The bond market is making a comeback with the yields it is offering. But how does it work?
A market left a little on the sidelines in recent years given the very poor yield component. The crisis in Europe, the low inflation of recent years and the enormous influence of central banks, have caused a real depression of this market which is now instead at the center of the attention of many operators due to the possibilities it offers in the long term, with the return of returns and a certain volatility that is coveted by trading professionals in this sector.
In this article we see how bonds work and make some comparisons between the current situation and the recent history of the last 10 years of this market that right now returns to being the protagonist of long-term investment decisions
Bonds, what are they and what are they for
When we hear about bonds, we can only think of the famous government bond, be it 1 year (the infamous Bot) or the multi-year bonds also called BTP (Multi-year Treasury Bills), but what are they? Basically, the word itself says it, a bond is a credit security where the creditor (we) lend money to a future debtor (in this case the State) who is in fact obliged to periodically give us a rate interest, a yield (called "coupon") and to return the capital loaned to us at the expiry of the contract. To make a very simple example, let’s assume the existence of a 5-year government bond with a return of 3%.
It means that, by buying the security in question, the State will have to pay us 3% per year for 5 years and then return all the invested capital to us at the end of the 5 years, a very simple mechanism. These securities are, at least on a practical level, like loans: in this case the State finances itself for 5 years and recognizes a percentage for this loan, as happens with loans between credit institutions and debtors, although obviously in a different manner. Conceptually, the principle remains the same, the economic principle according to which a capital loaned in a given period of time must have a return mainly due to the revaluation of prices, what we now call inflation.
Without apparently wanting to, we have already said what is the first factor that affects the return of government bonds, namely inflation. It should be noted that inflation is not a decisive factor in the return of government bonds alone but of all listed financial assets, so be careful to isolate this factor only from the bond market. Bonds therefore serve to finance whoever "issues" these bonds and rightly so the issuer will have to recognize a "risk premium", ie a return, to whoever lends money. A primordial mechanism that is the basis of investments and economic-financial growth of each individual state.
Bonds as an investment
In a nutshell, bonds are seen as one of the instruments with the lowest risk, all of which is mainly due to the risk of the issuer. Furthermore, issuer risk is also partly represented by the return it offers, since the more the issuer offers yield, the more it needs money and the more risky it is, by definition. Let’s take real cases to better understand what has been said: until recently there was talk of the BTP-Bund spread, where the Bund is the ten-year bond of Germany, the most virtuous country in Europe.
Why was the spread (the yield differential) calculated precisely on the Bunds? Simple, because the yield of the Bund was close to 0%, in practice having Bunds was like having money in a safe, in fact there was no risk and if there is no risk there is no return. What if we took Venezuelan government bonds instead? The ten-year yield on these bonds is around 45%, an insane return that paradoxically few buy due to the very high country risk. These two extreme examples are helpful in helping you understand the association between risk and reward.
At the level of investments the truth is obviously in the middle, that is, buying securities with yields close to 0% could be an unwise choice, just as it is unwise to buy very high risk securities, the best choice is to consider a good trade-off between risk and return, i.e. virtuous country bonds that offer an acceptable return for our investment portfolio. But given the examples, a question spontaneously arises: How come government bonds can reach 0%? Let’s see some recent history
Government bonds, the recent history of recent years
We have heard for years about the BTP-Bund spread, that is the difference in yield between German and other European 10-year government bonds, a very approximate, not to say sensationalist, measure of country risk. In the period after the sub-prime crisis, from 2009 onwards, we have seen a liquidity crisis, that is, a shortage of money in the system that would have led to the ruin of companies and states. In this context, the ECB absolutely had to remedy the damage coming from the US and found itself having to inject liquidity in a forced and immediate way.
The idea was to buy many government bonds so that governments could find themselves with a lot of liquidity, essentially injecting liquidity into the financial system buying government bonds for years, doping the prices of these bonds who then saw the offer of ridiculous yields as in the case of Germany, which ended up with government bonds that even offered negative yields. In practice, the ECB, by buying securities, raised their price and at the same reduced the perception of the risk which had become almost nul since the central bank was the first buyer and creditor.
In essence, buying government bonds in that context was useless and therefore investors opted to buy only equities, drugging the world stock exchanges until the arrival of the "knots to roost" that we are seeing from recent months to this part. Now that perception of risk has increased, yields on government bonds also rise. Do you remember the inflation we talked about earlier? Inflation in the period from 2010 to 2020 was almost zero or close to that level.
The role of inflation in returns
This rule applies not only to bonds but also to all other financial assets. Inflation reduces returns, year by year. Let’s take a simple example immediately: Let’s assume that inflation is 8% and that a 1-year government bond yields 3%. To obtain the real return on an investment, it is sufficient to subtract the inflation from the bond yield, in this case subtract 8% of the inflation from the 3% return. As a result, the real yield will be -5%. Is it worth it? Absolutely not.
But what if our money stands still? At that point we would have a real return of -8%, that is we would suffer totally inflation. Seen in this other way, it is worth buying government bonds right? The answer as always is "it depends". It always depends on the needs of the investor, if he wants return he will buy securities with a certain maturity, if he needs liquidity he avoids investing and if instead he wants to avoid suffering inflation he will buy other maturities.
Some explanations
In this article we have spoken in a simple but at the same time not exhaustive way as we have always talked about bringing “to maturity” the bond. We have explained the simpler role of a bond without talking about the fact that bonds have a price, that we can sell the bonds whenever we want and sometimes it is possible to profit on price differences over time, as if we were doing trading .
We have not talked about the fact that there are also “corporate” bonds ie private companies and that bond yields follow a curve called “yield curve”. What we have seen is a smattering of the concept of bond as we know it and most importantly, we have linked the concept of return at risk and we have seen the role of inflation in returns, concepts of absolute importance if we want to talk about finance.
