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11 21 2015 | by Victor Xing | Capital Markets

Why is Fixed Income important?

Fixed Income is the Lifeblood of an Economy

Fixed income markets and instruments allow lenders to finance everything from a
single family home, a hundred-floor office tower, a major toll road, to a sovereign nation’s budget expenditure in exchange for fixed or variable cash flow into the future.

Aside from the common examples above, fixed income also help build submarines!  Below is BAE Systems’ Barrow shipyard, showing Astute-class attack submarine under construction.

fixed income - funding capital intense operations

BAE Systems’ capital intensive operations need outside funding (submarines are not cheap)

fixed income - funding capital investment

BAE Systems’ outstanding debt, or from another perspective, lending to BAE Systems by bond investors (source: Bloomberg)

fixed income - borrowing cost

The highlighted bond is its on-the-run 10 year issuance, and its current yield at 3.787% is a reflection of its borrowing cost.  Participants of an active fixed income market determine a corporation, municipality, or a nation’s borrowing cost by buying or selling bonds on secondary markets.  If enough investors are bearish on an issuer (and the bearishness are manifested in bond yields), it would need to issue bonds at a higher yield to attract investors.  This also illustrates the importance of a healthy fixed income secondary market.

fixed income - bond yields

When we go to a football game, we rarely think about how the stadium is financed.  Below is the Sonny Lubick Field at Hughes Stadium of the Colorado State University Rams, and the CSU recently sold $239mm of bonds to build a new football arena to attract out-of-state students (Football Stadium Arms Race Pushed This School Deeper Into Debt)

fixed income - funding stadiums

Purpose of the bond issuance (per procedure) is very specific about the stadium construction:

Fixed income - bond issuance

Everywhere we look, there are signs of funding via fixed income – it is the lifeblood of an economy, and interest rates (borrowing cost) controls the flow of “economic fuel” between lenders, investors, and borrowers.

From the perspective of many investors, bond returns achieved by investment firms are passed to them, and they count on fixed income for extra income.  Corporations issue debt just like other entities, and they would use the cash to fund major acquisitions or even buy back their own stocks (Bonds for Buybacks Never Bigger in U.S. as $58 Billion Sold).

Central Banks and Credit Cycles

Given that the availability of credit affects pace of economic growth, central banks such as the Federal Reserve would try to manage borrowing cost by “toggling” its short-term funding rate (via interest rate on excess reserve and overnight reverse repurchase agreements, or ON RRP) or use its balance sheet to cool growth or accelerate borrowing and lending to help meet its Congressional mandated objectives.

Since it is (generally perceived) futile to fight a large central bank (Mr. Soros may disagree, but what he did was extraordinary), investors would price-in the FOMC’s projected rate path via the expectation channel.  For example, if the FOMC indicates the economy is on a path to overheat, then investors would price-in more rate hikes in the future – if the investors own 5 year bonds, it would only make sense to own them at a (higher) yield that already reflects number of hikes in the years ahead.

fixed income in the form of short-term rates
The (in)famous FOMC “dot plot” (source: Federal Reserve, September 2015 Summary of Economic Projections)

Thus, the Federal Reserve and other central banks would use forward guidance, interest rates and other unconventional tools to affect credit availability, and bond investors paid heed to FED’s communication would buy or sell bonds (if they haven’t already) to lower or raise longer-term borrowing cost for homeowners, corporations, municipalities, and the nation itself (the FED can also affect longer-term rates via large scale asset purchase under extraordinary circumstances).  Former Federal Reserve Governor Stein called this the “recruitment channel,” meaning market participants are “recruited” by the FED to help transmit its monetary policy into the real economy.  From this perspective, one can see that banks are often merely enablers, not “masterminds” of changing funding costs.

Fixed income and its role in central bank policy
Photo credit: Bridgewater Associates “How The Economic Machine Works by Ray Dalio”

Therefore, central banks’ ability to tighten or loosen credit conditions has been a majorcatalyst behind modern credit cycles.  Central banks would lower borrowing cost at times of recession (or some time prior) to fuel faster growth, or to raise rates to forcefully reduce credit availability.  Businesses, governments, individuals would then change their economic behavior, leading to large scale changes in economic conditions.

All these manifests themselves in fixed income, and as mentioned before, fixed income investors and borrowers are at the front-line which central bank policies are transmitted into the real economy.  Without fixed income, it will be much harder to establish a market-based borrowing cost, which would make borrowing and lending much more inefficient.

Next article11 19 2015 | by Victor Xing | Central Banks

October FOMC Minutes – Policy Summary