Today I would like to discuss about bonds. The one that is supposedly safe (except AT1 bonds- see yes bank and hdfc cases). Bonds generally have a binding agreement to pay interest and capital after a mutually determined set period of time.
Below I will generally talk of US bonds as they are currently presumably the safest. All govt. bonds are generally safe till they default on payments. That way US with huge economic and defence power is presumably the safest issuer of bonds (also Called Treasury or T- bills). They come in various tenure but our focus is on Short term bond (91 days T bonds) or Long term bond (30 Year T bonds). These two are famous with many in between.
Short Term T bonds are considered safe (till $ rules) and most liquid and lot of companies/govts buy them to hold their $s and earn some money. Current int. rate is around 3.97%.
Long Term T bonds are also considered safe but come with a duration risk. 30 year bond carries risk in the sense that $ may go our of fashion. If int. rate rises, then LT bond holders are holding the bonds at a lower int. rate. In LT, the risk is postponed and govt has to pay the principal after 30 years and more importantly it cannot be cashed easily (at full value- only on maturity) and only after waiting 30 years. ST and LT are duration based. Thus 29.8 year old over of the 30 year bond can be a ST bond.
Due to liquidity and duration risk, the ST bonds offer a lower int (3.97%) vs. LT bonds ( 5.29%). This is called a YIELD curve. Generally up from ST bonds to LT bonds (remember duration risk). But what is Yield.
Let us give an example. I buy a ST Bond of Face Value 1000$ and it pays a coupon rate of 3%. I.E. it gives me an annual int of 3% or 30$ every year I hold it. But (mkt is liquid) I sense a good opportunity of earning 8%, so I dump these bonds at 800$ (even at a loss I have an opportunity with lower cash to make better money). Please note we are talking of billions of $s and the impact larger. Eg of 1000$ is only to understand. Thus a guy who buys the bond at $800 still gets 30$ interest. Thus 3%/800*1000=3.75% a higher int. on his investment. This is called Yield. The Yield rises on every fall in Bond prices. This is the fundamental of Bond investment.
As I said earlier the Yield curve is generally a rising curve from ST Bonds to LT bonds. But some time the curve is reversed i.e ST interest higher than LT interest. This is called an Inverted Yield Curve.
Why does this happen? Before that understand that for an Inverted Yield curve to happen the ST Interest Yield rate should be higher than LT Interest Yield rate. In bond parlance the YIELD is dropped though it actually is, and people refer as ST or Lt interest rate.
Coming back to the question- Why does this happen. Implies ST bonds are being dumped at a faster rate than LT bonds. This could be because ST holders are finding a) better asset class returns (eg AI) and dumping bonds to buy stocks of - Google, Meta, SYhynx, Samsung, TSCM etc) b) a big liquid call to pay dividends or redemption or margin calls c) Interest expectation to go lower -so sell ST and buy LT bonds to lock higher interest rate.
LT bonds can also fall a) interest rate expectation to go higher b) higher inflation c) higher govt deficit (causing confidence loss on bonds), d) Economic slow down e) rising oil prices.
Some economists and market watchers, consider the Inverted Yield curve as a sign of recession, primarily because of (d) above.
Banks profit by paying ST deposit rat and charging higher LT rates - Net Interest Margin or NIM
Recently, lot of AI companies went for Bonds to fund their AI forays and they paid a higher bond interest. While the bond boom in supply, instead of companies putting their cash, increased, these were absorbed by bond market. But higher interest in these bonds, made investor also want higher interest in long term bonds and thus the spike in long term bonds (only if govt. offers higher int, will investors put in bonds for safety.
Another reason is Bond investors look for Duration risk and if they find that 10-30 years from now they are not sure about the country (due to inflation risk, rising int. cost, country borrowing etc.), they abandon it going for short term treasury (91 days to 2 years).
All this have made the bond yield rise.
