Bond Markets

Question 1

What is a bond?

Answer 1

A certificate that gives the holder a claim to future cash flows (essentially a standardised loan). The issuing party promises a stream of payments. The bond price is determined based on supply and demand.

Question 2

What does the maturity of a bond mean?

Answer 2

The length of time the bond remains valid.

e.g. 5 year maturity= final payment at end of 5th year

Question 3

What does the face value of a bond mean?

Answer 3

The final payment

Question 4

What are the coupons of a bond?

Answer 4

The regular payments from start to end of maturity

Question 5

What is a zero-coupon bond?

Answer 5

Coupons aren’t paid, just a face value at the end of maturity. They are usually issued for short term loans

Question 6

Why do governments issue bonds?

Answer 6

Long run- to finance government consumptions

Short run- to manage liquidity

Question 7

Why do corporations issue bonds?

Answer 7

Long run- as a direct route of financing

Short run- manage liquidity

Question 8

What are convertible bonds?

Answer 8

Bonds that can be converted into equity (a certain amount of shares). This is a cheap way for a company to issue equity

Question 9

What are treasury bonds/gilts?

Answer 9

Bonds issued by governments. Viewed as the safest types of bonds.
Short term= treasury bonds/bills
Long term= gilts

Question 10

What are high quality bonds?

Answer 10

Bonds issued by companies with strong balance sheets (investment grade bonds). Pay higher interests than government bonds but perform worse in economic downturns

Question 11

What are low quality bonds?

Answer 11

Bonds that have a high default risk compared to investment grade bonds (junk bonds).
Were historically avoided by investors but in 1970s a student realised profit could be made by investing in them because premiums were high for the risk level. Small companies used the junk bond market to raise money to take over large companies- this led to high defaults.

Question 12

What are foreign bonds?

Answer 12

Bonds issued by foreign companies in local currencies

Question 13

What are mortgage backed bonds?

Answer 13

Bonds made of a pool of mortgages. Money raised is invested in mortgages and coupons and face value are drawn from mortgage repayments. Common in USA

Question 14

What are securitisation bonds?

Answer 14

Bonds used to securitise streams of cash flows (e.g. mortgages). Private companies also use them to secure cash flows.

Question 15

What is the yield to maturity?

Answer 15

The total return anticipated on a bond if it is held until it matures

Question 16

How do you calculate the yield to maturity?

Answer 16

face value / current price -1

Question 17

How does expected inflation impact the demand of bonds?

Answer 17

Rise in inflation expectations reduces the expected real return on bonds so demand will fall.
Demand curve:
- fall in inflation= shift to the right
- rise in inflation= shift to the left

Question 18

How does risk impact the demand of bonds?

Answer 18

If the perceived riskiness of investing in bonds compared to other assets rises then demand will fall
Demand curve:
- fall in relative risk= shift to the right
- rise in relative risk= shift to the left

Question 19

How does wealth impact the demand of bonds?

Answer 19

If the economy is expanding, demand may rise as people have more to invest.
Demand curve:
- rise in wealth= shift to the right
- fall in wealth= shift to the left

Question 20

How does the liquidity if bonds impact their demand?

Answer 20

If it becomes easier, cheaper and quicker to sell bonds then demand for them will increase
Demand curve:
- increased liquidity= shift to the right
- reduced liquidity= shift to the left

Question 21

How does expected inflation impact the supply of bonds?

Answer 21

Higher inflation lowers the real cost of borrowing.
Supply curve:
- higher inflation= shift to the right
- lower inflation= shift to the left

Question 22

How does the availability of profitable investment impact the supply of bonds?

Answer 22

If there are lots of profitable investment opportunities within companies, the demand for fund raising though selling bonds rises.
Supply curve:
- many opportunities= shift to the right
- few opportunities= shift to the left

Question 23

How does the size of government borrowing impact the supply of bonds?

Answer 23

If the government has a large gap between taxes and expenditure it may increase the supply of bonds.
Supply curve:
- larger fiscal deficit= shift to the right
- lower fiscal deficit= shift to the left

Question 24

What is the yield curve?

Answer 24

Describes the yield pf bonds with a similar risk profile as they vary in maturity.
We expect an increasing curve because the further away the loan is in the future the harder it is to forecast risk. Also if the equilibrium interest changes it will effect bonds with a long maturity more as more future payments will be impacted.

Question 25

What does a flat or reversed yield curve show?

Answer 25

It is a sign of recession.
People are worried about economic downturn so try to ensure future consumption so demand for bonds with high maturity increases. This pushes the yield of these bonds down or reverses the curve

Question 26

What is the expectation hypothesis?

Answer 26

Implies the future expectation regarding the yield will determine the shape of the yield curve

Question 27

What is the liquidity preference hypothesis?

Answer 27

States that because long term investments are less liquid investors have to be paid a higher premium to invest in these assets. Long term investments expose investors to future unexpected changes

Question 28

What is the market segmentation hypothesis?

Answer 28

States that different participants in the market have different preferences regarding the maturity they invest in (e.g. banks invest in bonds with shorter maturity compared to pension funds). The curve shows the different needs of market participants.
Banks tend to be less active or in need of cash so sell bonds rapidly, pushing up short term yield and creating a downwards slope.