About the column: In our column “Bull’s Eye“, we take up articles from business dailies like Economic times and Business Standard, and explain them. In each article, we cover an economic/financial concept and a market occurring that the article is focused around; and explain it in the context of that news update.To read more from the column, click here.
By Naman Sanghvi & Sangeet Agarwal:
Actual Article (Original)
Italy’s borrowing costs dropped at an auction of 5-year and 10-year debt on speculation the European Central Bank may buy euro nations’ bonds to stabilize their economies.
Italy sold 4.73 billion Euros ($5.8 billion) of 5- and 10- year bonds. The Rome-based Treasury priced the 10-year debt to yield 5.96 percent, down from 6.19 percent on June 28. The Treasury priced its 5-year bond to yield 5.29 percent, compared with 5.84 percent last month.
Italy also sold 750 million Euros of a 3% 2015 bond to yield 4.49, bringing the total amount sold to 5.48 billion- Euros, near the 5.5 billion Euros that was the maximum target for the auction.
“Expectations that the ECB will contribute to more forceful policy action to bring down Spanish and Italian yields are running high,” Nicholas Spiro, managing director of Spiro Sovereign Strategy Ltd., a London consulting firm specializing in sovereign-credit risk, said in an e-mailed note. The Italian Treasury couldn’t have issued longer-dated paper at a better time, he said.
ECB President Mario Draghi is trying to persuade policy makers to agree on a multi-pronged approach to reduce bond yields in countries such as Spain and Italy, two central bank officials said July 27, asking not to be identified because the talks are private.
Italy’s 10-year yield was up 6 basis points at 6 percent at 11:34 a.m. in Rome, pushing the difference with German Bunds to 464 basis points.
’Under Pressure’-
The ECB is under pressure to lower borrowing costs after three interest-rate cuts since November failed to stop bond yields soaring in Spain and Italy, threatening the survival of the euro.
Draghi, who meets with U.S Treasury Secretary General Timothy Geithner in Frankfurt today, sparked a global market rally last week by pledging to do whatever it takes to preserve the euro. His proposal involves Europe’s rescue fund buying government bonds on the primary market, buttressed by ECB purchases on the secondary market to ensure transmission of its record-low interest rates, the two central bank officials said.
The ECB, which holds its next meeting on Aug. 2, has disbursed more than 1 trillion Euros to European lenders through its longer-term refinancing operation, or LTRO, since December.
German Chancellor Angela Merkel, French President Francois Hollande and Prime Minister Mario Monti have already endorsed Draghi’s approach, echoing his language in saying they will do what’s needed to protect the 17-nation euro.
Merkel and Monti agreed by phone on July 28 that the EU’s June summit decisions “must be implemented without delay,” according to a statement by the Italian premier’s office. Monti agreed to travel to Berlin for talks with Merkel in the second half of August, and will meet with Hollande tomorrow in Paris, according to his agenda.
Explanation:
Like companies, nations borrow money to fund their activities. In a country like India the government takes a loan from its Central Bank and pays it interest, and India’s central bank further manages the money. Like a company, a government can also borrow money. Now the rate at which Italy will borrow money reduced on speculation/ on ‘a feeling’ that the ECB (European Central Bank) will buy Italy’s bonds. A couple of intertwined concepts are involved. In the real market when banks lend money to companies, they do so based heavily on the financial credibility and stability of a company. A company with volatile and unstable operations and financials will attract a higher interest rate from its lender as the lender perceives the transaction to be of a higher risk. Hence Italy getting a lower rate means that the outlook of its economy is considered to be ‘less risky’ in comparison and ‘relative to its earlier image’. Keeping in mind Italy’s perception by lenders, now lenders believe that the chances of a default are lesser and their investment is safer; hence giving a lower rate.
What is it that gave this confidence to investors? — Speculation that ECB will buy the country’s bonds.
What are Bonds ?
