Question: How does central bank’s monopoly affects the interest rates?
Answer: The central bank or Fed’s monopoly over liquidity creation helps in setting up overnight rates. But not the rates for longer maturities. As longer maturities rates influenced by the aggregated demand.
Question: Which all factor contributes the long term maturity interest rates?
Answer: This is mainly driven by the following things - Business cycle - Inflation - Savings rates - Government deficits Above are not in the hands of Fed or Central Bank.
THE YIELD CURVE With this fundamental background in mind, let’s think about the yield-curve and, crucially for corporate bonds, the spread curve. The yield-curve represents the relationship, at any particular point in time, between yields on bonds and their remaining maturities. Yield-curves are typically presented for benchmark government bonds, so that the curve reflects “pure� interest rate factors and is not confused with credit risk, liquidity, and other factors.11 Fundamentally, the shape of the yield-curve is determined by:
• Expectations on the part of market participants as to future (short-term) interest rates
• Expectations as to inflation over the period covered by the bond
• Interactions between supply and demand factors pertaining to particular points (maturities) on the curve plus risk aversion
• Interest rate volatility and bond convexity12
The first two factors can be said to be primary, as they explain, in a quantitative sense, the bulk of the yield-curve; the last two factors are secondary. The state of the macro-economy, its point of cyclicality, and expectations thereof, find expression in the primary factors. This is where the above analysis will suit us perfectly. So, let’s examine the stylized yield-curve contained in Exhibit 5–1. It is upward sloping, a curve shape typical of an economy in the early days of economic expansion. The “yield� column contains long-term interest rates, the focus of yield-curves. Each yield equals the average of the “forward� rates up until that year, contained in the second column.13 Forward rates may be thought of as market participants’ expectations for the one-year interest rates to obtain during that future year. Bond yields are “nominal,� in that they equal the sum of the real interest rate and the market’s view of inflation over the term of the bond. Hence, the next two columns present these ingredients for each future year. Each pair represents the market’s expectation for the real interest rate and inflation rate, respectively, for that particular year, and sum to the forward rate for that year.14
EXHIBIT 5–1 Components of Corporate Bond Yields for 10-Year Yield-Curve
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Let’s examine the entries of Exhibit 5–1, and the resultant yield-curve, in the context of macro-economic dynamics. Keep in mind that the interest rates in the columns under discussion thus far are for Treasury securities, i.e., they are (default) risk-free rates. The exhibit paints a stylized picture of a weak economy, but one expected to begin its rebound within a year. Consider the (nominal) forward rate column, which equals the sum of the next two columns, as just stated. In the current year (year 1), with economic activity restrained, labor and commodity markets have a great deal of slack, hence inflation is quite tame at 1%. The central bank has added liquidity, pushing the nominal one-year rate down to 2%. Taken together, this means that the real interest rate is 1%. The Fed’s hope is that the low rates will make borrowing and spending more attractive. Market participants, in this scenario, believe that the policy will work. When economic activity picks up next year, if expectations are borne out, liquidity demands will rise concomitantly, the central bank will be less accommodating, and short-term real rates will increase as shown in Exhibit 5–1, from 1% to 3%.
Take particular notice of the expected inflation rate column in the exhibit. Even though a pickup in the economy is expected for next year, inflation is not expected to accelerate. True, there is an empirical regularity of inflation rising and falling, more or less, together with aggregate economic activity. But it is also generally true that this relationship is lagged. That is, price pressures tend to mount only after the economy has strengthened for a while, not concurrently with the start of the strengthening. Our stylized scenario assumes that market participants expect inflation to accelerate three years from now. Thus, even though real rates are anticipated to rise only moderately then—by a half percent in year 4—as the economy continues its expansion, the higher expected inflation term interacts with the real forward rate to produce a more sizable 1% jump in the nominal forward rate.
