The bond market, which is the fountainhead of the money supply to other asset classes, affects all the markets
Financial markets are an enchanting place. Money changes hands every second. There is just one criterion – the smartest ideas win. We traders and investors are ‘Brain Warriors.’ We fight with our ideas and knowledge of the markets. Needless to say, the more knowledgeable investors and traders win. This is why you must know about all asset classes – equity, commodity, forex, and bond.
The makers of the unsinkable ship ‘Titanic’ boasted that the ship was the safest ever built. Because it had steel doors that could seal off any part of the ship that developed a leak. Unfortunately, water found its way around these hermetically sealed steel doors and the ship sank. Money is like water. It flows from one asset class to another whenever it feels better prospects are available there. You cannot stop the money flow. Money wants profits. It doesn’t care from which asset class. This is why investors must know which asset class is witnessing inflows and where there are outflows.
In terms of size, equity markets are the smallest around the world. Yet most people think it’s the only game in town. The largest is the forex market which is approximately 100x-200x bigger than equities. Then comes the bond market. In addition to being 50x bigger than equity markets, it is also the fountainhead of the money supply to other asset classes. If the bond market went dry, all markets would wilt immediately. Next comes the commodity markets which are 20x-50x bigger than equity markets. Commodities form raw materials for the companies whose shares are traded in stock markets. If commodities get expensive, corporate profits fall. So money is like water that flows in and out of asset classes.
You cannot afford to look at any asset class in isolation
Bond markets are a place where people invest their money to receive a fixed rate of return. These are not just for senior citizens and retirees but also savvy young investors who know that riskier investments like equities must be balanced by fixed income at regular intervals. That avoids panic situations where one is forced to sell one’s shares to meet survival expenses. Bonds are also safer than other asset classes if you are investing in ‘Sovereign Debt.’ These are bonds that are guaranteed by the government of the country. Only the central government has the authority to print currency. This means if anything goes wrong the government can always print paper currency and repay bondholders. This safety net does not exist with private sector bond issuers or even bank fixed deposits.
Any resident Indian can buy bonds as easily as investing in a fixed deposit. Just walk into your bank and talk to your relationship manager. Many new-age private banks even allow you to buy bonds online from the comfort of your home.
Why are bonds in the news? Many central banks were issuing bonds at almost zero interest rates, with some even quoting negative rates. That has miffed many high-net-worth investors. They started selling their bonds sometimes even at a loss. That sent bond yields soaring (If a Rs 100 bond offers 10 per cent interest then your yield is 10 per cent). But the same bond is available at Rs 90 your yield rises to 11.11 per cent). This is a cause for concern.
It shows the investors want higher interest rates. Sooner or later, it could happen. Which means the cost of money will rise. With it will raise the cost of doing business. The savvy investors in the markets sensed that and booked profits in equity.
If investors had paid attention to bond yields they too could have been forewarned.
The author is Head of Research – Behavioural Technical Analysis at Equitymaster
DISCLAIMER: Views expressed are the author's own. Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.