Triple Option

By Michael Maynard

**This article served as the final project for Intermediate Microeconomics at Franciscan University of Steubenville**

From a microeconomic perspective, bond markets are created by firms who need cash to finance business activity (supply) and investors who want to create interest income from their capital.  While the macro treatment for bonds focuses mostly on what the interbank interest rate should be in order to target inflation, the micro view looks more closely at the individual decision of the firm or investor, which relates primarily to their risk preferences. The Intermediate Microeconomics course textbook from Pindyck & Rubinfeld (2018) does not exclusively treat government or corporate bonds, but they provide applications for how bonds are a type of asset that carries risk, so Chapter 5 has the strongest connection to this topic of the material discussed in this course. 

HEADLINES

As of May 4, per Goldfarb and Omeokwe (2022), Jerome Powell announced that the Fed would not raise interest rates significantly, meaning nothing more aggressive than a half percentage point.  The market reaction was overwhelmingly negative, as the stock market saw its biggest daily decline since the dark days of the pandemic. Treasury yields fell initially, but then saw the biggest daily jump in two years up to 3.066% (Bond Slide Intensifies, May 5), as investors seemingly discredited Powell’s statement.  The negative reaction to the news shows that investors are concerned about inflation spiraling out of control, and believe the Fed will not be effective in its monetary policy. 

Bonds are more of a primary focus in macroeconomics, as through open-market operations the Fed control the money supply, which balances inflation.  However, while studied more in macro, inflation is just as important of a factor in micro because the firm is where the price increase takes place.  In the past six months, inflation has been a hot topic because of noticeable gas price increases that open consumer eyes to price increases everywhere, reflecting a reality that too much money is in the economy.  U.S. inflation jumped from 1.2% to 4.7% in 2021, so investors have good reason to nitpick the Fed’s policies, and as consumers see market prices climbing and panic.  

THEORY

The single most important concept to understand about bonds is that their yields reflect their riskiness.  Government bonds are considered a riskless asset because the government is unlikely to default on its loans (Pindyck & Rubinfeld, 174).  At the corporate level, perceived likelihood of default is the key hurdle for investors.  Pindyck and Rubinfeld (2018) illustrated a simple comparison for government and corporate bonds in Chapter 15, page 560-61.  From May 26, 2016, the interest rates for Microsoft and Caesar’s entertainment are respectively 3.8% for a 25-year bond and 12.1% for a 5-year bond.  Microsoft has a favorable bond rating of AAA, while Caesar’s has an alarming rating of CCC-. 

While the rating systems provide a simplified explanation of riskiness, the interest rates tell most of the story.  Microsoft has a great track record, so their yield rates are similar to government rates because they are probable to return that money at its maturity date.  Blue-blood bonds are just as safe of an option as their corresponding stocks, with the only variable being the magnitude of profitability reflected by the stock.   On the other hand, companies in volatile industries with unproven track records carry a higher level of risk in their bonds, but significantly less risk than their stocks because as long as the company does not default, the investor gets their money back at the maturity date.  The Caesar’s bond reached full maturity in 2021, and looks juicy in hindsight because the company has grown significantly since 2016.  However, a recent decline suggests the increase may have come from an economy of scale, as gambling has surged in the past five years due to more states legalizing mobile sports betting.  Their stock index is down 37.2% since late November, which suggests the gaming industry may have already peaked, and these companies will require better management in the future and no longer be able to ride the wave of legalization benefits.

Stocks and bonds also tend to move as substitutes for investors.  While bonds are inherently less risky because of a pseudo-guarantee of profit, with low interest rates it is more worthwhile to take the risk on the stock market.  Goldfarb (2022) reinforced that higher treasury yields, which are negatively related to bond prices, mean borrowing costs increase, slowing the capital accumulation process.  From a trading perspective, when bond yields rise (as they are presently), a higher interest rate makes the return from bonds a more profitable investment strategy, at both the government and corporate levels.  As bonds become more in demand with higher interest rates, stocks are considered too risky, and investor preferences shift to bonds.

