One may ask, what at all is a bond? A bond is a debt security that promises to make payments periodically for a specific period of time. The bond market is very important to economic activity because it enables governments and corporate institutions to borrow funds to finance their activities. Bonds are issued with their respective coupon rates, and these rates signify the interests thereon.
The coupon rate is the cost of borrowing or the price paid for the rental of the funds. These coupon rates are usually expressed in percentages per annum. Interest rates are important on a number of levels in aggregate demand. On a personal level, high interest rates could deter an investor from acquiring a mortgage property because the cost of financing it would be high. Conversely, high interest rates could encourage a prospective investor to save or invest because he can earn more interest income. On a more general level, interest rates have impact on the overall health of the economy because they affect not only consumers willingness to spend, save or invest but also businesses investment decisions. High interest rates, for instance, might cause a corporate institution to postpone its borrowing to build a new plant or expand its activities that would provide more jobs.
Before tackling the understanding of bond operations there is the need to analyse the demand in the bonds’ market. What determines the demand for an asset is equally vital for our consideration here. Recall that an asset is a piece of property that is a store of value. Items such as money, treasury bills, bonds, stocks, shares, land, buildings, equipment, et cetera are all assets. Saddled with the question of whether to buy and hold an asset or whether to buy one asset rather than another, there are factors that the individual should consider.
The factors that a prospective investor might consider before buying bond include his wealth, expected returns on the bond, the risk associated with the bond and the extent to which the bond would be easily convertible into cash (liquidity).
When an investor finds out that his wealth has increased, then it means that he would have more resources at his disposal to buy more assets like bonds. Therefore, the effect of changes in wealth on the quantity demanded of an asset means that, holding everything else constant, an increase in wealth raises the quantity demanded of an asset. When an economy is growing rapidly in a business cycle expansion and wealth is increasing, the quantity of bonds demanded at each bond price (or interest rate) increases. With higher wealth, the quantity of bonds demanded at the same price must rise. Another factor that affects wealth is the public’s propensity to save. If households save more, their wealth increases as we have seen, the demand for bonds rises. Conversely, if the households save less, wealth and the demand for bonds will fall.
The expected returns on bonds determines the demand for bonds. When an investor makes a decision to buy an asset, he is influenced by the returns on that asset. If Ghana Amalgamated Trust (GAT) bond, for instance, has a return of 9% per annum a prospective investor might prefer to buy compared to a bond with 7% return per annum. If the expected return on the GAT bond falls relative to the expected return on alternative assets, holding everything else constant, then it becomes more desirable to buy the alternative and the quantity demanded will definitely increase and that of GAT will fall. For a one-year discount bond and a one-year holding period, the expected return and the interest rate are identical, so nothing besides current interest rate can affect the expected return.
For bonds with maturities of greater than one year, the expected return may differ from the interest rate. A rise in the interest rate on a long-term bond would lead to a sharp decline in price and a very large negative return. Hence, if people begin to think that interest rates would be higher in the subsequent years than they had originally anticipated, the expected return today on long-term bonds would fall and the quantity demanded would fall at each interest rate.
Higher expected interest rates in the future lower than the expected return for long- term bonds, demand will decrease and definitely, there would be a significant decrease in the quantity demanded of the bonds. By contrast, a revision downward of expectations of future interest rates would mean that long-term bond prices would be expected to rise more than originally anticipated, and the resulting higher expected return today would raise the quantity demanded at each bond price and interest rate.
Lower expected interest rates in the future of other investments will increase the demand for long-term bonds and definitely, there would be a significant increase in the quantity demanded of the bonds. Changes in expected returns on other assets can also change the demand for bonds. If investors suddenly become more optimistic about the stock market and begin to expect higher stock prices in the future, both expected capital gains and expected returns on stocks would rise.
The degree of risk or uncertainty of bonds returns also affect the demand for the bond. A risk averse person prefers risk free investment and such people will prefer investing in sovereign bonds. By contrast, some people prefer investments with high risks and high returns, by responding to the finance rule that, “investments with higher risks attract higher returns”. No wonder such people start castigating authorities if their investments in such assets become impaired. But in general, holding everything else constant, if the risk of bonds rises, the quantity demanded of the bonds will fall.
Another factor that affects the demand for bonds is how quickly it can be converted into cash at low cost. A bond is liquid if the market in which it is traded has depth and breadth, that is, if the market has many buyers and sellers. The more liquid a bond is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded.
On the 20th of March 2019, the Government of Ghana issued USD3billion Eurobond which will mature over three periods of time. The three tranches come at a maturity period of 7years with 8.75% coupon rate, 12years with 8.125% coupon rate and 31years with 8.95% coupon rate. The bond which was the highest ever for an African sovereign nation was oversubscribed by 7times more. The demand for a nation’s bond depends upon its credit rating, in the sense that, a credit rating concerns the evaluation of the credit risk of the nation. The tasks of these credit rating agencies include the prediction of the nation’s ability to pay its debts and an implicit forecast of the likelihood of the nation defaulting. In simple terms, the rush for a particular nation’s bonds depends upon its credit worthiness assessed by a credit bureau. Standard and Poor’s (S & P), a credit rating agency, has rated the USD3billion Eurobond as stable.
S & P holds the view that Ghana currently has the capacity to meet its financial obligations, however, it went further to say that the nation faces major ongoing uncertainties that could impact its financial commitment on the obligation. Sovereign credit rating indicates the risk level of the investing environment of a nation. This sort of evaluation is used by investors when looking forward to invest in particular jurisdictions. These investors also consider the political risk associated with the jurisdictions where they channel their investments.
The Euromoney Country Risk Rankings for year 2017, ranked Singapore as the least risky country to invest. Out of a score of 100, Singapore obtained 88.6 score in the country risk rankings. This placed Singapore as the least risky country to attract investments. There wasn’t any country from developing world found in the ten least-risky countries for investment as of January 2018. The idea behind country risk is that, it determines the country’s specific factors that could adversely affect its ability to meet its financial obligations. This rating expresses the likelihood that the related party will default within a given time horizon.
Credit ratings are not restricted to sovereign countries. The credit rating agencies including Standard and Poor’s, Moody’s and Fitch address corporate institutions’ financial instruments, that is, debt securities such as bonds and the institutions themselves. These credit rating agencies use letter designations such as A, B, C and sometimes D to rate countries and corporate institutions. Higher grades are intended to represent a lower probability of default. The agencies do not attach a hard number of probability of default to each grade. They use descriptive definitions such as “the obligor’s capacity to meet its financial commitment on the obligation is extremely strong” or “less vulnerable to non-payment than other speculative issues”. However, different rating agencies may use variations of an alphabetical combination of lowercase and uppercase letters, with either plus or minus signs or numbers added to further fine-tune the rating. Standard and Poor’s rating scale uses uppercase letters and pluses and minuses(egs, AAA, AA+, B-), whilst Moody’s rating system uses uppercase and lowercase letters as well as numbers (egs, Aaa, Aa1 and Ba2).
In conclusion the government should pass a law to pave way for the establishment of local credit rating agencies in Ghana, to evaluate the credit risks of companies especially, financial institutions in Ghana. This could go a long way to safeguard the most vulnerable customers and investors of these financial institutions. If possible, the ratings should include public companies, listed companies and all state-owned enterprises. The law when passed should empower these local agencies to have access to the institutions’ qualitative and quantitative information to enable them carry out their responsibilities. Such independent ratings could raise red flags of illiquid financial institutions and Ponzi schemes. This could help in averting a situation where an institution with doubtful business objectives swindle customers and investors of their investible funds.