All your bond market questions explained
The RBA has doubled the value of bonds it buys to $4 billion a day. Why is the RBA doing this, why is the bond market important, and what does it mean for stocks?
Jonathan ShapiroSenior reporter
The bond market has existed for hundreds of years and, while most of the time its machinations are uneventful, every now and again it reminds us it’s the boss of everything.
We are now living through one of those moments as a sharp rise in yields has forced us to rethink the risks and rewards in financial markets and put seemingly all-powerful central banks back on notice.
To help understand past, present and future bond market conniptions, here is an explainer that we will keep updated for the latest developments.
What is the bond market?
The bond market is arguably the oldest financial securities market on the planet. It is where governments, corporations and other lenders borrow money to finance their activities.
There are several parts to the bond market but two main ones: the government bond market and the credit market.
The former is the market for government securities, the latter is for private-sector borrowers who are riskier to lend money to and therefore have to pay a higher rate, or a credit spread.
Governments that borrow money in their own currency (like the United States, Australia and Japan) are considered risk free in that they can never really default.
Some bond market terms
There are a few key terms to understand when looking at the bond market.
The rate or yield is the market interest rate of a particular bond for a particular maturity. The Australian 10-year bond rate is around 1.61 per cent.
The maturity is the length of time until the bond is due to be repaid. Typically, the longer the maturity is, the higher the yield, as investors want to get paid a higher rate for lending for a longer term.
The price of the actual bond is hardly ever referenced as traders tend to focus on the yield as a measure of price. But it is important to remember that when the yield goes up, the price goes down (and vice versa). This reflects the fact that previous owners bought at a time when rates were lower and need to drop their price if the market rate is higher. The longer the maturity, the more sensitive the bond price is to moves in yields.
The spread refers to any difference in rates from one bond to another. Common spreads are the difference between the US and Australian 10-year rate, the difference between the two-year rate and the 10-year rate. The credit spread is between the government bond rate and a particular state or corporate bond and is a measure of the additional risk.
The yield curve is a plot of the rates for different maturities. A steep yield curve describes a market where long-term rates are high relative to short-term rates.
Key factors determining the bond rate
The government bond rate is the price at which a government must borrow money over various terms. For example, the three-year government rate is the cost of borrowing over three years, the five-year rate for five years etc.
In major bond markets, the rate for that year is the market’s best estimate as to the average future central bank cash rate setting at that time – or the term path of interest rates.
What determines those future rates depends on economic growth and therefore inflation expectations.
That is because central banks, such as the Reserve Bank have a mandate from the government to achieve full employment and inflation below a certain level.
So if inflation is expected to exceed that level in several years, the market will price in rising interest rates as it anticipates the central bank will lift interest rates to bring inflation rates back within its band of tolerance.
Other forces that influence bond rates
Those are fundamental factors. There are more technical factors that determine bond rates. An increase in supply as governments raise more money can put upward pressure on yields.
Sometimes selling from domestic and foreign buyers can move yields. At times bond dealers can become overwhelmed, resulting in short-term increases.
Another factor over the last decade is central bank buying. Before the global financial crisis, central banks set monetary policy through the short-term cash rate.
But once they hit zero, they resorted to attempting to influence longer term rates through purchasing longer term bonds.
Central banks also figured that by purchasing government bonds in the market they would inject the financial system with much-needed funds that would flow to the private sector.
Why the bond market matters
The bond market matters for several reasons. One, of course, is that it is the rate at which governments borrow. If the rate goes down, it becomes cheaper for governments to borrow money.
If the rate goes up, it becomes more expensive, and if governments have accumulated large stocks of debt, the budget becomes more sensitive to moves in borrowing costs.
But the bond market is also an important influence in other markets, from corporate bonds to stocks. The government bond rate sets the risk-free rate upon which all other investments are priced.
If the three-year bond rate is 1 per cent, it makes little sense to accept a similar rate for a three-year loan to a risky corporation at the same rate.
The effect on stocks, particularly tech
If an investor is buying shares in the major banks because they have a dividend yield of say 5 per cent, that yield is more attractive when the bond rate is 1 per cent and less attractive when the yield is 7 per cent.