For the subsequent few years, expectations are that both real interest rates and inflation will increase. Real interest rates will rise because the expanding economy becomes more credit demanding; inflation will increase because resources are being used more intensively, thus forcing up their prices. For year 8, market participants foresee a decline in real rates, reflecting their view of the expansion coming to an end. Yet they believe that inflation will continue to accelerate, again reflecting its lagged response to the economy’s dynamics. This prevents the forward rate from declining. It is not until year 10 that inflation, with a couple of years of economic weakness behind it, is expected to turn. The forward rate then falls. The yield-curve’s shape, though, remains upward sloping throughout.15
THE SPREAD CURVE The sixth column contains the credit-spread for the relevant future year. Credit-spreads are the investor’s compensation for risk of default, hence are added to the risk-free government bond rate to produce corporate bond yields.16 The greater the risk of default, the wider the spread. Which corporate bonds? As this is a stylized analysis, we’ll assume it refers to an average of various grade credits for each maturity. When analyzing credit-spreads over maturities, two factors come into play.
1. Cyclical nature of corporate profits. As explained at the outset, expanding economic activity is usually associated with increasing corporate profits, and narrowing spreads. The expectations set underlying the yield-curve in Exhibit 5–1 is one of a rebounding and then accelerating economy. Hence, along with expectations of rising risk-free interest rates, due to increasing credit demand, come expectations of narrowing corporate credit-spreads, reflecting ever greater ability of firms to service their debt. With inflation expected to gather steam in later years, however, the worry is that wages and material costs start to accelerate, perhaps faster than output prices, hurting corporate profitability and widening spreads for further-out years.
2. Time factor in credit risk. All else the same, the longer the maturity of a corporate bond, the greater the likelihood of default. Why? The longer the time frame, the more chances of negative events occurring, which reduce profits and, as the events compound, lead to default. True, the chances of positive events increase as well. But remember, bondholders do not gain from positive shocks to corporate earnings (as equity owners do). They stand only to lose from negative events. Hence, the longer the maturity, the greater the default risk, and the wider the credit-spread.
In short, during expansionary periods, or expectations of such, these two factors are typically counteractive elements in the corporate yield-spread curve—adding years to the (noninflationary) expansion narrows credit-spreads, while lengthening maturities widens them. The corporate yield-curve presented in Exhibit 5–1 assumes the cyclical factor dominates in the near years. For later years, the combination of the time factor plus expectations of wage and materials price inflation does the reverse. If, instead, the economy were in the throes of a contraction, the factors would typically be re-enforcing. Corporate credit-spreads would widen substantially with maturity, even for the early years. Indeed, a result is that in some situations the government bond yield-curve may be downward sloping, reflective of overall macro-economic weakness and expectations of such, yet the corporate curve slopes upward.
CYCLICALITY OF CREDIT SPREADS In the previous section we examined a stylized picture of yields and credit-spreads over a range of maturities for a particular point in time (i.e., a corporate bond yield-curve). Here we’ll look at how corporate yields and spreads tend to behave dynamically over the business cycle. We consider both high-grade and high-yield corporates.
The discussion revolves around the information in Exhibit 5–2, which contains long-term, stylized averages of bond yields. The first column describes the state of macro-economic activity relative to the country’s potential, as explained above. Let’s begin with Treasuries, the yields of which anchor the rest. Recall that government bond interest rates, lacking a credit risk factor, contain only two components: a base interest rate, known as the real rate, plus a premium for the inflation rate expected over the life of the bond. The line labeled “potential� in Exhibit 5–2 refers to an economy operating with a GDP gap just above zero, a sort of neutral situation. In such an environment, we can assume a ballpark average real rate of 3%. A midpoint 3% rate for inflation is reasonable as well, since we need to look at time periods longer than just recent experience. Hence, the Treasury (nominal) yield is 6%.17 The “weak� line denotes the economy operating substantially below its potential. This is not necessarily a recession (a contracting economy), but recessionary periods are included in the average here. Real interest rates are lower in this stage of the business cycle, reflecting both weak credit demand and ample liquidity supplied by the central bank. Inflation tends to be more volatile than real interest rates. Hence this entry assumes a real rate of 2% and inflation of 1%, or a Treasury yield of 3%. Conversely, the economy operating above potential—the line labeled “strong�—results in higher inflation, say 5%. Credit demand is more robust, which, together with the Federal Reserve holding back on liquidity growth to prevent further inflation, pushes the real rate up to 4%, for a total of 9%. We’ll get to the last line later.
