Bonds, both corporate and treasury, remains an important
means for raising capital for both companies and the government (Becker &
Ivashina, 2011). One of its major advantages is that bondholders do not end up
exerting significant influence in the relevant company. An understanding of the
relationship between the business cycle and the factors affecting bond demand
and supply is, therefore, very crucial for businesses.
Bond demand and supply are each affected by a set of
factors which are themselves impacted in one way or the other by business
cycle. For bond demand, the relevant factors are wealth, expected interest
rates, risk, liquidity and expected inflation. On the other hand, factors
affecting bond supply are profitability of investment opportunities, expected
inflation and government fiscal activities.
Wealth is simply the sum total of all resources owned by
individuals in an economy. There is a distinction between ways through which
wealth can change. Thus, there can be a change initiated through savings. This
is in fact the only reliable way through which shifts in bond demand can occur.
The other avenue through which the wealth of individuals can change is through
revaluations. For instance, someone holding a portfolio of $ 2,000 worth of
bonds may see his wealth change as a result of a revaluation of his portfolio
either up or down. Changes in wealth occasioned by revaluation of assets is a
very misleading indicator for gauging both demand and bond supply. There is a
direct relationship between the wealth of individuals and levels of savings. As
wealth increases, individuals have to make a decision on whether to hold the
additional wealth in money or savings. Holding wealth in the form of money come
with the opportunity cost of not earning the interest associated with investing
in financial assets such as bonds. This explains the direct relationship
between wealth and bond demand. More wealth means an upward shift in the demand
for bonds.
Economic actors heavily rely on expectations of long term
changes in the economy to make important economic decisions. This applies to
interest rates expectations just as it does to other important economic
indicators. Expectations that bond interest rates will rise in the future will
induce economic agents to postpone their demand for bonds in anticipation of
investing in bonds offering higher returns when the expectation actually
materializes. In contrast, expectations that bond interest rates will fall in
the future induces more people to invest in bond assets hoping to cash in
before the lower returns in the future sets in. Inflation expectation similarly
affects bond demand in the same way as interest rate expectations.
On its part, the perception of bond asset risk would see
people shying away from investing in them (Mishkin, 2004). Those who do invest
in them only do on condition that they receive premium returns for the
assumption of additional risk. Even assets whose level of risk is not easy to
tell may elicit the same kind of reaction from investors as those assets
actually known to be risky. The quick divestures from the subprime mortgages
during the last financial crisis is a classic illustration of this point.
Furthermore, economic agents tend to prefer bonds as an
alternative to holding money in a liquid environment. The consequence is to have an upward shift in
bond demand. In contrast, economic agents prefer holding their wealth in cash
in times of tight liquidity thereby fostering a downward shift in demand.
On the supply side, increased profitability of real
capital investments also induces businesses to float more bonds to finance more
investments (Mishkin, 2004). Profitability of financial investments does not
have any effect on bond supply. This in turn leads to an outward shift in the
quantity of bonds supplied. Expectations of increased inflation in the long run
also leads to an outward shift in the supply of bonds since high inflation is
associated with lower real costs of borrowing. Again, government fiscal
activities also affect the supply of bonds. This is especially so with respect
to government deficit. A government running a deficit finances its budget by
floating treasury bonds. This directly results into an outward shift in the
supply of bonds.
Robust economic growth engenders increased wealth
accumulation. As already noted, both supply and demand also improves since
businesses are registering higher levels of profitability. This also goes for
general business conditions as well as default risk. The fact that bond prices
reduce in times of high economic growth only reveal that default risk is the
most important factor (Mishkin, 2004). Bond holders are more willing to hold
bonds in expansionary economic times since businesses are able to generate the
necessary cash flows to avoid default. The effect is to eliminate the risk
premium that issuers must pay to induce investors into holding risky bond
assets.
References
Becker,B.,& Ivashina, V.(2011).Cyclicality
of Credit Supply: Firm Level Evidence.Hrvard Business School Working Paper.
Mishkin, F.S.(2004).The Economics
of Money, Banking and Financial Markets, Seventh Edition. London: Pearson.
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