The transgression mechanism for inflation occurs as follows: When the Federal Reserve buys bonds, they increase the amount of money in circulation, as the cash transfers into the consumer’s hands.  With more money in the economy, consumption will increase because of the perceived change in purchasing power, but a trilogy of price increases occurs to balance out the money in the economy.  With a higher money supply, consumers want to spend more, so firms feel the need to raise prices to keep maintain real profits.  Firms that understand price theory know that the marginal cost has to be equated with marginal revenue, and that simply charging more for their product is too shallow of a strategy.  At the end of the day, wage rates, rental rates, and finished product sticker prices all end up increasing as an effect of inflation.   

In the ideal economy, a 1% increase in the money supply will see identical increases in the CPI and in wage rates, as well as the rental cost of capital.  Because of time and implementation lags, these shifts usually do not occur in perfect proportion, inflationary effects occur at the micro level when firms do not understand their cost and revenue changes as nominal or real increases.  Even for firms with a good understanding of economics, business cycles and Fed policies are difficult too anticipate, and the uncertainty also can create frictions.  Individual firm decisions to purchase bonds become important as when inflation occurs, a higher interest rate is needed to make the money worth more at maturity, because during inflation, the opportunity cost of holding bonds is higher.

ANALYSIS

While inflation is a serious problem with the U.S. economy in 2022, price level spikes are not a new occurrence, but the U.S. has not seen alarmingly high inflation rates since the 1980s. In that regard, declining stocks can cause alarm of the public attention on the stock market, which is relatively easier to understand than the bond market, but the seasoned investor does not panic, and simply adjusts their portfolio with more bonds.  In other words, smart investors adjust and make money regardless of the overall state of the economy.  Investor expectations will probably be correct in this modern case of inflation, as the Fed has shown by their actions that they do not want to slow down the perceived pandemic recovery by jacking up interest rates and slowing consumption in an already inefficient economy.  The inflationary period of the 2020s is probably still in its toddler stages, and the firms who believe they are immune to price changes and fail to monitor bond trends will slowly receive negative feedback in purchasing power. 

These issues affect me directly as one specialization of intrigue is monetary economics. With the modern wave of MMTers causing a catastrophe by suggesting that printing money is always a solution, and that Fed independence is not necessary, a new generation with sound monetary policy principles and a willingness to be proactive about inflation will be needed to settle this mess and future monetary crises.  The main takeaway from bond developments that I can apply personally and in my investment strategies and professionally is that portfolio diversification must be established not just between mutual funds and stocks of different industries, but also between stocks and bonds.  Electronic banking has made investing much easier and lowered the entry barrier on the stock market, but this surge of new investors begged the question of if the stock market was becoming a bubble mid-pandemic, and the recent market developments support a short-run decline.  As I move into the professional stage of my life, exposure to this topic has inspired me to invest more in bonds with an app like E-Trade, in addition to stock and ETFs on Robinhood, CashApp, etc. 

With more time and more sources considered, a good research topic would be to study several different government bond yields over time, and how it relates to national financial crises or bankruptcies, or similarly with corporate yields, to show if interest rate portrays an accurate estimation of the likelihood of default.  Additionally, attempts to quantify how effective the Fed is at controlling bond markets by their statements could help project inflationary timelines and the effects, which would help Fed members be more attentive to their statements and estimate the effects of an announced policy.  In the next six months, monetary policy will be in the spotlight as the Fed realistically has until the end of the year to raise interest rates and settle inflationary expectations, as the longer inflation can spiral out of control, the greater the effect on firms and consumers will be, and a recession of a greater impact than the pandemic will devastate the United States.

REFERENCES

Goldfarb, S. (2022, May 5).  Bond Slide Intensifies, Rattling Other Markets.  Wall Street       Journal.

Goldfarb, S. and Omeokwe, A. (2022, May 4).  Treasury Yields Fall After Powell Downplays

         Chance of 0.75 Percentage Point Rate Increase.  Wall Street Journal.

Inflation, Consumer Prices for the United States.  (2022, May 3). FRED.

https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

Pindyck, P. and Rubifeld, D. (2018).  Macroeconomics, 9^th Edition.  Pearson. 174, 560-61