EXHIBIT 5–2 Yields over Various Stages of the Business Cycle
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The entries in the investment grade corporate bond column equal the Treasury yield (real interest rate plus inflation) plus a spread for credit risk. That spread, in turn, reflects a host of fundamental factors including the makeup of the firm’s balance sheet, characteristics of the particular industry, company and management history, and from the investors’ side, their degree of risk aversion. In terms of our macro-economic focus, most important is the firm’s expected earnings. Each individual firm’s sensitivity to the stage of the business cycle is unique. However, considering the high-grade sector overall, corporate profits, as we saw above, are certainly positively related to macro-economic activity. Let’s begin with the middle line again. A midrange figure for credit-spreads, associated with the economy operating near its potential, is 1.5%, hence the 7.5% entry. Weak economic activity reduces average corporate profits, raising default risk and with it default spreads, from 1.5% to 2.5%, producing the 5.5% figure. At the other end, with macro-economic activity above the country’s potential, spreads tighten to 1%, reflecting outsized corporate profits, which adds up to 10%. Credit-spreads, in other words, are counter-cyclical—they contract during an economic expansion, and expand during an economic contraction. This is a very important conclusion because, as explained just above, Treasury interest rates are pro-cyclical. Thus, the two components of corporate bond yields—Treasury rates and credit-spreads—offset each other over the course of the business cycle. Another way to say this is that corporate bond yields exhibit less volatility—on an absolute or a relative basis—than Treasury yields, as is clear from the first three lines of the table. Nevertheless, their correlation is positive. Notice further that weaker than average corporate earnings add a full percent to average credit-spreads (compared to the potential line), whereas stronger than average earnings subtracts only half a percent. Why the lack of symmetry? Simple: the most spreads can fall to is zero, while upside is limited only by actual default. To summarize:
• The yields on high-grade corporate and government bonds exhibit positive correlation over stages of the business cycle.
• High-grade corporate bond yields are less volatile than their Treasury counterparts.
Turn now to the final column. Credit-spreads for high-yield bonds preserve the cyclical pattern found in the high-grade column—widening during recessions, tightening in expansions. But the degree of cyclical sensitivity is so high for the speculative bond sector that it perverts the overall relationship with Treasuries. Consider: the “high-yield� in speculative grade bonds is due, of course, to their very wide credit-spreads over credit-riskless government bonds. The wide spreads, in turn, reflect substantial risk of default, largely the result of greater leverage in the firms’ balance sheets and, compared to the high-grade sector, more volatile industries (e.g., manufacturing as opposed to utilities). The sector’s earnings, therefore, are acutely susceptible to movements in aggregate demand in the macroeconomy. The effect of this earnings cyclicality on credit-spreads is augmented by the dynamics of investors’ risk appetites. Risk aversion tends to decrease during expansions, increase in recessions, reflecting the natural correlation between income/wealth and willingness to take risk. Together, these factors tend to make spreads on high-yield bonds sharply sensitive to the business cycle. This combination of high-yield and greater sensitivity to the business cycle has two major implications for investment portfolios. Compare high-yield spreads (column 4 less column 2) with high-grade spreads (column 3 less column 2). The former exhibits much greater volatility. Here lies the perverse relationship. Both spreads are counter-cyclical, as is clear from Exhibit 5–2. But the proportion of a high-yield bond’s interest rate due to the credit-spread component is of an order of magnitude greater than it is for high-grade interest rates. For example, in line 2, the highgrade spread accounts for one fifth (1.5/7.5) of the total rate, whereas the high-yield spread accounts for nearly one half (5/11). Hence, any movement in Treasury rates over the business cycle is swamped by movements in the high-yield spread. This negates the correlation between Treasury bond and high-yield bond interest rates. We can conclude:
• Not only do speculative grade bonds present higher yields than investment grade, their credit-spreads are more volatile over the economy’s business cycle.18
• Whereas investment grade bond yields exhibit positive correlation with those of Treasury bonds, the larger role of credit-spreads in speculative grade bonds erases any meaningful correlation with Treasury yields.19
STAGFLATION There have been few episodes of stagflation in the modern U.S. economy, but they are not forgotten. Stagflation denotes a period of macro-economic stagnation accompanied by inflation. Stagnation describes an economy operating well below its potential, hence with substantial unemployment. It does not necessarily qualify as a recession, as economic activity is not contracting further, though it may likely follow a period of contraction. Yet, despite the macro-economic weakness, inflation is relatively high. A situation of stagflation can be the result of a period of rising commodity (typically oil) prices, and/or inflation expectations which have become embedded in the economy. Stagflation is devastating for corporate bonds.20 Profits are down, due to weak economic activity. Firms are not adding to their capacity, as inflation creates uncertainty regarding future product demand. This combination of inflation, uncertainty, and economic lethargy causes risk premiums on corporate debt to widen dramatically, as shown in the last line of Exhibit 5–2. A sharp eye will notice the qualitative difference between the stagflation line and the others in the exhibit. Using the potential line as the benchmark, observe, as we have before, that in both the weak and strong periods, the Treasury rate and the risk premia (for both high-grade and high-yield corporate) move in opposite directions. The dynamics are starkly different under a regime of stagflation. Treasury rates increase, due to their inflation component. Yet, at the same time, spreads widen considerably. In short, credit-spread widening exacerbates corporate yield increases during periods of stagflation.
