3. Bond markets Flashcards

1
Q

What types of investor are bonds suitable for?

A
  • Investors with a relatively short-term investment horizon (e.g. older people).
  • Risk averse inidividuals
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2
Q

What is the effect of increasing inflation on bond yields and prices? Why is this?

A

As inflation increases, investors expect the central banks to increase interest rates, reducing the real interest rate (bond’s nominal interest rate - inflation) of existing bonds with fixed nominal interest rates. This makes existing bonds less attractive to investors, especially since new bonds with similar characteristics will be issued at higher nominal interest rates, offering better returns. As a result, the market price of existing bonds falls, which increases their yields (since bond prices and yields are inversely related).

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3
Q

What is bond yield?

A

Bond yield is the annual interest paid (coupon payments) on a bond as a percentage of its current market price.

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4
Q

What are some factors that affect the difference in nominal interest rates offered for long-term (maturity) bonds and short-term (maturity) bonds?

A
  • Nature of the economy. In a recession, investors value long-term bonds more if they expect the economy to improve in the future. If there is uncertainty on when and if the economy will improve, investors may value short-term bonds more due to the reduced risk.
  • Inflation expectations. If investors expect inflation to persist into the future, investors will value short-term bonds as their present value will be negatively impacted to a lesser extent than long-term bonds (as coupon and principal payments will be received sooner).
  • Outlook on the relevant government’s or company’s (in the case of corporate bonds) financial health.
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5
Q

Who account for the largest share of bond issues?

A

Governments

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6
Q

What is redemption? What is redemption date?

A

The process of repaying the nominal value of a bond on or before the maturity date.
Redemption date is the date when the bond issuer has the right to pay off the bond before the maturity date.

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7
Q

Why are domestic government bonds from developed country governments less risky than government bonds issued by emerging economies in overseas markets?

A

Because when issuing in their own currencies, domestic goverments from developed countries can always refinance by “monetary financing” (i.e., borrowing from their own central bank). Governments borrowing in foreign currency must raise taxes to repay their borrowing, and these taxes must be worth enough in foreign currency in order to repay their bond obligations, which may be less likely in emerging markets.
For example, the governments of Greece and Portugal have faced difficulties as they have borrowed in foreign currency and cannot use momentary financing to repay bond obligations. The resulting loss of confidence in turn has undermined their public finances.

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8
Q

Why are corporate bonds considered more risky than government bonds?

A

Corporate bonds are issued by companies and backed by their own current and future earnings. If a company is profitable the bond will be repaid. If the company is not profitable then it may “default” on the bond (i.e., not make full repayment). Because of this default risk, investors treat corporate bonds very differently from government bonds. Lenders demand higher returns and also special protections, known as “covenants”, to protect investors from actions taken by borrowers.

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9
Q

What are Eurobonds?

A

Eurobonds are bonds issued offshore by governments or corporates denominated in a currency other than that of the issuer’s country. Both bond issuer and bond investor could come from anywhere in the world.

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10
Q

What are international bonds?

A

Bonds issued in large domestic markets by overseas issuers. While the issuer is international, the investors are domestic.

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11
Q

What is flight-to-quality?

A

A sudden shift in investment behaviours in a period of financial turmoil whereby investors seek to sell assets perceived as risky and instead purchase safe assets (e.g. treasury bills). This causes a decrease in government bond yields due to their increased demand.

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