Counter-intuitively, bond rates have the biggest influence on high-growth technology stocks. When bond rates rise, tech stocks tend to get hurt. This is for several reasons.
The first is that low bond rates imply low growth for the economy, which in turn forces investors to pay more for companies that are growing by other means, such as a disruptive product.
The other reason is that many tech companies aren’t profitable (yet) so the market is valuing their ability to make money well into the future. When bond rates are low, the cost of waiting for those profits to come is low.
But when rates rise, that cost goes up and those future profits are less valuable. Low rates also make it cheaper for companies to spend money to grow.
The effect of rising bond rates on stocks is nuanced. Some businesses, such as insurance companies, make more money when rates are high.
Also, the effect on stocks depends on the reason why bonds are rising. If the rate is going up because the market is expecting better economic growth in the future, that should bode well for future corporate profits.
The main reason they’re rising is because the market is anticipating that the economy will emerge from its pandemic slump far quicker and more robustly than previously anticipated.
That is due in part to vaccines, to government spending packages and to central banks’ willingness to keep short-term interest rates low.
To instil confidence among borrowers, central banks committed to not raise interest rates until there was clear evidence of higher inflation.
Now the bond market is testing that, but the central banks don’t want to blink. Sharply higher rates, however, suggest the market thinks that keeping short-term rates low will only amplify inflationary effects in the future.
Sharply rising bond rates are therefore providing an early test of the resolve of central banks to maintain low rates and the confidence of the equity market, as prices in some parts of the market are predicated on long-term rates staying low and central banks holding down borrowing costs for households in the short term.
What’s inflation got to do with it?
Over the past 10 years, rising bond yields have tended to subside as deflationary forces – such as an ageing population, a less unionised workforce and technological disruption – have exerted themselves.
But there is no doubt the market is on alert that there could be a sustained and meaningful outbreak of inflation in the future.
This is the challenge for central banks that want to stoke inflation – rising prices would reflect that workers are able to demand higher wages because the economy is at or near full employment.
Inflation also eats away at high government and household debt burdens as incomes rise relative to loan amounts. (This is how the post-war debt problem was solved).
But too much inflation in the form of rising prices for goods and services also destroys the purchasing power of workers and savers, eroding their wealth.
In March last year, the RBA committed to buying bonds to set the three-year bond rate at the same level as the cash rate.
This was to make businesses, banks and households comfortable to borrow money cheaply for three years. To achieve this they bought bonds when the rate moved away from its target.
In November, the Reserve Bank went further and pledged to buy $100 billion of longer term bonds with maturities of between five and 10 years. This was later extended to $200 billion.
The reason was to counter the fact that other central banks were aggressively buying bonds in their markets, forcing down yields relative to Australia.
That put upward pressure on the currency, which was unhelpful for the country’s exporters and was therefore adversely hurting growth.
But since the Reserve Bank began buying bonds, yields have increased materially, in line with global rates as the market explores the possibility of rate hikes. And even the three-year rate has drifted above the three-year target of 0.1 per cent.
The bond market has therefore been testing the Reserve Bank’s resolve and some speculate it may coax it into increasing its bond buying to achieve its policy objectives.
On March 1, the Reserve Bank did increase the amount of long-term bonds from $2 billion to $4 billion as a demonstration of its commitment to achieving its objectives.
One problem the Reserve Bank has tried to manage is to not overwhelm the bond market or be seen to provide direct government financing.
The Reserve Bank’s stance is that it sets borrowing costs in the economy to achieve its mandates but it doesn’t print money so the government of the day can spend to its heart’s content. The more bonds it buys, the harder it becomes to peddle that line.
We may find out more about the Reserve Bank’s thinking or its intentions to deal with rising bond rates at Tuesday’s meeting.
What is the takeaway?
The events of the past few weeks have shown that, despite decades of commentary lamenting central bank distortion, there is still an actual government bond market, and it is still very powerful.
For central banks, investors and policymakers it is an important reminder that there is no free lunch in markets.
There is a risk that too much stimulus – whether monetary or fiscal – could come at a cost. The bill could come sooner and be higher than we think.