CORRELATION AND CAPITAL STRUCTURE Our final topic relates not to the impact of macro-economic shifts on corporate bonds as a whole (or on corporate bond sectors). Rather, we examine the differential effects of macro dynamics on corporate bonds situated at different points on the issuer’s capital structure. Some bonds are secured by collateral (effectively making them more senior in the firm’s capital structure), while others are uncollateralized (known as debentures, hence are subordinated, or junior). The role of collateral in reducing the credit risk of corporate bonds is intimately wrapped up with the concept of correlation. This is not a well understood concept. But it is crucial in correctly analyzing the relative values of collateralized vs. uncollateralized bonds, particularly in a macroeconomic context.21
Suppose a retail chain has issued bonds, half of them senior, half subordinated. The company owns a major building within which lies its flagship store. The building serves as collateral for the senior debt, hence that debt is secured. In the event of default, the keys to the building are handed over to the bondholders. The junior, or subordinated, debt is uncollateralized.22 Exhibit 5–3 examines the four possible scenarios facing the firm, and their implications for the two classes of bondholders.
EXHIBIT 5–3 Possible Scenarios for Retail Chain Bond Issuer (√:survival; ×:default)
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A“√� mark denotes survival of the particular entity or asset (at least until the bonds mature); an “×� represents lack of survival. Clearly, the four scenarios exhaust all possibilities. We will make the simple assumption that the functioning retail business on its own can pay off both classes of bondholders, and the real estate, if necessary, can be sold to pay off the senior debt. For our purposes no probabilities need be associated with the possible outcomes. Still, from a macroeconomic perspective, Scenario I is the most likely. If the firm’s retail business survives, both the senior and junior debt will be paid in full. The fact that the building has retained its value is certainly a good thing for the firm, but in this situation presents no additional benefit to any of the bondholders.
If the firm’s core retail business falters, and the firm defaults on its debt, the senior secured debt holders will look to the collateral (assuming the firm’s other assets have already been deployed to pay off other creditors standing in line before bondholders, such as the government looking to collect any back taxes) for repayment. In Scenario II, the building has held up, so the senior debt is paid in full, which was the point of the collateral in the first place. The subordinated claimants go home empty handed (the building’s market value is only enough to pay of the senior debt).
Scenario III represents the reverse, and less common, situation—the firm’s business is doing fine, at least enough to cover its obligations to both bondholders, but the building has lost value. The decline in real estate, in this case, is effectively irrelevant to the bond positions.
Finally, Scenario IV has the retail business failing and the real estate depreciating to the point where the senior debt holders cannot be repaid in full. Not very likely, but quite possible (the recent recession serving as a dramatic example).
