Here are some statistics that I got from the New Zealand Herald that show investment in the stockmarket has been outperforming 10 year government bonds. The table below shows Bond rates v stockmarket dividend yields over the last 12 months to May 2013. Investors seem to be more comfortable about European economies as they don’t have to offer higher yields on Bonds to attract investors. The countries that have seen a significant drop in rates are Greece, Portugal, Spain and Ireland. Also note the very low interest rates which threatens a liquidity trap. This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.
Here is a powerpoint on “Keynesian and Monetarist Theory” that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:
- Cicular Flow and the Multiplier
- Diagrammatic Representation of Multiplier and Accelerator
- Quantity Theory of Money
- Demand for Money – Liquidity Preference
- Defaltionary and Inflationary Gap
- Extreme Monetarist and Extreme Keynesian
- Summary Table of “Keynesian and Monetarist”
- Essay Questions with suggested answers.
Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote
I quite like this graphic from the WSJ showing bond yields before and after the bailout. Remember that a yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Say an American Treasury (government) bond with an 8.125% coupon rate payable at $100 (par value) was trading at $103. In return for the $103 outlay, a buyer would receive the coupon payment of $8.125 (that’s 8.125/103 = 7.8% current yield). What usually holds is that:
Discount rate (price below par) – Coupon Rate less than Current Yield
Premium rate (price above par) – Coupon Rate greater than current Yield
Par Value (price = par) – Coupon Rate = Current Yield
So let’s apply this to the graph below. Because the risk associated with buying Greek Bonds, the trading price is very low which means that its current yield is correspondingly high. Notice that the current yield on Irish bonds has started to fall as the market believes its austerity measures – including dropping the minimum wage – is working.
Have had a few discussions with my classes about the bond market and how the issue of government bonds are so vital to fund their current spending. There is also an earlier post on Bonds – Bond Prices and Interest Rates
Bonds are essentially a form of debt. Companies and Governments sell bonds to raise money, promising to pay those who buy the bonds a return on their investment, which usually comes in the form of interest payments. The term, or duration, of a bond is important in understanding its risk. A ten-year government bond promises the buyer that it will return the original investment of the bond, plus pay a fixed interest rate, or coupon. So, say you wanted to buy a $1,000 in ten-year bonds (in the US $1,000 is the minimum purchase amount). You would expect to get an annual return which in recent years has been about 4 – 5%, plus the original $1,000 at the end of ten years. Since the interest rate is set for life investors are betting that the return they get is greater than inflation.
Once a bond has been issued they can be traded like any other security. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity – and these are the fears which have been pushing down Irish bond prices.
European Countries and Bond Yields
Because of the poor financial condition that many Europen countries are in they have had to issue bonds in order to raise finance. However because of the risk associated with the loan they have had to offer much higher yields than is normally the case. Take for instance Greece and Ireland – they have had to offer returns of 11.8% and 9.1 respectively – see below.
With the last posting on the bond market I thought it appropriate to continue this theme with the expression “Getting a Haircut”. In order to raise finance governments issue sovereign bonds and the total amount owed to the holders of the sovereign bonds is called sovereign debt.
Argentina – 2001
In 2001 an economic crisis in Argentina meant that the government could no longer service its debts and decided to default. Then in 2004 it offered to swap its defaulted bonds, worth $81 billion, for new ones worth only $35 billion. The bonds were held by financial institutions at home and abroad, as well as by many individual investors in Japan and Europe. Most accepted the offer and thus lost around half their money – know as ‘taking a haircut’. Others, who held around $20 billion worth refused the deal. As a result Argentina’s name remains mud in interenational capital markets and has had to rely on other governments such as Venezuela, who by mid-2008 had bought $7 billion in Argentinean bonds, the latest of which had to pay interest rates of 15%.
Ireland – 2010?
Ireland’s sovereign debt crisis has been the focus of talks between the biggest EU economies meeting at the G20 summit in the South Korean capital, Seoul. The relentless pressure on Irish sovereign bonds has seen the yield on Ireland’s ten-year government bond nearing 9% on November 10th, 6.2 percentage points above the yield on safe German Bunds (see chart); Portugal’s topped 7%. There is real concern that unless there is a major EU bailout plan Ireland could go bankrupt. The majority of global investors predict Ireland will default on its sovereign debt, showing that weeks of efforts by the government of the onetime “Celtic Tiger” haven’t allayed concerns about its creditworthiness.
This topic normally comes up in A2 as a multiple-choice question or as part of an essay on the money markets. It is something that my A2 students have found difficult to understand. Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑
Say you buy a 10 year Treasury Bond is issued for $1,000 for five years with a coupon (interest rate) of 5% per annum, meaning it pays $50 per year in interest. You decide to sell your Bond on the secondary market to get your money back. However, the RBNZ has raised interest rates and 10 year Treasury Bonds are being issued with a 7% coupon rate (interest rate). Therefore these new Bonds are sold at $1,000 and pay $70 per year in interest. If you now want to sell your Bond you will have lower its price to around $714. Your Bond still pays $50 per year in interest, as stipulated in the Bond’s contract. However, the new owner buys it for $714 and receives $50 per year in interest, which calculates to a 7% interest rate (50÷0.07 = 714). The actual coupon payment has not changed ($50) but the ratio of that coupon payment to the price has changed.