9 - Bond and money markets

Question 1

Outline three situations when index linked bonds will appear relatively more attractive to an investor than conventional bonds

Answer 1

1. When the investor needs to match real liabilities and hence requires inflation prediction
2. When the investor expects the future inflation to be higher than that currently predicted in the market
3. When the investor expects the inflation risk premium to be higher than that currently predicted in the market

Question 2

List ten investment and risk characteristics of conventional government bonds

Answer 2

1. Income = Coupon that is fixed in nominal terms
2. Capital = Redemption amount that is fixed in nominal terms
3. The yield is fixed in nominal terms. The real yield is eroded by actual inflation.
4. The expected yield is lower than for equities and property
5. Variability in capital values is lower for short term bonds than for long term bonds
6. Tax treatment depends on the territory
7. Very marketable if in a developed country
8. Very low default risk if issued by a developed country. Almost non-existent
9. Term: Short, medium, long, irredeemable
10. Very low dealing costs if a developed country

Question 3

List nine investment and risk characteristics of money market instruments

Answer 3

1. Liquid
2. Short term
3. Generally, very low default risk due to the short term (although depends on the issuer)
4. Low expected yield compared to other assets
5. Return expected to more broadly in line with inflation
6. Stable market values due to short term
7. Very low dealing expenses
8. Usually taxed as income
9. Marketable (except for call and term deposits)

Question 4

What does the size of the inflation risk premium reflect?

Answer 4

The inflation risk premium reflects the additional yield required by investors with real liabilities for taking on the risk of uncertain future inflation.

The size of the inflation risk premium is determined by:

• The degree of uncertainty about future inflation
• The balance between the number of investors who require a fixed return and investors who require a real return

Question 5

Outline the main players in the money market

Answer 5

I. The money market is dominated by the clearing banks who lend and borrow via short term deposits to control their liquidity levels.

II. The central bank acts as a lender of last resort, standing by to help with the clearing banks’ liquidity issues. The central bank sets short-term interest rates by buying and selling bills.

III. Other financial and non-financial organizations also operate in the money market by lending and borrowing short term funds.

Question 6

Why do institutional investors not normally invest a large proportion of funds in money market instruments?

Answer 6

I. Money market instruments give a lower expected return than other, riskier assets

II. Money market instruments are not a good match for long-term liabilities.

III. There is reinvestment risk – Proceeds will have to be reinvested on unknown terms

IV. Short term interest rates will move broadly in line with price inflation. However, money market instruments are not a good match is the investor has real liabilities linked to some other index

V. Too large a proportion would result in a lack of diversification

VI. There may be a limited supply of money market instruments available

Question 7

Write down an equation stating the link between nominal yields and real yields.

Answer 7

Nominal Yield = Risk-free real yield + Expected future inflation + Inflation risk premium

Question 8

Why do institutional investors hold money market instruments?

Answer 8

Institutions mainly hold money market instruments for liquidity reasons:

• Protect monetary value
• Opportunities (to size them)
• Uncertain liabilities
• Recently received cashflows
• Short term liabilities

Institutions may also hold cash because they feel that other assets are going to perform poorly:

• General economic uncertainty
• Recession expected
• Increase in interest rates expected
• Depreciation of domestic currency expected

Institutions may also hold money market instruments for diversification.

Question 9

List three distinct types of bond markets

Answer 9

I. Markets in government bonds listed in their country of origin

II. Markets in commercial bonds listed in their country of origin

III. Markets in foreign commercial and government bonds listed in other than the ‘home’ country.

Question 10

Describe the cashflows of a conventional government bond from the perspective of the investor

Answer 10

I. Bond purchase:
- An initial negative lump sum cashflow equal to the price paid for the bond plus dealing expenses

II. Coupon payments:
- A regular series of positive cashflows. The timing of the cashflows are known and the amount is known in monetary terms. The term of the payments is known in advance, except if the bond is callable (The borrower can repay the bond at any time)

III. Redemption payment:
- A single positive cashflow that is received at redemption. The timing is known, and the amount is known in monetary terms.

Question 11

Describe the cashflows of an index-linked government bond from the perspective of the investor

Answer 11

I. Bond Purchase:
- A single negative lump sum payment that is equal to the price paid for the bond plus dealing expenses

II. Coupon Payments:
- A series of regular positive cashflows. The timing is known in advance and the amount is known in real terms. The term of payment is known, except if the bond is callable.

III. Redemption Payment:
- A single lump sum positive cashflow received at redemption. The timing is known in advance and the amount is known in real terms.

Question 12

Outline three ways in which cash can be placed on deposit

Answer 12

I. Call deposit – The depositor can withdraw the funds at any time

II. Notice deposit – The depositor must give a period of notice before withdrawal

III. Term deposit – The depositor cannot access the capital until the end of the fixed term

Question 13

Certificates of deposit

Answer 13

• Tradable notes.
• Short term security issued by banks showing a stated amount of money has been deposited for a specified term and rate of interest.
• Interest payable on maturity
• Kind of like a tradeable term deposit

Question 14

Uses of Money Market Instruments (why do investors hold them?)

Answer 14

P - Protect market value
O - Opportunities may occur, liquid
U - Uncertain outgo/ liability
R - Recently received cashflow
S - Short-term liability

Question 15

When are money market instruments attractive for institutions and investors?

Answer 15

G - general economic uncertainty.

R - start of recession (a fear that equity and bond prices will fall)

I- interest rates rising (might cause other asset values to fall)

D - the domestic currency to weaken (makes overseas cash holdings attractive. And it may be followed by rising interest rates)

Question 16

Circumstances under which money market instruments would be temporarily unattractive

Answer 16

• flip the reasons for grid around
• General economic Certainty
• Expectations of falling interest rates
• The end of a recession / start of a boom
• Expectations of a strengthening domestic currency
• If the investor is not risk averse or not concerned with liquidity

Question 17

3 Types of corporate bonds

Answer 17

• Debentures
• Unsecured loan stock
• Subordinated debt

Question 18

Risk and investment characteristics of corporate bonds

Answer 18

Less:
- secure
- marketable
- liquid
than government bonds.

Consequently, they generally offer a higher yield to investors.

Question 19

Real yield curve

Answer 19

Plot of real gross redemption yields on index-linked bonds against term to maturity.