Let’s step back and take a closer look at the senior, secured bondholders’ position. They will only lose under Scenario IV, as they draw their payment from either the retail business or the real estate. Looked at another way, they will only lose if both businesses, or assets, fail to cover their claim. Now think about an extreme case. What if the real estate and retail business are perfectly negatively correlated? In that case Scenario IV could never unfold. The senior debt holders could never lose! Said differently, their only possibility of loss reflects the extent that the building and the firm’s business show any degree of positive correlation, making Scenario IV at least possible. Indeed, the more highly correlated, the more risky their position, as this would increase the chances of Scenario IV unfolding.23
Before we consider the other theoretical extreme—the retail business and the real estate are perfectly positively correlated—let’s look at risk from the subordinated bondholders’ perspective. If the company defaults, due to the retail business’s deterioration, the junior bondholders will not be looking to the real estate for payment; the building secures the senior debt holders, and that’s it. Both scenarios II and IV are what these lenders worry about. In other words, the second column in Exhibit 5–3 is irrelevant to them. If the two businesses are perfectly negatively correlated, they still lose in Scenario II; in contrast to the senior, the junior bond holders do not benefit from the negative correlation.24
Now consider the opposite extreme—the firm’s retail selling business is perfectly positively correlated with the value of the building serving as collateral. In this case, only Scenarios I and IV can occur. In I, both classes of bondholders are paid; in IV, neither. Under perfectly positive correlation, therefore, there is no added benefit to being senior/secured. Another way to say the same thing is, the more positively correlated the collateral is to the core business of the bond issuer, the less valuable the collateral as an enhancement to being senior in the company’s capital structure. And the less valuable, the less it should cost to be senior; that is, the less they should give up in yield. In bond terminology, the greater the correlation, the narrower the difference in interest rates, or spread, between the senior and junior debt holders.
Here, then, is the straightforward macro-economic implication. Business cycles are characterized by their breadth as well as depth. A downturn can be quite severe, but it may bypass some sectors of the economy. Real estate, for example, may hold up as aggregate demand falters, i.e., it exhibits weak correlation with the rest of the economy. In that case, collateralization is useful, and secured bonds are not as negatively impacted (their credit-spreads widen modestly). The 2008–2009 downturn was different. It was not only sharp, but broad. Indeed, real estate suffered relatively more than the economy as a whole. Collateralization proved less beneficial, which was reflected in dramatic corporate bond spread widening across all classes.25
KEY POINTS • The ability of firms to service their debt is, in the aggregate, dependent upon the level of macro-economic activity. Generally, higher GDP levels are associated with greater income and profits. Conversely, recessionary GDP levels reduce the ability of firms to service debt, hence increase the risk of default. Understanding the drivers of the economy, therefore, are crucial to investing in corporate bonds.
• Corporate bond yields are the sum of the Treasury rate plus a default risk premium. In turn, the former includes a real interest rate and a premium for expected inflation. The Treasury yield-curve reflects, fundamentally, investors’ expectations regarding the course of the business cycle and its interactions with inflation. Inflation in the short run is a function of the GDP “gap;� in the long run it is a monetary phenomenon. The monetary authority can “control� short-term (interbank) rates through its near monopoly on liquidity creation, but in the long run it cannot deviate significantly from the economy’s equilibrium interest rate.
• Spreads on corporate debt are determined by overall economic dynamics, sector sensitivity to the business cycle and firm-specific factors such as leverage. Investor risk appetites play an important role as well, especially in the high-yield sector. The “spread curve� reflects two, sometimes competing, factors. The longer the maturity, the greater the chance of a negative event. At the beginning of a macro-economic rebound, the longer the time frame, the greater the chance of the economy, hence companies, gaining earnings momentum.
• High-grade corporate bond yields are less volatile than Treasury yields over a complete business cycle because credit-spreads are counter-cyclical, whereas the risk-free rate tends to be cyclical. Still, investment grade bond yields show positive correlation with Treasury rates. High-yield bonds may show greater volatility, depending on the sharpness of the cycle, and by nature present little correlation with Treasuries.
• Corporate bonds of the same issuer can react differently to macro-economic dynamics, depending on their positions in the firm’s capital structure. Senior bonds, particularly those secured with real estate, are hurt only if both the firm’s business (producing the cash-flow) and the collateral are insufficient to pay off the debt. Hence, the more negatively correlated the two, the less risk faced by the senior debt holders (and the narrower their required credit-spread). Subordinated, uncollateralized bond holders gain little from negative correlation, as they do not look to the collateral for payment.
Question: What is the Yield in Fixed Income Security means?
Answer: Actual return received by holding the Bond it could be more or less than the coupon. Depend on the price of the bond and many other factors.
Question: What do you mean by a price of the bond?
Answer: Price of a bond represent the present value of expected cash flow. To calculate the price of the bond a comparable security’s yield is used which is available in the market and with that also interest rate or discount rate would be used.