Fixed Income Securities Prospects in Usa

INTRODUCTION

A bond is a debt security that reflects the creditor-debtor relationship between the issuer of the bond and its customers. It is issued by the issuer for a fixed period and he pays interests, called coupons, and at maturity he repays the principal. Bonds are bought and traded mostly by banks, insurance companies and pension funds.

We know many different types of bonds; government, corporate, municipal, mortgage, bank bonds and more. In this paper I will focus on government bonds which are issued by different government mostly in order to fund their expenses.

There are many risks involved when dealing with bonds. There is interest rate risk, credit risk, risk of recall, reinvestment and inflation risks. I will concentrate mostly on interest rate risk which is the risk of change in bond price due to change in common interest rates. In the event of interest rates increase in the national economy, bond prices usually fall. So interest rates and bond prices have an inverse relationship.

Experts say that rising interest rates are bad for bonds, but some say that it is good to invest in bonds when interest rates are high. Both points are in fact true because in an environment with rising rates bonds bond investments are bad, but on the other hand, bonds are great investments when bond yields are already high.

For instance, you buy a 10-year treasury bond worth 1,000€ with a coupon rate of 5%, which would earn you 50€ each year. If interest rates rise to 10%, the bond's market value would drop because at this new rate, someone could earn same interests by investing just 500€. So if you wanted to sell the bond, the buyer would pay you less because he would only earn half of market's interests. That is why rising interest rates aren't good for bonds that you currently own. But if the interest rates decreased, your bond would be worth more, because it would earn higher interest rates than those on the market. That is why it's good to buy bonds when interest rates are high, especially when interest rates are expected to fall.

This assignment is split into 11 parts. Each part gives an analysis of different factors that affect bond prices and their impact on (government) bond markets. These factors are interest rates, GDP growth, government policies and more. Each part will include its effect on interest rates and bond markets and a market outlook based on each factor's forecast for year 2012. In the end I will give a complete government bond market outlook for 2012. Every prediction will be made from perspective of investor based in United States.

KEY INTEREST RATES

For starters, I will present some historical figures of a 10-Year US Government Bond Yield and its forecast.

We can see in this graph that bond yields have been falling for over 10 years and this was very good for bond markets as prices were rising. But the question is if this trend can continue for a long time because yields can't be in decline forever and are bound to go up again.

March April May June July August

2.03 2.1 2.29 2.5 2.73 2.94

http://www.forecasts.org/10yrT.htm

The Monthly Treasury Average (MTA) is the 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year.

Mar Apr May Jun Jul Aug Sep Oct Nov Dec

0.152 0.149 0.153 0.16 0.169 0.186 0.205 0.226 0.249 0.274

http://mortgage-x.com/general/indexes/mta_rate_forecast.asp

In the upper 2 tables, there are 2 forecasts for US Treasury securities in year 2012. We can see that bond yields are predicted to go up which would be a bad sign for bond prices. To make sure that this is the right prediction for current year, I will now make present some other factors that influence bond markets and what is their predicted movement and effect in year 2012.

The first and the most powerful factors that affects bond prices are interest rates. As previously stated, interest rates (bond yields) and bond prices have inverse relationship. When bond yields go up, bond prices go down or vice versa.

Interest rates for US government bonds are first and foremost influenced by Central Banks and their equivalents as they determine the key interest rates. In the case of United States, Federal Reserve Board or FED controls the Federal discount rate or an interest rate at which an eligible financial institution may borrow funds directly from a Federal Reserve bank. The FED also controls the Federal funds rate, which is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis.

Fed policy has basically fixed these short-term interest rates until 2013. Fed policy is also focused on keeping long-term rates low until the Fed feels that the threat of recession has passed. Federal discount rate has been 0.75% since 2010, while the target rate for Fed funds rate has been the same since 2008, when the Fed set the target rate range from 0.00% to 0.25%. So the interest rates from FED are already almost zero and they don't plan any changes until 2013 or even 2014. So there will be no effect on bond prices from this perspective.

Another term is used in reference to interest rate used by banks, so called Prime rate. It is an interest at which banks lend funds to favoured customers, i.e., those with high credibility. It runs approximately 3 percentage points above Fed funds rate, so that makes it 3.25% at the moment. And similar to Fed funds rate, it is not going to change for a while and is not going to impact bond prices.

U.S. key interest also consist of LIBOR rates (London InterBank Offered Rate) which are the interest rates that banks charge each other for loans. Current 1-month LIBOR is 0.24% and prediction for January 2013 is that it will increase to 0.50% which would have a negative effect on bond prices.

I can also add two important interest rates in U.S. that don't have such strong effect as key interest rates, but they still do. Mortgage rate which is the rate of interest charged on a mortgage and Certificate of Deposit (CD) rates. These are similar to savings account where you get interest on money deposited in a bank, but in the case of CDs you agree to leave money on deposit for a set period of time and earn higher interests.

Mortgage rates are predicted to stay low in 2012, but borrowers may have to pay more for mortgages this year as the rate