The Basic
In Corporate Finance 101 course every MBA grad would have come across the price yield relationship graph under bond valuation section. As shown below the relationship between bond price and yield is inverseand it is quadratic in nature. The two major factors that determine the convexity of the relationship are the coupon rate and time to maturity. The curve becomes more convex as coupon and / or time to maturity increases and the curve flattens as these two factors decrease. Due to relationship of quadratic in nature the first derivative of the relationship doesn’t remain constant and as shown in the figure below the first derivative of the relationship keeps decreasing as the yield decreases. The slope at point A is steeper than the slope at point B which means that a basis point move in yield at A will have higher impact on bond price than a basis point move at B i.e. when yield increases bond price at A will fall at faster rate than at B.
The Yields
As on Friday close 5 year yield is at 0.72% while 10 year is quoting 1.68% and these are close to the lowest readings since 1990. The lowest yieldssince 1990 for 5 year and 10 year maturities are 0.56% and 1.43% respectively were registered on July 25th, 2012.Unless the economy slides dismally the chance of yield declining aggressively is very low. With talks of next round of QE and inflation, especially food inflation, creeping up the chances of yields increasing are on rise. Since currently yields are closer to point A as marked in the figure above we can expect bond prices to decline sharply when yield increases, a 100 basis point increase in yield of 10 year will wipe out 14% of bond’s price.
When we look at the components of yield (nominal yield), real yield and expected inflation as show in the figure below it is pretty clear that if not for the positive bias of expected inflation the nominal yield would have breached zero mark. The bond market is one of the most reliable markets with speculation playing a minor role compared to equity or other asset classes. Historically, yields had predicted recessions with higher precision, for instance recessions were prophesied by an inverted yield curve. If yields still have that predictive ability then we can expect stagflation if we are not in one already.
Borrowings
As of June 2012 foreign investors had investment of more than USD 5tn in US Treasury securities which was up by 13% over a decade. And as shown in the pie chart below China and Japan have lion’s share in the pie while India had less than a percent. As mentioned earlier those countries with large exposure to US Treasuries will be more affected when the yields starts to risehence China, Japan, Oil exporters and Brazil will the most affected.
The following chart looks at year on year change in investment in US Treasury securities by various countries.
Except for China, the largest investor in US Treasury securities, all other countries have increased their exposure to the securities on the other hand a worried China is trying to get out a trap it laid by manipulating its currency. The country has sunk so deep in this trap along with USA that any effort on its side to ditch US and get out of this trap will cost it dearly. The two largest economies are so intertwined that they have to work in tandem to get out of this mess. And that is the price one pays for globalization.