Bond Prices: Change in Influencing Factors and the Future

I have been suggesting to investors for quite a while now that a bond pricing/yield shall not work the same as in the past for various reasons.

Let me elaborate, the price of a bond depends on two primary variables and is calculated as below:

Bond Price/Yield is equal to 'Risk Free' Interest rate of underlying currency for same period PLUS Risk Premium of the issuer.

Until now, when the world was quite stable, in the past 20-25 years since 1971, most of us have not seen difference or volatility in Risk Premiums. As we all now know that Lehman Brothers (wonder if it was called Lehman Sisters, if it would have had the same downfall), Enron, Arthur Andersen, Emaar, Nakheel, Bear Stearns, Citi, Fortis, ABN AMRO, RBS, Bank of Ireland, Satyam, Madoff etc, have changed the perception of risk even if backed by 'solid' balance sheets or the assurance of Governments or guaranteed inflows as in the case of Madoff. Large banks such as Citi, RBC, Fortis, Spanish and Irish banks and over 500 US banks that have closed in the last 4 years, have all been brought to their knees despite backing from various Govts. Despite being a lender of last resort, Central Banks are unable to help the banks nor the borrowers and nor the clients.

Coming back to bond price/yield, we have all assumed that ALL THINGS BEING EQUAL, as taught in Economics 101, if interest rates rise, only then bond price declines. When another function such as underlying risk of the Company/Govt is introduced in this equation, then the ALL THINGS BEING EQUAL does not hold true since now two variables are at work, interest rate and credit risk (or Risk Premium) of the company/issuer.

In the past 4 years, all things have NOT been equal and various unprecedented events have occurred causing markets to seize and play havoc with lives of various common citizens such as unemployment, lack of new job prospects, closure of large companies such as Fannie and Freddie, closure of car factories, outsourcing companies, large and small banks, various businesses etc and decline in stock markets and real estate among other things.

When Risk Premium is added to the equation, and is quite volatile, then the impact of USD interest rates even if they go close to zero, stops having any impact on the bond price / yield. We have observed this, first hand, in the past 2 years when Fed rate and USD LIBOR has been stable at close to 0.25% levels but bond prices across various countries including USA have continued to move tremendously upwards and have been volatile for some which has been due to only ONE FACTOR: RISK PREMIUM.

My contention is that in the past two-three years, economic theory, as investors have been led to believe by teachers, media, advisors and bankers has altered permanently.

Interest rate movement no longer will have the same influence on the movement of bond prices/yields as it had over the past two/three decades, until stability returns. We must, therefore, change our way of thinking in terms of fixed deposits or fixed income bonds if we need to navigate these treacherous waters called investment markets, currently and in the coming years.

There are various factors why emerging market or developing market companies have done well:

1. More and more money is being deployed to invest in the developing markets from the western world, in the search for higher yield, greater than the one in USD or EUR at close to zero levels, thus increasing liquidity in developing markets. New mutual funds are being created all the time in developed markets to invest in emerging markets. More and more asset allocation is being done towards Asia and other developing countries. This has increased both demand and liquidity in the emerging markets and created depth.

2. Companies in developing country are growing despite global recession especially in BRIC and some other emerging countries. This has created huge cash reserves and surpluses in the balance sheets of some of these companies which make them more stable that companies in the developed world.

3. The thinking in the developed markets has been changing and the money from those countries does not put more emphasis on liquidity premiums i.e. liquidity risk in the developing markets. As mentioned in Point 1 above, liquidity is higher than ever before in the developing countries.

All these factors are making emerging markets develop their bond and currency markets more efficient and more liquid every single day and causing more and more new bond issues being launched which would not have been possible a counple of years back. These factors also cause RISK PREMIUM to decline in developing countries vis-a-vis developed countries.

I will show some examples where large companies from the developed world who 'were' highly respectable and used as a blue chip or a benchmark have come down to levels of companies in emerging markets. All these were issued in the last few weeks.

Goldman Sachs issued a 10 year bond which is an A rated company at 5.25%.

Morgan Stanley issued a 10 year bond which is an A rated company at 5.50%.

Meanwhile, Woori Bank from Korea also A rated issued a 10 year bond at 5.875%.

NTPC from India rated BBB- issued a 10 year bond at 5.625%.

POSCO from Korea which is A rated issued a 10 year bond at 5.25%.

Govt of Sri Lanka which is only B+ rated issued a 10 year bond last week oversubscribed to USD 7.5bn versus issue amount of USD 1bn, was at 6.25%.

What the above indicates is that A rated companies from AAA country such as USA are almost as close as BBB rated companies from the developing world.

Until a few years ago, Sri Lanka would have paid 10%, about 4-5% higher (called RISK PREMIUM) than high rated companies from America, while POSCO and Woori would have paid 3-4% higher and Indian companies would have paid the same 3-4% higher. This risk premium is declining and developed countries are coming closer to emerging markets all the time. With declining risk premiums in emerging markets, the bond prices are set to rise much higher, depending on when they were issued and at what rate. An Indian company issuing a bond at same rate as Goldman Sachs is a first timer!

This indeed was happening until last year or two when the markets and investors were demanding higher interest rates from emerging market issuers but now the investors are clearly indicating their preference towards companies which are solid, receive no direct financial Govt support, are cash rich regardless of which part of the world they are from.

The 'solid' or 'blue chip' companies from USA or other developed countries are being 'punished' and have to now issue bonds at rates previously unheard of. This is because the Govts themselves behind such companies in US or Ireland or Greece etc are extremely tight on their cash positions and are therefore unable to help these companies, should the need arise.

With such precarious situation arising where Govts and companies are in tight spots, it is expected that extreme volatility in the stock, bond and currency markets will continue.

It is interesting to note that no media or newspaper or any Bloomberg or Reuters or research reports is alerting investors to such dramatic changes where the RISK PREMIUMS between developed and developing countries have been shattered and have come down to an extent where they are almost the same and in some cases even better.

Question is: Will Developing market rate of returns continue to decline i.e. improve with lower risk premiums and the returns in developed markets continue to rise, i.e. higher risk premiums?

My answer is: Yes!

Meanwhile, bond prices will rise and decline not because of changes in USD interest rates, but because the underlying risk and future growth is what investors are worried about. This was the case in USA also when the markets were beginning to rise in 60's and 70's and interest rates continued to decline as long as prosperity continued, however, now that the prosperity in USA has come to end, interest rates for borrowers based in USA must rise, regardless of the fact whether Fed and LIBOR rise or not....