Bond Knowledge is the Foundation of Investment

1. While the high-end world of stocks is still in a daze, the decline in bonds leading to a retreat in the net value of financial products has taken people by surprise, leaving most feeling wronged and angry: "I've already laid flat, why can't the fluctuations leave me alone?" Instead of complaining and panicking, it's better to learn some basic knowledge about bond investment!

2. Why learn the basics? In 2004, I joined Bosera Fund and received a book on my first day, "Common Sense on Mutual Funds," a classic work by the founder of Vanguard, Bogle. Upon reading it, I found many things half-understood, yet impressive. Eighteen years have passed, and the book has been updated and re-read, from which I have benefited immensely. Therefore, when venturing into any field, it is essential to study the masterpieces of the masters in that field; it will provide a panoramic view and serve as a guiding light on the path ahead.

3. Once in the fund industry, it is natural to study the classics of stock investment. "Security Analysis" by Graham, the teacher of Buffett, is a must-read. Graham is not only famous for his deep value but also for his more significant achievement of founding the industry of security investment analysis. The CFA Institute was initiated by him, making him the true patriarch.

4. He has an autobiography that is extremely fascinating, but "Security Analysis" is not only a monumental work but also extremely abstruse and profound because it talks about many things that people did not know at the time, such as how to analyze investment and speculation. Perhaps because it was read by too few, for the sake of sales, he wrote a popular book called "The Intelligent Investor," which became a bestseller and well-known worldwide. Buffett went to Columbia to study under Graham after reading this book.

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5. The biggest doubt Dong had while studying "Security Analysis" was that he spent half of the text discussing bond investment. Although it was confusing, he had to read on with a stiff upper lip, from investment and speculation to ordinary bonds, high-yield bonds, convertible bonds, preferred stocks, and common stocks. Later, he realized that bond investment is the foundation of all investments. The DCF cash flow valuation model is very understandable when it comes to bonds; it's just the discounting of cash. Once you understand bonds, looking at the DCF model for stocks becomes even more insightful.

6. In fact, Graham unfolds his discussion from the perspective of the evolution of securities. In real life, the creation of bonds predates that of stocks. A large number of bonds were created more than 400 years ago during the Age of Exploration. Bonds are certificates of investment where people pooled money to support adventurers in exploring the oceans and engaging in global trade. When the captains returned, everyone received the agreed-upon fixed returns.

It was because bonds were issued more and more frequently that there were times when no one was willing to buy them, and the printed bonds became inventory, known as "Stock." Later, a clever person suggested to the boss to adjust the bond terms: first, not to repay the principal, which delighted the boss; second, not to pay interest, which made the boss almost ecstatic; third, those who bought the "Stock" shared the same fate with the boss, with the same returns whether they lost or made money. The boss, of course, had no objections, so these "Stocks" are also called "Shares." Thus, stocks are a special kind of bond.

7. Since then, stocks were born and have surpassed their origins to become the mainstream. Subsequent investors, however, no longer knew what bonds were. The Chinese capital market originated with the establishment of the stock exchange, without experiencing the gradual evolution of the Western securities market over hundreds of years. Therefore, investors lack the cultural accumulation of the basic principles of bond and stock investment, instead chasing the by-products of the capital market—fluctuations and speculation.

8. After the 2006-2007 bull market, I came to a conclusion: there are many sorrows in the Chinese capital market, one of which is that the stock market came before the bond market. Investors lacking a culture and literacy in bond investment seem to be able to bear risks, but in reality, they are just keen on fluctuations. The retail investor structure is the quantitative reason for the significant fluctuations in the Chinese market, and retail investors without bond investment literacy are the qualitative reason.9. Later on, when taking the CFA exam, investment analysis and valuation of bonds are fundamental, and the complexity involved is far greater than that of stocks. If stock investment is more of a self-suggestion-based coarse logical deduction, bond investment is a refined and scientific mathematical algorithm.

10. This also leads to a convergence in the thinking and behavioral patterns of bond investment managers, which can easily trigger synchronized buying and selling at certain critical moments. Especially when facing liquidity issues caused by macro and micro factors, it can easily trigger an avalanche-like stampede in trading. This issue is more terrifying than bond defaults. There have been several liquidity crises in history, such as the stress test in 2013 and the bank's external management cleanup in 2016, both of which caused the market to bleed, leaving a lingering fear. At that time, there was support from non-standard assets and regulatory protection, without involving ordinary retail investors.

11. The recent bank wealth management net value drawdown has many inducing factors, but ultimately, it manifests as a liquidity crisis. The risk was originally controllable, but the chain reaction triggered by public panic is the real risk. This is the boomerang effect of the financial market. Water can carry a boat and also capsize it, but everyone should not panic. Based on previous experiences in handling similar risks with money market funds, the regulatory authorities will not stand idly by, otherwise, it may trigger a larger crisis. Wealth management investors need not worry, and should not rush to redeem, causing a new "stampede event."

