3. Bond markets 2 Flashcards
What are mortgage-backed securities (or MBS)?
Bonds backed by a pool of mortgages. The coupons and final principal payment come from the payment of interest and principal from the mortgages.
What are Islamic bonds (a.k.a. Sukuk)?
Islamic law discourages the charging of interest. To get around this prohibition there is now a fairly large and rapidly growing market for so called Islamic bonds (known as Sukuk). The income on these bonds is not based on coupon rates but rather on a principal of sharing of returns. They are thus, in many ways, more like equity than a bond.
What are examples of motives for investing in bonds?
- Low risk (especially with government bonds)
- Legal obligations or investment mandate (instructions given by clients) to invest only in high quality safe instruments.
- Short investment horizon (e.g. individuals at or near retirement, or pension funds where most clients are near retirement).
Why does investment time horizon matter when it comes to bond investment?
Investors with short investment horizons will favour short-term bonds due to the lower uncertainty with future payments.
Investors with long investment horizons will be cautious about investing in short-term bonds because this investment exposes them to “reinvestment risk”, they cannot be sure that they will get as high a return when they reinvest after 5 or 10 years.
What is the main risk for government bond investors?
Inflation risk. For most bond investors a major concern is that inflation will erode the real value of the coupons and principal. This is especially true of longer maturity bonds.
In most cases there is only a low risk that the bonds of governments will not be fully repaid. Risk of default is higher in emerging economies than developed countries.
Why do interest rates (and yields) on government bonds of different maturity tend to move fairly closely together?
Because the main determinant of yields are inflation expectations (and consequent interest rate changes).
But long-term bonds are more sensitive to inflation / changing interest rates and are thus more significantly affected. Long-term bonds are also exposed to a greater probability that interest rates will change over their remaining duration.
What is a bond yield curve and what is it used for?
A bond yield curve is a graph that shows the current bond yields of bonds with different maturities. It is used to make decisions on which bonds to invest (short-term, medium-term, long-term etc.) (if any) and to interpret the state and direction of the economy at the time that the data plotted on the graph was recorded. The shape of the bond yield curve is often indicative of current economic conditions and market participant’s predictions.
What have been the government bond yield rates in the US over the last few decades?
Up until 2020, for several decades bond yields were decreasing due to decreasing inflation. Inflation increased 2020-2023 and bond yields continue to increase.
What is credit spread?
The difference in yield between two debt securities of the same maturity but different credit quality (default risk). Credit spreads are often used to compare corporate bond yields to risk-free bonds (e.g. US government bonds). It is a measure of the additional yield that investors demand for holding a bond with a higher perceived credit risk than a safer bond.
What are the main bond types?
- Domestic government bonds
- Sovereign bonds (emerging markets issue bonds overseas in domestic currency)
- Corporate bonds
- Eurobonds (issuer and investor can both be international)
- International bonds (issuer is international, investor is domestic to the market)
- Public corporation bonds (e.g., by government owned post offices)(often guaranteed by governments)
- Municipal or local government bonds
- Mortgage backed securities (MBS)
- Structured credit securities (bonds backed by a pool of assets)
- Islamic bonds (a.k.a. Sukuk)
Maybe make a flash card on bond issue asymmetries covered in end of lecture notes.
Could potentially be in the exam.
