Aside from capital gain, an investor may be looking for an income stream from dividend payments. The decision to pay dividends, and the amount of any payment, is entirely at the discretion of the company’s board. There is no obligation.
Newer companies in a growth phase will typically not pay dividends, or perhaps just token dividends, while longstanding companies tend to be reliable payers.
For some companies, dividend payments fluctuate with economic cycles. Witness Australia’s iron ore miners being the biggest dividend payers of all right now. That could well change down the track.
Equities are an open-ended investment. One can sell out at any time, or hold on for retirement. Equities do not have a maturity date.
Equity investment represents the largest allocation in any standard investment portfolio (not counting direct investment in a property). The second largest allocation typically goes to fixed income (including bonds). This is our starting point.
What is a bond?
A popular alternative to investing in equities, which come with capital risk, is to put your money away in the bank where it’s safe. Depositing money in a bank equates to lending the bank your money, for which you are paid interest. The rate you are paid on your money is at the discretion of the bank.
Bank deposits can either be open-ended, such as a savings account, for which interest rates can rise and fall over time, or have a specific maturity, as is the case with term deposits. A term deposit comes with a fixed interest rate for a fixed period.
Given Australia’s is a sound and well-regulated economy, a bank deposit is essentially “risk free”. The regulator (APRA) ensures banks are carrying sufficient amounts of capital to ride out any crises, the central bank (RBA) acts as the “lender of the last resort” to banks, and if necessary, the federal government will guarantee deposits up to a certain amount (as was the case in the GFC).
An Australian government bond is basically a term deposit, but with the government rather than a bank. Bonds have a maturity date, and pay interest, and at the end of the life of the bond you get your money back.
In buying a bond, you are lending money to the government, for which you receive interest. Australian government bonds are also considered “risk-free”, as are the government bonds of other “first world”, developed economies.
Not necessarily so in emerging or unstable countries. Argentina, for example, has a long track record of defaulting on its government bonds.
Why does the government need my money?
As Australians are more than aware, governments either run a budget deficit or budget surplus. A deficit in any one year implies the government is spending more (through welfare, defence, health, infrastructure, so on and so forth) than it is earning (primarily through taxes).
A government’s annual budget is little different to any average household budget. If you spend more than you earn in any year, the difference has to come either from savings (surplus) or through borrowing money (deficit). A household budget typically includes various debt servicing obligations, from the mortgage to the car loan to credit cards.
When the government is running a budget deficit, that deficit has to be covered. This is done by borrowing money from Australians, either from individuals, or from super funds, other funds and corporations, or from offshore investors.
To borrow money, the government issues bonds across different maturities. The “benchmark” maturity is the ten-year bond, which is indicative of an economy’s perceived health into the future, but not too distant a future.
Right now the Australian government, and virtually every government, is borrowing money hand over fist to fund rescue packages (such as JobKeeper) and economic stimulus measures (such as infrastructure) to get us safely out of the covid mess. To do this the government issues bonds.
Were covid to never have happened, the Australian budget would by now have been in a significant surplus (thanks to commodity prices), suggesting the government need not borrow any money and thus not issue any bonds.
However, governments always issue bonds, be the budget in deficit or surplus. In times of surplus, the money may not be immediately needed but it is important to maintain a “liquid” bond market in a first world economy as the “risk-free” bond rate is a benchmark for all other capital markets, and government bonds offer a safe alternative investment for all Australians via their super or other funds. Fund managers need to "roll over" bonds in their portfolios that have matured, in order to maintain that investment. To do so they need the government to continue to issue new bonds, even in times of surplus.
One might have assumed the benchmark for capital markets would be the RBA overnight cash rate and at the shorter end of things, time-wise, this is indeed the case. But Australian banks are unusual in the world in pricing, say, a 30-year mortgage rate based on the overnight interest rate.
American banks price a 30-year mortgage off the government 30-year bond rate. Apples to apples.
So how does a government bond work?
Government bonds typically have a face value of $100. This means one can lend the government money in increments of $100, making bond investment accessible to most Australians. (Corporate bonds typically begin at $10,000, but we’ll examine corporate bonds another time).
If you buy a ten-year government bond for $100, in ten years the government will pay you back $100. Each year the government will pay you interest on that loan at a rate fixed at the time of issue (just like a term deposit).
The fixed interest rate on a bond is known as the “coupon”. For the sake of easy maths, let’s say you buy a ten-year bond with a coupon of 1%. This means as well as getting your money back in ten years, each year you’ll be given a dollar. So your net gain over ten years is $10, on top of your money back.
Whoopee, you say, but these are the unfortunate times we live in, since the GFC, not just covid. But at least you know your money is safe.
What we can deduce is that a $100 dollar ten-year bond at 1% is actually worth $110 by the time it matures.
Except for one problem.
The price of milk
That problem is inflation. We all well understand inflation – it’s why we were paying a lot less for a litre of milk, in face value terms, ten years ago, and will be paying a lot more in ten years’ time.
(This writer well remembers working in a pub as a uni student when the price of a schooner was 72c, in 1980. Now you can’t buy that same schooner for less than $7.00.)
The inflation implication is that when you get your $100 back in ten-year’s time, it’s not really worth $100. It is at face value, but not in today’s money.
And not only that, as each year goes by that $1 interest payment you’re receiving is also diminished in value in today’s money terms. That $110 in total you were coveting will gradually pay for fewer and fewer schooners over time.
The last reading of Australia’s headline CPI, for the December quarter, was an annual 0.9%. This quite simply means your 1% annual interest payment is eroded each year in “real” terms by 0.9%, so in reality your “real” interest rate is 1.0-0.9 = 0.1%.
And your original $100 will by maturity have been eroded by inflation over a full ten years.
Which begs the question, why on earth would you buy a government bond? The simple answer is if you want to keep it safe, where else can you put it?
One year term deposit? Currently you’ll get 0.1% before inflation. The stock market? Well your money’s not safe there. Investment property? If you can afford it, and be approved for a loan, but you’re not entirely safe there either.
In some countries, government bonds are currently paying negative interest rates. Well that’s plain stupid, as it implies you are paying the government to have your money. Who would do that?
The answer is many, many people, mostly pension funds, large corporations and even other governments. Because other than that money being safe, if the inflation rate is also very low, in “real” terms you can actually be ahead if positive inflation is actually lower (in absolute terms) than the negative interest rate on offer.
So if we consider all of the above, we can move on to why the ten-year bond rate has been rising recently (here and offshore) and why everyone is subsequently becoming panicked, as is evident in a volatile stock market.
Presently, every daily movement of the ten-year bond rate can either sends stocks soaring or plunging.
Pricing a Bond
Now I hope you’re sitting down, because I have to tell you something.
There is no such thing as a daily ten-year bond rate.