Bond Valuation: Maturity, Interest, Discount Rate

12. Alright, let's return to the common sense of bond investment. Since 2017, Dong Ge has been teaching at the National Association of Financial Market Institutional Investors (if you are not clear about what this association does, it means you know nothing about bonds. Most of China's bond issuance and trading are not on the exchange, but in the interbank market. The interbank market is an over-the-counter transaction, and the trading counterparty is very important, otherwise, liquidity will be an issue). He has mainly taught three types of courses: "Credit Bond Investment," "Convertible Bond Investment," and "Fixed Income + Investment." Among them, the "Fixed Income +" course is also the main lecturer for the association's online courses.

13. The valuation model for bond investment is very simple: the value of a bond = the present value of future interest and principal. Since the principal is always 100 yuan, the factors that determine the value of a bond are three: maturity, interest, and discount rate.

14. The first is maturity, which is how many years after issuance the principal is repaid, ranging from less than a year to ten or twenty years, with various bonds available. Treasury bonds are generally longer, central bank bills are very short, and corporate bonds are mostly 2-5 years. The term of a bond is fixed, with one day less for each day that passes.

15. The second is interest, which is similar to bank deposits. The longer the term of the bond, the higher the interest; different risk bonds have different interest rates. Treasury bonds have the lowest interest, and corporate bonds have higher interest. Back in the day, trust products were called non-standard products. What is the corresponding standard product? It is bonds. So, non-standard trust products are a type of fixed-income product that is not listed for trading. Why are people willing to issue bonds? It is because the interest (coupon) promised by bonds is mostly unsecured, hence also called credit bonds. The issuers of credit bonds naturally have good credit, so the coupon of credit bonds is far less than that of trusts.

16. The third is the discount rate, which is determined by market pricing and can be broken down into the market risk-free rate and the risk premium rate. The discount rates for government bonds and financial bonds only include the market risk-free rate because they are backed by national credit and have no credit risk. The discount rate for credit bonds must be priced on top of the risk-free rate.18. Market interest rates are determined by macroeconomic conditions and monetary policy, with the yield on ten-year Treasury bonds being a commonly used indicator. The yield indicator for U.S. interest rate hikes is also the Treasury yield, this base rate, not only determines the valuation changes of bonds but also affects the valuation changes of stocks. Any financial product that uses a discount rate in its valuation formula will be influenced by it. The most important function of macroeconomists is to predict the trend of interest rates.

19. The degree to which different bonds are affected by interest rates varies. For instance, the price of a five-year Treasury bond is much less affected by interest rates than that of a ten-year bond. This can be easily seen from the formula, and since the discount rate is in the denominator, when interest rates rise, prices fall, and when interest rates fall, prices rise. Of course, this is a simplified conclusion; the actual mechanisms are much more complex, but they are all realized through investors voting with their feet.

20. Credit risk can be divided into two parts: the risk of interest and principal payment, which is the ability to repay the debt, broken down into three indicators: repayment capacity (whether there is money), repayment willingness (whether those with money want to repay), and external support (whether those without money can borrow to repay).

21. The second part is the risk premium rate, which is the part of the discount rate for credit bonds that is higher than the risk-free rate. This reflects the market's belief in a certain promise and is a form of market faith. It is very simple: the higher the credit, the lower the interest you require. Why? Because the lower the discount rate, when Bill Gates asks to borrow money from you, you can just ask for the Treasury rate.

22. This also illustrates that in the business world, the most important business outcome is credit. If everyone trusts you, they will buy your products; if everyone trusts you, the cost of borrowing is very low, and cooperation with anyone is very convenient. The development of the bond market in recent years has essentially been a process of continuously breaking the belief in the ironclad promise, with the beliefs in municipal investments, state-owned enterprises, and real estate being continuously shattered. A rule can be summarized: any belief has the potential to be broken. Now the belief in wealth management products has also been broken. There are no miracles in this world, and with the beliefs in underlying assets shattered, how could the products built on them still have faith? This is common sense and there is no need for alarm.

23. Finally, there is liquidity risk. The DCF valuation model is a static method that does not address the issue of momentum. Valuation models can only determine the direction of equilibrium in the spatial dimension but cannot judge the rhythm and repetition in the temporal dimension. Unfortunately, the basis of most investment judgments is based on models, so any time liquidity risk appears, it is very dangerous. The greater danger comes from consistent stampedes. This is similar to wearing outer clothes when going out normally, but when there is a fire or earthquake, or when people think there is a fire or earthquake, what to wear downstairs or whether to wear anything downstairs is no longer important, panic is the root of the liquidity crisis.

24. In conclusion, bond investment may seem simple from the formula, but it is extremely complex in actual investment decision-making, with interest rate curves, duration, and convexity, you will find yourself entering a mathematical world. Today's discussion is about basic concepts and principles, and interested friends can supplement their learning.

Additionally, stock investment is no more complex than bond investment, and may even be simpler, but all the variables in the valuation model are more unruly, so the difficulty of investment is a hundred times greater than that of bonds. Many people are very confident and ambitious when investing in stocks or predicting the stock market, which I often find incomprehensible. This is clearly a display of a lack of common sense. It is better to start with the DCF model!