In Finance, it's all connected.

 

Before talking about how bonds are affected by the economic growth of a country, let’s talk about economic growth first. What exactly is economic growth? Economic growth means the prosperity of a nation because of increased economic activities. These economic activities can increase the production of economic goods and services. An increase in the working population, advanced technology, skilled labor, and productive work forces can all lead to the economic prosperity of a nation. One of the ways to measure the prosperity of a nation’s economy is by using an indicator called the GDP, or gross domestic product. GDP, in simple language, means the total sales made by a country in a financial year. 

An increase in GDP on a year-over-year basis can mean economic prosperity because this year, the country managed to sell more goods because of factors such as economies of scale, skilled labor, PLI schemes, etc. The four main components of GDP are household consumption, government spending, investments by businesses, and exports.

FUN FACT: Because government spending is a key component of measuring GDP, the government can build, break, and rebuild a road, and thus we can say that GDP increased. What I mean is that a well-constructed road that can last 10–20 years is good for us as citizens but bad from the perspective of measuring GDP. This is because the government will have to spend money to build the road, break it, and re-build it. We experience government spending. But a well-constructed road is not good. A well-constructed road is like a fixed investment, but building, breaking, and then again re-building is a recurring process. So, next time you see a well-constructed road being broken down for "rebuilding" purposes, consider that GDP growth is taking place. 

Now, let’s talk about bonds. Bonds are a type of fixed-income security that pays us fixed interest rates. These are issued by the government as well as corporations for short- and long-term borrowings. But why are bonds used to raise funds? And why do investors subscribe to bond issues? A bank may charge up to 12–13% interest on a loan issued for a project, whereas bonds can cost 8–9%. So, this is a win-win situation. You get 3-4% more return than FD, and the corporation saves 4-5% of its interest costs. 

Bond returns can sometimes outperform inflation, and they are almost always guaranteed (95%). This interest cost is called the cost of capital. The cost of capital, in simple language, means the cost of raising money. The cost of capital is illustrated by a 5% interest rate on a home loan. 

So, talking about their interconnectedness, as the economy grows, so does the demand for money. This phenomenon leads to an increase in spending. One of the most important factors that affects both bond prices and economic growth is interest rates. The interest rate is essentially the cost of funding. So, lower interest rates lead to an increase in borrowing, which eventually leads to an increase in spending and economic growth, and vice versa. When interest rates are low, we get access to cheap capital, and hence, capital assets that are risky in nature, like stocks, allure us. On the other hand, when raising capital becomes expensive, stable and non-dynamic assets like bonds and REITs allure us. 

Comparing histories is always advisable. Bonds are neglected during bull runs, and volatile assets are neglected during recessions or during bear runs because people don’t want to grow their money at that time; they just want to protect it. One thing with bond investing is that the longer you hold it, the riskier it becomes because it is susceptible to interest rate fluctuations. And the longer you hold equities, the safer they become. If interest rates rise or have risen since the day you bought the bond, you’ll have to sell the bond at a lower price. This is because bonds and interest rates have an inverse relationship.

During an economic boom, people are greedy for money, and hence the demand for currency increases. High currency demand causes inflation. As a result, central banks use various methods to combat this, such as overnight reverse purchase (repo) agreements (just ignore this). These tools affect interest rates. Bond yield is the return an investor earns from a bond’s coupon payments. Bond yields increase when interest rates rise, and they fall when interest rates fall. Rising interest rates take the fun out of borrowing, so no one takes loans to spend, and the economy slows down. 

Looking at the current economic scenario, the above statement holds true. Central banks around the world are increasing interest rates so as to tame inflation. An addition to this is that coupon payments on Indian 10-year government bonds have increased since the RBI started increasing interest rates. Just keep an eye on these coupon rates or interest rates. When the RBI begins to lower interest rates, demand will fall, and bonds will become less appealing. 

To summarize, when the economy slows, central banks use interest rates as a fuel to accelerate economic growth, which leads to an increase in borrowing, which leads to increased spending and asset bubbles. In this situation, no one gives a damn about bonds. On the other hand, when interest rates are low for a long time and the economy has been running too fast, the central bank uses interest rates as fire extinguishers on a burning economy to slow it down. This leads to a decrease in borrowing and spending, and hence, volatile investments become unattractive. 

Then everyone starts giving a damn about bonds, because the main motive is to protect the capital. Hence, we can conclude that, in times of economic growth, no one cares about bonds, and during stagnant economies, bonds become favorites, like during exam times, when suddenly everyone starts respecting toppers for obvious reasons. As exams get over, toppers become what they originally were: shitty geeks.

HAPPY INVESTING.