3. Bond markets 2 Flashcards
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 and inflation instability 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? Why is there a slight difference?
Because the main determinant of government bond 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 exposed to a greater probability that interest rates will change over their remaining duration. Long-term bonds will be more significantly affected by discounting than short-term bonds due to the later receipts of long-term bonds.
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 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, particularly very-short term bonds such as treasury bills). 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.
