Bonds and iBond (Inflation-Linked Retail Bond)
金融海嘯筆記 二 : 債券及通脹掛鉤債券（iBond）
Preamble: The HKSAR 2011-2012 Budget has been criticized by politician of different background on every possible aspect. We are not here to discuss if the government should give out cash our put money in MPF. In response to complaint on increasing inflation but staggering salary increase faced by the people, the Budget proposes to issue iBond as a means for citizen to counter inflation. What is iBond? Well, what is bond anyway? Would iBond work? Who would benefit from it？This short note attempts to answer some of the questions; the rest is left for you to find out…
1. What are bonds?
- Bonds in plain English are IOUs (I-OWE-YOU). Bonds are typically issued by governments and companies. When an institution (government or corporation) issues bonds and sells them to investors, she is borrowing money from the investors.
2. Why invest in bonds?
- Bonds typically pay interests at fixed periods. The rates are typically higher than what you get from bank deposits. For example, US 30-year Treasury bond pays about 4%, 10-year about 3%, 1-year about 0.2% (rough figures in January 2011).
3. What are the risks?
- The risk depends on what kind of bond you buy. As always, return and risk are inversely related. High risk bonds pay high interest, and vice versa.
- Government bonds are typically very safe. Corporation bonds depend on their ratings. Here are a few examples. According to data published in December 2010, 10-year government bond from Greece pay 10-12%, Ireland 8-10%, Portugal 4-6%, Germany and US 2-3%. You can see that the safest countries, Germany and US, pay the lowest interest.
4. Why should I invest in bonds?
- Bonds typically are very safe. US Treasury bonds are considered the safest in the world. Bonds may appear to pay low interests (2-3%) compared to returns in stock markets (in good days). However, (1) it is still higher than what you can get from bank deposits, and (2) hedge funds can use high leverage on bond investments because bonds are safe. For example, if a hedge fund can borrow 10 times the money you have at 1% interest rate while the money makes 2% interest from a treasury bond, the effective return is 50%, roughly.
5. In this case, is investing in bond the same as putting money in bank deposit? Is the interest difference the only difference?
- Surely they are not the same. Bonds can be traded in open market. That is, you bought $10,000 US 10-year Treasury bond at an interest rate of 3%. Anytime before the bond matures, you can sell it in the market at the market price, meaning that you may make money or lose money compared to the $10,000 you paid. You cannot do the same with your bank deposit. In the extreme, you withdraw all of your money from the bank, but that can hardly be called trading.
6. If the bond is paying interest to me, why should I sell it?
- You want to maximize the return of your investment. That is, if the bond pays 3% interest, but you can get 5% interest from your bank deposit, you definitely want to sell the bond and put the money in bank deposit. This means that you likely would be willing to sell it at a lower price (even less than $10,000) and suffers a loss from the selling.
7. Interesting, that means bond price fluctuates depending on the sentiment of the investors?
- This is true. Bond price goes up and down even though the interest it pays remains unchanged. Bond price depends on the current interest rate in the market. Remember that the interest rate of a bond is fixed at issue date (e.g., 3%), if the current interest rate goes up, the relative return of the bond decreases (because its interest rate is fixed while watching the market rate goes up) and its price decreases, and vice versa. Now, interest rate is tied to inflation, and inflation is tied to economy (GDP) growth.
8. Is bond price an economy thermometer?
- Yes, it is. When most investors believe the economy is going to be better (and hence inflation and interest rates go up), bond price does down, and vice versa.
9. If I don’t invest in bonds, should I still pay attention to bond yield (孳息，收益率)?
- The answer is already given above. If you want to know the economy, bond price is one thing you should watch.
- Besides, Treasury bond yields are used by commercial banks as a benchmark for setting bank loan rates. For example, mortgage rate in USA is typically tied to the 10-year Treasury bond rate. Given the fact that the Finance Tsunami was caused by sub-prime mortgages and the USA home industry is still in deep trouble, changes in 10-year Treasury bond rate, and hence, mortgage rate, will tremendously impact homeowners in USA.
10. OK. So much about bonds. What is iBond (Inflation-Linked Retail Bond通脹掛鈎債券) that the government is trying to sell us?
- According to the government’s 2011-2012 budget, the government plan to issue HK$5 billion to 10 billion of iBond that can be purchased by holders of the Hong Kong Identity Card (3 stars are not required).
- Each unit is (每手) HK$10,000.
- Interest is payable twice every year
- Maturity in 3 years
- Cannot be redeemed before maturity but the government encourages iBond to be tradable in the open market
- The interest payable is calculated based on the larger of the following two amounts: (1) the interest rate of high-quality 3-year corporate bond on the market and (2) the CPI (Consumer Price Index) of the most recent six months at time of bond issuance
11. You said a bond is a loan, and the government has lots of money, why does it issue iBond?
- Yes, the government has no need for issuing bonds. According to the Budget, the government introduced the bond program only in 2009 and has since issued only HK$ 24 billion dollars to institutional investors and nothing to retail investors. iBond will be her first retail bond. The government issues iBond as a response to people’s complaint on high inflation rate. With iBond, you will make more money from iBond when inflation is high so that the higher return can offset the higher prices of meat, vegetables, and rent, etc. (that is the objective, whether it is enough is another issue).
12. I know nothing about investment, should I buy it?
- It is a gift to the Hong Kong citizen. When inflation rises, the return of iBond increases accordingly; when inflation falls, the return is guaranteed not to be less than 3-year high-quality corporate bond rate. In other words, you don’t lose either way.
14. Is it free lunch?
- Yes, it is free lunch for the investors (Hong Kong citizen), and the risk is borne by the Hong Kong Government (i.e., indirectly by tax payers). Besides, iBonds are likely sold through banks and administration fee will be charged by the banks (either the investors pay or the government pays or both pays).
15. Why doesn’t the government simply give out cash?
- It is now :-)
16. Is iBond invented by Hong Kong Government?
- No. TIPS (Treasury Inflation-Protected Securities), issued by the US Treasury, has similar objective but the determination of return is totally different:
- Investors buying TIPS in fact bets on the expectation that the real inflation rate turns out to be higher than the expected inflation rate at the time of TIPS issuance (in which case, investors win, or else lose). That is, investors can win or lose in TIPS, but are guaranteed to win in iBond.
- Because different investors have different views on the future of inflation, TIPS can be traded in open market; iBond, though thought to be tradable, can hardly be priced because there is no reason an investor would want to sell it.