Bonds & Interest Rates

Question 1

If you are buying bonds who are you lending to?

Answer 1

Governments or corporates

Question 2

Name 5 key attributes of standard bonds?

Answer 2

1. Usually fixed size
2. determined interest rate
3. fixed amount of time
4. Principal returned at the end
5. Coupon paid at fixed intervals.

Question 3

Do stocks or bonds deliver positive returns more often?

Answer 3

Since 1926 bonds have delivered positive returns 80 times versus large cap stocks only 63 times

Question 4

What are three types of bond risk?

Answer 4

Default risk or credit risk, Interest rate risk

Question 5

What are the 5c’s of credit risk?

Answer 5

Capacity, capital, conditions, character and collateral

Question 6

What is capacity in Credit risk?

Answer 6

ability to repay liabilities out of income, including having the necessary human resources;

Question 7

What is capital in Credit risk?

Answer 7

financial resources available to meet commitments should income not materialise;

Question 8

What is conditions in Credit risk?

Answer 8

how the current environment may impact upon the enterprise, whether via competition, economic, industry, or other factors;

Question 9

What is character in Credit risk?

Answer 9

integrity, honesty, flexibility, leadership, etc.: and

Question 10

What is colaterial in Credit risk?

Answer 10

security provided, including the pledge of assets, guarantees from third parties, or other risk mitigation.

Question 11

Give some examples of Defaults?

Answer 11

Defauts are rare but not unheard of. Think Russia late 90s, Argentina 2002, Greece very close recently.

Question 12

What are junk bonds?

Answer 12

Bonds issued by Corporates with a poor credit rating are called junk or non investment grade.

Question 13

Key feature of Junk bonds?

Answer 13

These pay higher interest to reward investors for the higher risk.

Question 14

Describe Interest rate risks?

Answer 14

the risk that market interest rates rise over time, making older lower yield investments worth less (price falls).

Bond prices rise when interst rates fall.

Question 15

What amount of real (inflation adjusted) bond draw downs have happened in the past?

Answer 15

The U.S. and the U.K. have both seen real bond drawdowns of over 50% (1920 and late 1970s)

UK ‘46-‘74 lost 73% and took till ‘93 to recover their value.

Question 16

How can the starting yield of GOvt bonds be helpful?

Answer 16

Historically there has been a 90% correlation between the starting yield and the 10 year forward return cagr.

Question 17

On what basis are bonds just as risky as Stocks?

Answer 17

After inflation (in real purchasing power terms) returns make bonds just as risky as stocks.

Question 18

What are 3 core impact of negative interest rates?

Answer 18

1. Savers get hurt
2. People borrow because money is almost free
3. Asset prices go up as people use the loans to buy stuff

Question 19

Why is the risk free interest rate so important in Finance?

Answer 19

Its essentially the price of money and all other securities are pricced off it.

Question 20

What does long or short duration assets mean?

Answer 20

When there is less interest rate risk, bond investors usually take on more duration risk.

Short duration assets do well when there is more interest rate risk

Long duration assets do well when there is less interest rate risks

Question 21

Name Certain long duration assets?

Answer 21

Things like growth stock, bond proxies like utilities, REITs, Healthcare and consumer staples.

Question 22

Name certain short duration assets?

Answer 22

Gold, commodities, mining, EM, heavy industrial stocks, banks and insurers.

Question 23

When do bonds provide the highest returns?

Answer 23

During environments of slowing growth and inflation or outright deflationary depressions.

Question 24

Which three things tend to move in the same direction so that you know when 2 out of 3 are doing, you have a good idea what the 3rd should be doing.

Answer 24

The economy, inflation and interest rates.

If the economy is heating up and inflation is rising, you would expect interest rates to be rising as well.

Question 25

What happens to bond prices and interest rates when there is a demand for safe assets?

Answer 25

Prices rise and yields fall.

Question 26

What happens to bond prices and interest rates when the economy is growing safely?

Answer 26

Investors dump bonds, prices fall and interest rates rise.

They buy stocks instead.

Question 27

What happens to bonds during periods of inflation?

Answer 27

Investors dump bonds and prices fall as yields rise.

Question 28

What happens to yields and prices of bonds when supply is rising?

Answer 28

If the Govt/Treasury is issuing more bonds, their yields have to rise to attract more buyers and prices fall.

In reverse when you have QE and the CB is buying bonds (essentially injecting money into the economy)

Question 29

What do bond yields track nicely with?

Answer 29

The rate of change of inflation.

Question 30

What is good for understanding inflationary expectations?

Answer 30

inflation breakevens, commodities and oil.

Question 31

What has been the nominal and real return of US long term bonds over the last 100 years?

Answer 31

4.5% nominal and 2% real.

Question 32

What is the historical real return of short term government bills (tbills)?

Answer 32

0.8% real - a bit better than inflation.

Question 33

What does it mean when CB’s are increasing the size of their balance sheet? Reducing?

Answer 33

Increasing means that they are selling Bonds to the public markets which means that it is taking money out of circulation and interest rates are likely to rise.

When they are reducing the size of the BS, they are redeeming the bonds, putting money back into circulation which reduces the rate of interest.

QE was essentially buying bonds off other people and injecting money into the system.

Question 34

What happens to the price of money when CB’s begin to withdraw the punchbowl?

Answer 34

The cost of credit becomes more expensive and access becomes harder to loans.

Question 35

Before 2008 when was the last time that CB’s bought bonds and we had negative interest rates?

Answer 35

1905-1907

Question 36

Compare Bonds vs Stocks Annualized volatility and returns

Answer 36

Bonds ann vol is about 6% (stocks 15%) but only deliver 6% return vs 9-10% for stocks.