A financial market refers to a marketplace where buyers and sellers are engaged in exchange of assets such as bonds, equities, derivatives and currencies. A financial market is characterised by transparent pricing, basic regulations concerning costs and fees and a number of market forces, that determine the prices of securities trading in that market.
The two very popular financial markets that can be found in every country across the world are the Bond Market and the Stock Market.
Trends across Bond and Equity markets
According to the Russell Investments/ASX 2017 Long-term Investing Report, the gross returns per annum for the Australian bonds averaged 6.2% in over 10-year period through December 2016. Meanwhile, for the same period, Australian shares averaged 4% in gross returns per annum making it the second-lowest-returning Australian asset class. However, it should be noted that the period in context encompassed the Global Financial Crisis.
The recent trends suggest that the global interest rates have recorded a downtrend over the past few days. For example, the German 10-year Bond yield had a record low of around -0.3% as of June 2019 while the Italian 10-year government bond yield also reached its lowest point in the whole year to 2.106%. The US 10-Year Bond Yield also touched a low of 2.016%.
In Australia, the RBA recently announced interest rate cuts and it is anticipated that the interest rates are likely to fall further over the next few months, as per the market participants.
Usually in a typical economic scenario, a dip in interest rates is followed by an uptick in share prices. As a result, investors look to the equity markets for profits.
The Australian equity market, though not amongst the most expensive in the world, has been in the limelight for generating great returns even in times of national disruptions like dwindling interest rates, federal election commotion, housing slump, or even global trade uncertainties.
Being the most enormous and diversified securities markets in the world, a Bond Market offers a myriad of investment options for investors to choose from. Once perceived as an investment to earn interest while preserving capital, the bonds have now evolved into a massive $ 100-trillion global marketplace where attractive returns may be earned, and investment portfolios can be largely diversified.
Essentially, a Bond is a loan provides by the investor to the bond issuers like Governments, corporations or municipalities whenever they require capital. A periodic interest is paid to the bondholder and eventually principal is also returned at a predetermined time, known as ‘maturity date’.
Every bond is associated with some risk concerning the inability of the issuer to fully repay the loan. For that, there are independent credit rating services that assist the investors to execute better discernment. Usually, issuers with a high credit rating pay a lower interest rate than those with a low credit rating. So, investors who prefer purchasing bonds with low credit ratings to earn higher returns must be ready to bear the probable default risk associated with the bond issuer.
Most bonds are traded over the counter (OTC) between large brokers and dealers on behalf of the clients while few are traded publicly through exchanges as well.
Bond price and its yield determine its value in the secondary market. Bonds are generally priced at a face value (fixed). Upon entering the open market, the trading price can be lower than the face value, called a discount, or higher, called premium.
Bond yield is defined as the actual annual return upon maturity. A bond’s price is also inversely proportional to its yield.
In other words, rising interest rate imply that new bonds would pay higher interest rates to investors than the old ones, so old bonds tend to drop in price. On the contrary, a dip in interest rates increases the value of older bonds, who now offer relatively higher interest rates than new bonds, which in turn causes the older bonds to sell at premiums in the bond market.
The different bond categories include government bonds, foreign bonds, corporate bonds, mortgage-backed bonds and municipal bonds.
A stock market, also popularly known as an Equity Market, a place where shares of the publicly listed companies are traded through centralized exchanges like Hong Kong Stock Exchange, New York Stock Exchange, Australian Securities Exchange, London Stock Exchange Group, National Stock Exchange (India) and across the world. The shares can also be directly traded over the counter (OTC).
The stock exchange, also known as bourse, is a conventional medium through which shares, bonds and other securities are exchanged. Its key function is to facilitate the issue and redemption of financial instruments, inclusive of the payment of income and dividends.
Stock markets have established a free-market ecosystem where the companies have easy access to capital in lieu of offering interested investors a stake in the ownership of the company.
The share prices are determined by the supply and demand dynamics as investors place their orders to buy/sell shares. Stock market specialists or market markers often maintain order flow and bid-ask spreads to ensure an organised and fair market.
There is a certain extent of risk, however small or big, associated with engaging in the stock markets. However, it also offers an opportunity to investors to augment their income without establishing their own businesses, characterised by high overheads and opportunity costs. So, when approached in a disciplined manner, evaluating fundamental, technical and macro developments, stock market trading/investment can prove to be highly advantageous to build up one’s net worth.
The stock market can be categorised as Primary and Secondary.
- Primary Market– An open stock market where the securities are initially created and directly sold for the first time by the company.
- Secondary Market– In the secondary market, the shares are traded by the investors and the company, that sold the stock initially, is no more a participant.
There is also a decentralized market known as the OTC Market or an off-exchange, where trading can directly take place between two parties, such as the trader and the broker.
There are a number of key factors or strategies (see figure below) that the investors adopt to derive the best return on their investments and make profits.
Stock Market Indices
Indices represent aggregated prices of several different stocks listed on an exchange and provides measurement of a certain section of the stock market. For example, the Dow Jones Industrial Average (DJIA), the S&P/ASX 200 or the S&P/ASX 200 Information Technology Index.
What do investor prefer?
The bond market moves when market participants speculate about the changes in the macroeconomic variables such as about economic growth and inflation. Unlike stocks, whose future earnings can be judged based on deductions or predictions, bonds make fixed payments after a certain time period. If the expectations around inflation grow, investors are less willing to pay for the bonds and vice versa.
It is also known that the pricing of bonds is not as volatile as stocks and is often more responsive to interest rate changes than other market conditions. As a result, patient investors with lower risk tolerance, looking for safety and income in the long-run, often prefer bonds over stocks as they get closer to retirement. On the other hand, stocks have the potential to offer higher returns.
The best course for investors to take is diversification of their portfolio, which also helps in mitigating risks and hedging against the same.
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