In the economy, financial markets play a significant role in providing a place where sellers and buyer of financial instruments can easily trade their securities. Since the break out of COVID-19, the overall operation of the most institution has been affected. This report will analyze extensively the risks associated with investing in either bond or stock market during the pandemic and how the hazards will evolve in each market when the impact of the virus flattens.
Risks Associated with Bond Market
Normally, bonds are regarded by investors as a safe investment worth taking. During this pandemic, their markets and financial institutions have been facing unpredictable performance following changes in the overall economic condition that has hit the entire globe. Most governments have structured their policies to minimize the impact of the COVID-19 on the economy. Despite the measures and adjustments made, financial instrument markets face the following risks; changes in interest rates, increased rate of default, and inflation.
Low Interest Rate Risks
Due to the effect of the pandemic on the country’s economy, the federal government initiated measures to allow most households have the opportunity to access funds through borrowing to supplement their expenditure. To achieve this, the interest rate is lowered to enable organizations and individuals to obtain the funds they need. When the borrowing rates are low, the demand for bonds will go up, therefore, making their prices increase (Falato et al., 2021). For instance, assuming a zero-coupon bond is trading at $900 and has a rate of return of 8%in the market, and if the rates drop to about 4%, the security will become attractive, and most people will purchase it, thus increasing its price. For the bond’s yield to match the 4% interest rate, the trading price would be [(4/100)*900 = $936]. It, therefore, means bondholders benefit in the market during the period of the pandemic.
Inflation Risk
The pandemic interfered with production, transport, and other important activities that propelled the effective running of the economy. The disruption made the cost of products and services shoot up, increasing the cost of living. Generally, bond investors expect a return from the market upon purchasing the financial instrument. When overall prices increase, the income will be affected compared to the expected return before inflation. When the inflation rate is faster than the income from the bond investment, the amount at which they acquired the security will erode, yielding low profit at the maturity period. For example, assuming the rate of return on the investment is 5%, then inflation hits with a rate of 7%, the bondholder would incur an income of about -2% due to the reduction in purchasing power of the money in the economy. This indicates a loss in the market for bonds for investors.
Liquidity Risk
During this pandemic, most people are not sure of the economy; therefore, they are reluctant to buy bonds from institutions whose operations are closely linked to the effects of the COVID-19. Corporate bonds are the most affected since individuals lack the confidence to stake in them. Furthermore, investors fear making losses; thus, they are holding back from investing in the debt securities. This situation makes it difficult for organizations to sell their financial instrument into cash.
Risk of Default
Bonds are money borrowed that is supposed to be paid by the issuer on an agreed future date. With the prevailing economic performance, most people and institutions have suffered from the effect of the pandemic reducing their income level. Having a low or limited source of income, the seller may not commit to the agreement made concerning the payment of the principal amount. This condition puts investors at risk of losing their funds and the expected returns. It is, therefore, appropriate to analyze the operating income of the seller before signing the contract.
Risks Associated with Stock Market
The stock market, also known as the share market or equity market, contains both buyers and sellers of the stocks. Generally, most people invest in this market by claiming the ownership of a given corporation or business through purchasing shares. The spread of the pandemic has led to a global economic crisis affecting the capital markets. The stock market has experienced several risks and uncertainties following the economic abnormality caused by the virus, including;
Volatility Risk
Since the outbreak of the pandemic, most governments have introduced various measures to curb the spread. Some of the actions taken were restriction of movement, social distancing, and the lockdown that made the productivity of the economy drop. The disruption caused the stock prices to keep fluctuating, making the trade complicated (Baek et al., 2020). Changes in the price of oil also affected the economies of developing countries, thus making the stock prices soar. Such an inconsistent volatility rate would mean equal chances of making a profit or incurring losses in the market. The condition can hinder most investors from investing in the market due to the fear of uncertainties.
Low Share Equity
The stock market is facing the risk of reduced equity share due to a decline in the cash flow and other activities that can increase the company’s overall revenue. Taking the great depression of 2008 as the reference point, most investors choose to withdraw their shares from the market, fearing the potential crush upon hearing about the virus. Furthermore, the closure of most workplaces and operations has also made individuals and institutions have less money to purchase the stocks. This has resulted in low capital in the market hence reducing its performance which affects the overall return.
Risk of Liquidity
Reduction of the income-generating activities and interference of most organization cash flows made it difficult for the stocks to be converted into ready cash. Firms could not easily sell their shares because people are uncertain about the future of the business (Mishkin and Eakins, 2019). The situation makes it challenging to trade stocks in the financial market. If the company needs cash, it will be forced to lower its equity price, which will make it run losses. For example, assuming Company A stock is trading at $45 per share in the stock exchange market, supposing it requires urgent funding to finance its project, it will be forced to lower the share price to about $40. Given that there are no people ready to buy the stock at the initial cost because of fear of uncertainties. Commodity Price Risk
Measures to control the spread of the virus resulted in the restriction of movement for both people and products. This caused some commodities to be less available in the market, making their prices increase. Changes in the cost of the product would make consumers manage their overall expenditure in the market, therefore, affecting the whole economy. For instance, an increase in petroleum prices would result in a surge in the cost of services that relies on fuel usage. Therefore, making the consumers keep check on their spending.
Investment Recommendation
If the country’s operations resume normally after the pandemic, most governments will reduce the imposed restriction, creating a good atmosphere for a business function. Both people and organizations would start working, thus generating income. Having the urge to rebuild themselves and cover for the losses made during the period, individuals and business organizations will require extra capital to finance their activities. The supply for the bond would be increased therefore lowering prices; as a result, investors should invest in the market. Similarly, in the stock market, upon reopening the economy, most people and organizations will resume business activities, increasing money movement in the system. This would make the commodities prices stable, reducing the risk of volatility. Furthermore, people will start investing, making the stock prices go up. For the investment purpose, an individual should invest in the market for bonds, especially Treasury bonds, due to the limited risk of default.
In conclusion, financial markets are the most affected in the economy; therefore, a proper analysis of the associated risks is necessary before deciding where to invest. The bond market has some hazards like credit default and illiquidity of some bond types. However, investing in government securities would minimize the uncertainties. The equity market relies majorly on commodities pricing, where any slight effect on the production can cause total volatility.
Reference List
Baek, S., Mohanty, S.K. and Glambosky, M. 2020. ‘COVID-19 and stock market volatility: An industry level analysis.’ Finance Research Letters, 37, p.101748. Web.
Falato, A., Goldstein, I. and Hortaçsu, A. 2021. ‘Financial fragility in the COVID-19 crisis: The case of investment funds in corporate bond markets.’ Journal of Monetary Economics, 123, pp.35-52. Web.
Mishkin, F.S. and Eakins, S.G. 2019. Financial markets. Pearson Italia.