Series: The Market of Their Own - A Guide to Bond Market

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The Market of Their Own | A Guide to Bond Market (Intro)

This entry is part 1 of 2 in the series The Market of Their Own - A Guide to Bond Market
Bond, or in more sophisticated way of expression, Fixed Income can be a ‘paradoxical’ financial instrument in some sense. The reason why I say as ‘paradoxical’ is, generally the bond market suffers from the rise of market interest rates when overall economy is booming, while bond investors are making profits when the economy is suffering. Therefore, most of market participants in bond market looks the financial market in an opposite side of the stock investors, and bond investors make money when majority of stock investors are losing. Also, as most of major market participants are institutional investors and direct participations from individual investors are quite limited, this market is not well known and not much interested by most of people out of this world.
Let’s take a look at the chart below. The data was published by the Bank of International Settlements, or BIS in short, and the numbers are total ‘International Debt Securities’ outstanding at the end of 2016, in billion US dollars. Total number was US$ 21.288 trillion. Isn’t this huge?
More importantly, the chart and numbers above are just counting so called ‘International Debt Securities’. If we count ‘Domestic Debt Securities’, the number should be even larger than these.
For example, only top 3 countries in terms of total debt outstanding, United States, Japan and China numbers look like this.
As you can see, only US’s total debt outstanding is US$ 38.17 trillion, which is even larger than total international debt securities. Japan follows as US$ 11.965 trillion and China is next to be US$ 9.409 trillion. Note that, only these top 3 debt issuing countries count for US$ 59.544 trillion outstanding debt, really huge size market.
However, how many people know about this market and closely monitor what is going on there? How many people do you think fully understand what happened in 2007-2008 subprime crisis? How many people know how subprime mortgages drove Lehman Brothers to bankrupt? Anyone understands ABS (Asset Backed Securities) CDOs (Collateralised Debt Obligation) triggered those events? Do you know what exactly happened in 1997 Asian crisis to most of Asian developing countries?
This is why the bond market is so important for overall economy and for all of us. The things that you have never heard about is impacting on your job security, housing prices that you own, depreciations of your personal belongings and many other bad things on yourself. But still this market is very closed market, and that’s why I named this series as ‘The Market of Their Own”.
Hereby, I am trying to help people understand very basic concepts of bonds, bond markets, and some other markets related to bond markets. These wouldn’t be enough to fully understand the market and various fixed income products, but I hope this can be a good base of your further studies and understandings.
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Is Bond difficult to Understand?

This entry is part 2 of 2 in the series The Market of Their Own - A Guide to Bond Market

Many people think bond, or the fixed income is too difficult to understand so not to invest. Even people in financial industry including equity specialists think bond is something different and something that they don’t want to try to understand. Is bond really difficult to understand?

If you ask my opinion, quick answer is “No”. And also “Yes”, I think it is more difficult to be a bond professional than an equity professional.

What do I mean here?

As I mentioned before, “Fixed Income can be a ‘paradoxical’ financial instrument in some sense.” Well, I believe bond is easier to understand, but being a bond professional is quite challenging. But why?

Bond is simple. It is just a contract between the person who lends the money and the borrower. And the contract says, how much money the lender lends, how much the interest the borrower should pay, and when to pay-off the principal. Plus, there will be some covenants that borrowers should follow. As a lender, the only thing that he or she should care is whether the borrower can pay the interest and repay the principal at the end of maturity. Lenders don’t need to understand other details or situations about the borrower unless the information is not directly related to repayment of the debt. And the maturity is mostly limited as few years (there are some bonds without maturity, e.g.. Perpetual Bonds). In other words, the lender doesn’t need to acquire too much information about the deal and the borrower, and buying bond is an investment for relatively “expectable” future of the borrowers.

Meanwhile, equity investment is different. Equity investors, or stock investors are getting dividends in the mean time but the dividends are based on the performance of the companies. Compare to expect whether the company can pay the preset interests in that year, estimating the profitability of the company should be much more difficult. Therefore, if someone wants to estimate the dividend income of the year, the information that the person need to gather would be overwhelming. In my thoughts, I don’t think it is possible for a stock investor to closely estimate even current year’s dividend unless the payment is nil. As we all know, the environment where each company participates is usually not that stable nor predictable. How the competitors are doing, launching of new products, market recession, unfavourable movement of foreign exchange rates, price movements of raw materials and increase/decrease of production/operation costs are just a few to mention. Changes of management, some directors’ embezzlement, various unexpected losses, changes of regulations, sudden jumps in tariff, appearance of new substitute… How can we foresee all of these potential events that will affect the performance of the company? Making things worse, the company can even change its dividend pay-out policy anytime.

How about the price of stocks? One can argue that most of stock investors are not buying stocks for dividends but for “capital gains”, which means the profit caused by price difference.

Again, in my thought, the stock prices cannot be calculated by those financial models. One of the most important assumptions to absolutely value a stock price is “going concern assumption”, which means the life of the company is unlimited. This doesn’t make sense as it is, and also because of this, it makes predicting stock price as somewhat unexplored territory. If you cannot forecast even current year’s dividends, how can you forecast future dividends, cash flows and profitabilities of the company for unlimited life of the company?

Compare to this complexity and unpredictability of stocks, the cash flow of bond is much more forecastable and also it’s about predictions of foreseeable future. An investor who bought and holds bond issued by A company will get expected interests and principal unless the company A is bankrupted before the maturity of the bond contract. Isn’t this much easier to predict than the price movement of stocks or dividends payouts? For example, predicting whether GE will get bankrupted in 3 years or not should be much easier than forecasting current year’s dividend of each GE share and dividends & profitability of the company going forward, shouldn’t it?

Yes, as I mentioned from the beginning, bond is not difficult to understand, but simple. As long as the issuer pays interests and principals on time and unless the company is not bankrupted nor about to get bankrupted soon, the investor will get fixed & expected cash flow without much consideration of others.

However, paradoxically, as it is investment of more predictable and about expectable future, the things in bond market gets more complex and difficult. The more predictable means the more mathematics and statistics get involved to foresee the cash flows, and this makes being a bond professional tend to get more headaches than being an equity professional. The people in bond markets should do more calculations, mathematics and statistical analyses to do their own work, be better with numbers, and also be more logical.