Different uses of Bonds

 Bonds as a mode of financing

 

When a company needs to expand its business, there are three ways to fund the expansion

1) Debt

2) Equity

3) Retained profits also known as Internal accruals .

 

Similarly Govt expenditures can be funded primarily in 3 ways.

1)Debt

2) Tax

3) Expanding monetary base (loosely printing money, you should have heard in business channels. Not applicable for countries like Greece. Why?)

 

For both corporates and Govt bond act as an important debt instrument for financing.

 

Bond as a collateral

 

Bonds with good credit rating can be used as collateral to borrow money in Repos. Repos and reverse repos are short term money market instrument .Central banks use Repos and Reverse repos in the financial market to keep the short term interest rates within its target range. Govt bonds is one of the important collaterals for such transactions. For example , if a bank has 100 million dollar Govt bonds , they can pledge bonds and can borrow  upto 99 million dollar at the repo rate from Fed if the haircut is 1%.

 

Bond Yields as Macro Indicator

 

While the short term interest rates are under the control of central banks, long term interest rates are market determined, though short term rates has an impact on it. Often 10 year bond yields (rate of returns ) can serve as an indicator for the state of the economy.

 In India, a softening 10 Y Govt bond yields could signal lower inflation expectation and lower interest rates which is a benign sign for Indian macro. (In 2015)

 On the contrary, a Strong dollar and softening of US 10Y yields signal that  investors sense risk in other markets and invest heavily in US Govt bonds, which is not a good sign for global macro.(During 2015)

 5Y movements of Greece 10 Y bond indicates the yield spikes whenever the fear and the possibility of the default risk increased in the market.(During 2015)

 

Spread and Exchange rate Expectation

 Interest rate or yield difference is normally called as spread. Consider 2 strong economies US and Germany whose risk of default is quite minimum. If their Govt bonds offer different yields, it can give an arbitrage opportunity to an investor in the form of carry trade, if exchange rate is not changed .People in Germany can invest in US bonds and get higher returns rather than investing in pricey German bunds. But investors still invest in Germany as the investors expect , the US dollar to depreciate at the spread rate over a 10 Y period. The yield differentials is a measure of exchange rate expectation in the market.

 Bond as investment option

 Fixed rate bonds give you fixed income at specified intervals in terms of coupon (interest). But the price of the bonds can vary according to market conditions hence you can make capital gains or lose. Bonds are also risky instruments, though bond market is less volatile than stock market. In bonds ,in downward interest rate cycle, you make capital gains and in the upward interest cycle you make capital loss.