Bonds are tradable commodities representing Debt of a company. For eg.- when you buy stock of a listed company you are buying equity and are a part owner of the company. The market value of the stock determines how much money you will make for your decision to decide to be a part owner in the company. Bonds are comparative, but instead of buying equity the investor is buying ‘debt’ i.e., ‘ the right to be paid principal and interest on a loan made’. So if a lender holds a bond of Italy, in simple terms- Italy will pay the lender the agreed interest in the agreed period of time.
Bonds are traded and are a critical market. Bonds also have categories of risk and range from safe ones to risky ones. Any external investor will buy a company’s bond if he/ she feels the company can repay and not default. The degree of confidence determines the rate and market value of the Bond. So when ECB buys bonds of Italy one would perceive this as a sign of trust of the bank in Italy’s financial health. The bank feels that Italy will be able to pay off the debt and hence it will buy in- it signifies to the investor that ECB has confidence in Italy and is ‘ready to support it’ while it turns around.
Thus ECB buying a bond of Italy signifies the banks faith in the country’s ability to pay its debt and not default; which translates to the country’s outlook as ‘safer’ which allows it to command better and lower interest rates for borrowing, thus improving its financials and showing a ‘sign of stability’
High Yield and Low Yield —
Yield is return an investor will receive by holding a bond till maturity. In simple terms it is nothing but interest rate that the investor earns when he/she provides money to the borrower on the principal amount.
Yield rate are fluctuated by various factors- for eg.- on 3rd August 2012 India’s yield rate increased as Reserve Bank of India is unable to maintain its positive outlook on inflation rates. This means that with increased yield the value of the bond decreases which translates to lower confidence of investors in the Indian economy.
Relation between bond price and yield —
Yield is defined and understood on the basis of money the bond will earn. Here’s a brief working.
A bond is purchased at INR 100 and will upon maturity give 110; then the return (coupon amount) is 10%.
Now bonds are tradable and buyers and sellers both want to maximize profits. An investor would have a fixed amount of money that he could invest in ‘different bonds, issued at different points in time, giving him different yields’– Also new bonds are issued all the time. So a company X might offer a bond with an X% return on 2011 and issue new bonds in 2012 with a Y% return.
Let us take a case where a new bond is issued at 12%. Now an investor would want to maximize return and will say instead of putting INR 100 in a bond with 10% return why don’t I put the same money in a Bond that gives me 12% return on maturity- thus the demand of the original Bond giving 10% return goes down. To attract an investor the value of the old bond has to be such that it matches the 12% return or higher.
Assuming the old bond wants to offer a return of 12%, instead of the offer value being INR 100, it will now have to be (110- X)/X = 12% = INR 98.2
The amount that an investor pays has reduced and thus the bond value at which it is traded is effectively reduced. In the real market depending on the current interest rates bond value fluctuates. Business cycles determine interest rates, which determine expectations of investors in terms of returns. Higher interest rates reduces bond values and vice-versa.
So a High Yield Bond will be one which gives a higher return and a low yield one which gives a lower yield, and is related to the risk of that investment-for a riskier investment the investor will expect a higher return.
By buying Italy’s bonds, the ECB will pump in more money in the Italian economy and also send out a positive sentiment that the ECB is ‘supporting the Italian economy’. There is more money in the system immediately which translates to more money being available in the system for businesses to use and invest, which would get a slowing economy moving.
The rise and cut of interest rates along with various other financial indicators has a direct effect on the economy of a country. Normally when the rates are high the economy is considered going down as the overall environment feels a grip because of high borrowing rates, high mortgage, reduced bank funding. So when ECB in November 2011 cut interest rates 3 times it would have expected the value of bonds to increase and decreased yield expectations making them more valuable and worthy to be held. This would also signify a stronger economy and a safer and positive outlook of the economy. Now when the market did not respond to such changes, and the yield’s expected kept on going up- it put the ECB under immense pressure to take action and correct the market. The coming weeks will be very trying for ECB given the deliverables to ensure survival of the Euro.