By Max Hess
Financial markets have been a key target of international pressure on Russia. They’ve been foreign policy tool for Russia as well, whether loans to Venezuela or conflicts with Ukraine. And that’s not to mention their role in domestic affairs, visible in preferential financing to friends of the Kremlin or as instruments for mitigating economic crises. Given the growing importance of financial markets to Russia, understanding its political economy frequently requires picking apart labyrinthine financial agreements. This piece aims to explain the workings of one key form of financing – bonds – and what you can learn from following them.
What is a bond?
Bonds are a debt investment sold by governments, corporations, and financial institutions to finance their operations, expansion, and more broadly, their business strategies. They’re an important asset class (ie kind of investment) for investors and are seen as less volatile than equities, in other words, stocks. The bond brings together a debtor with a creditor through a legally-binding contract that promises the latter regular interim payments in exchange for taking the risk of delayed repayment, usually at a set date in the future.
The key components to a bond are its principal (face value), coupon, yield, and maturity date. These in turn are shaped by the ‘five Cs of credit’: character, capacity, capital, collateral and conditions. Imagine the following hypothetical situation: you are a member of the bourgeoisie suddenly benefiting from an inheritance of US$1 billion. You wish to profit off of your good fortune and lend out some of this money, which is far more than one could ever need but not quite enough to flaunt a new yacht in front of your peers every few years in St. Tropez. Realizing that you are cash rich, friends and strangers alike will approach you to borrow some of this money.
Victor the Good, Ivan the Terrible
Your close friend Viktor asks you for US$100m. He pledges to pay you back in ten years, to use the money to modernize a profitable factory in your hometown, into which he is investing US$100m of his own money. If you fail to receive repayment, you will be given ownership of the land the factory lies on.
But word of your wealth has spread far and you get a call from a stranger introducing himself as Ivan. Ivan wants your money to invest in a factory in his home town, also requesting US$100m, saying he cannot afford to invest himself. He asks under what circumstances you will loan the money.
You are familiar with Viktor (he’s a good guy), the factory has been operating since your childhood and has good capacity, Viktor will invest with, and you get the land if the deal falls apart (known as collateral). That’s a pretty good deal. Ivan, on the other hand, you don’t know well. You have no information about his factory, there’s, no collateral (you won’t get the land if something goes wrong), nor do you have local connections to ensure the contract is honored. The risk of loaning to Viktor is far lower than loaning to Ivan. As a result, you tell Ivan you will loan him the money at a cost of US$10m per year, with a pledge to pay back the initial US$100m in 10 years while Viktor can have the same US$100m for ten years on the condition he pays you US$2m per year.
In other words, you have bought two bonds with US$100m in principal each, the one to Viktor carrying a 2% coupon on a maturity of ten years and the other to Vladimir with a 10% coupon on a maturity of ten years.
Yield, however, is what counts if you want to sell these loans on. Say your yacht (you decided to buy one anyway) has sunk and you desperately need hundreds of millions to buy a new one, far more than the US$12m your two loans are earning you per year. Your Viktor-bond has a low risk profile, although the potential buyers will not have the same relationship with Viktor and are aware you are in a cash crunch. So they offer you US$90m for the bond only a year after you bought it. US$2m is of course more than 2% of 90, so their effective annual yield is 2.222%.
Unfortunately, the Ivan-bond turns out to have been near worthless as he didn’t invest the money and instead fled to sunny Cyprus. Some entrepreneurial risk takers are willing to chase him down and sue for the money. As a result, they pay you only US$20m for the bond. Given it has a coupon of 10 per cent on a principal of US$100, the effective yield on that purchase is 50% ($10 million over $20 million). That’s is a risky proposition: they have to hope Ivan still sends the next US$10m next year and gets back to running the business, otherwise they may be left with no choice but to sue for repayment, and hope they are able to recover at least some of the principal. While the coupon usually reflects the risk at the price of the bond’s sale, the yield reflects its risk thereafter.
There are numerous other factors at play for determining how investors treat yield. Central Bank interest rates and inflation are particularly important factors. Investors will look at yield above inflation – after all if your yield is 2% and inflation is 2% then you are not making any real money. The currency of the bond also plays a major role, affecting which interest rates should be seen as the baseline as well as the level of currency risk: there is little concern that dollars will not be a widely-used currency in ten years but one would demand a premium (a steeper fee) for taking the risk in rubles and an even higher premium for taking it in Ukrainian hryvnia. Major financial institutions will engage in hedging to try to minimize their currency risks on bonds, a far more complex and fraught area of financing beyond the scope of Viktor and Ivan.
Why bonds matter
As stated above, the yield on a bond reflects how the market sees its risk. Unsurprisingly, Russian sovereign bond yields spiked in 2014 after the imposition of sanctions as there was widespread uncertainty over future events and concerns Russia’s economy could be severely impacted. This summer’s Russian banking crisis saw the yield of bonds issued by the Garden Ring Banks in Moscow spike, as there was uncertainty in the sector. Much as the rise and fall in the price of a stock can tell an investor about general market sentiment towards a company, rises and falls in bond yields provide information on the general market sentiment regarding the creditworthiness of the bond issuer.
When a company goes bankrupt, its bonds are typically restructured. While there is vigorous debate over whether sovereign nations can technically go bankrupt, they do go into default – the difference is largely rhetorical for non-theoreticians – and then seek to restructure their bonds. These defaults mostly affect foreign currency debt but when Russia famously defaulted in 1998, it also did so on local currency obligations, having been unwilling to print money amid already rampant inflation. Defaulting on foreign currency obligations, however, is the far more dangerous proposition.
When countries do so without reaching a restructuring agreement with their creditors they can be cut off from international financial markets. There are separate processes for restructuring foreign currency obligations to other sovereign countries and international financial institutions than for private creditors, known as the Paris and London clubs respectively. Bonds fall in the London club, although Russia has attempted to blur this line in its financial war against Kyiv. The are many weeds to dig through here, which the Bear Market Blog will cover in future pieces, but for now, what you need to know is that sovereign bonds provide a real time quantitative view into how the market prices the risk of one country versus another.
Due to this essential function, sovereign bonds are typically among the most liquid (easy to buy and sell at short notice, essentially) instruments in a given country’s economy. Banks are required to hold them and the credit ratings assigned to them are the baseline for viewing other creditors – both sub-sovereign entities (states in the United States, subjects in Russia) and private corporations – within that market. As a result, bonds provide an important signal when looking at market sentiment, and these signals have wide-ranging impacts across the economy. For more on those impacts, though, you have subscribed to the Bear Market Brief.