Chap 11 Flashcards
The required return on a bond can be expressed as:
ri = r* IP + RP
Yield spreads
differences in interest rates between the various market sectors.
For bonds, the risk premium addresses:
the default (credit) risk of the issuer, liquidity and call risks.
The risk-free rate
it accounts for interest rate and purchasing power risk
real rate of return plus expected inflation premium
Important subjects in the Market Interest Rates : (general info)
The bond market is not a single market, but consists of many different sectors:
- U.S. Treasury issues
- Municipal bond issues
- Corporate bond issues
There is no single interest rate that applies to all the segments of the bond market.
Municipal bond rates are usually 20-30% lower than corporate bond rates due to their tax-exempt feature.
Revenue bonds pay higher rates than general obligation bonds due to higher risk.
Treasury bonds have lower rates than corporate bonds due to no default risk and exemption from state income taxes.
The lower the credit rating (and higher the risk), the higher the interest rate.
Bonds with longer maturities generally provide higher yields than short-term issues (not ALWAYS the case).
Freely callable bonds generally pay higher interest rates than noncallable bonds.
What Causes Rates to Move?
- Inflation
- Money supply
- Federal budget (goverment)
- Economic activity
- Reserves policies
- Foreign interest rate
When money supply change, what happens with the interest rate ?
- Slow increase ——> decrease
- Slow decrease ——> increase
- Fast increase ——>increase
- Fast decrease —–>decrease
When federal budget change, what happens with the interest rate ?
- Deficit ———> increase
- surplus =====> decrease
When economic activity change, what happens with the interest rate ?
- Recession ——-> decrease
- Expansion =====> increase
Term structure of interest rates
the relationship between interest rates (yield) and time to maturity for any class of similar-risk securities.
Yield curve graph
a graph that depicts the Term structure of interest rates
Types of Yield Curves
- Most common type is upward-sloping
- Occasionally, the yield curve becomes inverted
- Flat: rates for short- and long-term debt are essentially the same.
- Humped: when intermediate rates are the highest.
Reason for the use of treasury security (bill, bonds and notes):
Treasury securities have no risk of default.
They are actively traded, so their prices and yields are easy to observe.
They are relatively homogeneous with regard to quality and other issue characteristics.
Can also construct yield curves with other classes of debt securities, such as A-rated municipal bonds, Aa-rated corporate bonds, and even certificates of deposit.
theories to explain reasons for the general shape of the yield curve:
Expectations hypothesis
Liquidity preference theory
Market segmentation theory
Expectations Hypothesis
The yield curve reflects investor expectations about the future behavior of interest rates.
- When investors expect interest rates to go up, they will only purchase long-term bonds if those bonds offer higher yields than short-term bonds; hence the yield curve will be upward sloping.
- When investors expect interest rates to go down, they will only purchase short-term bonds if those bonds offer higher yields than long-term bonds; hence the yield curve will be downward sloping.
Liquidity Preference Theory
long-term bond rates should be higher than short-term rates because of the added risks involved with the longer maturities.
- Investors may view long-term bonds as being riskier because long-term bonds are less liquid and are subject to greater interest rate risk.
- Borrowers will also pay a premium to obtain long-term funds. Borrowers thus assure themselves that funds will be available and avoid having to roll over short-term debt at unknown and possibly unfavorable rates.
Market Segmentation Theory
the market for debt is segmented on the basis of the maturity preferences of different financial institutions and investors.
- The yield curve changes as the supply and demand for funds within each maturity segment determines its prevailing interest rate.
- If supply is greater than demand for short-term loans, short-term rates will be relatively low. If at the same time, demand for long-term loans is higher than the available supply of funds, then long-term rates will move up. The yield curve will slope upward.
Upward-sloping yield curves result from:
- Expectations of rising interest rates.
- Lender preferences for shorter-maturity loans.
- Greater supply of shorter-term loans.
Downward-sloping yield curves result from:
- Expectations of falling interest rates.
- Lender preference for longer-maturity loans.
- Greater supply of longer-term loans
Yield Curve in Investment Decisions
-provides investors with information about future interest rate movements, which affect the prices and returns on different types of bonds
Consider the difference in yields on different maturities—the “steepness” of the curve.
- Steep yield curves are generally viewed as a bullish sign. Aggressive bond investors would look to move into long-term securities.
- Flatter yield curves reduce the incentive for moving to long-term maturities because the difference in yield between different maturities is small.
bond’s types of cash flow:
Periodic interest income (i.e. coupon payments).
Principal (par value) at the end of the bond’s life.
Bonds are priced according to …
the present value of their future cash flow streams.
= E C /(1+ri)^t + PVn /(1+ri)^n
= Present value of coupon payments + Present value of bond’s par value
Dirty price
a bond is the clean price plus accrued interest.
Clean price
a bond equals the present value of its cash flows.
Accrued interest:
the amount of interest earned on a bond since the last coupon payment.
Current yield
indicates the amount of current income a bond provides relative to its prevailing market price.
Simplest of all bond return measures.
Looks at only one source of return: a bond’s annual interest income (current income).
Current yield = annual interest income / current market price of the bond
Yield to maturity (YTM):
the most important and widely used measure of the return provided by a bond.
Also known as the promised yield.
The rate of return earned by an investor given the bond is held to maturity an all principal and interest payments are made in a prompt and timely fashion.
Implicitly assumes the investor can reinvest all the coupon payments at an interest rate equal to the bond’s yield to maturity.
Basically, the internal rate of return on a bond.
Bond equivalent yield
a market convention that states the annual yield as twice the semiannual yield.
Yield to call (YTC):
shows the yield on a bond if the issue remains outstanding not to maturity but rather until its first (or some other specified) call date.
The length of the investment horizon (N) is defined as the number of years to the first call date, rather than years to maturity.
Use the bond’s call price (premium) instead of the par value.
Expected return
indicates the rate of return an investor can expect to earn by holding a bond over a period of time that’s less than the life of the issue.
Also called realized yield
Duration: (bonds)
A measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments.
bond duration (properties)
- Higher coupons result in shorter durations.
- Longer maturities mean longer durations.
- Higher yields (YTMs) lead to shorter durations.
These variables (coupon, maturity, yield) interact to determine an issue’s duration.
Shorter the duration, the less volatility in bond prices (and vice versa).
Weighted-average life of a bond
Calculates the weighted average of the cash flows (interest and principal payments) of the bond, discounted to the present time.
Duration = pv(c) x t / BP
Bond Immunization
allows you to derive a specified rate of return from bond investments over a given investment interval regardless of what happens to market interest rates over the course of the holding period.
Price effect
change in bond value caused by interest rate changes.
Reinvestment effect
as coupon payments are received, they are reinvested at higher or lower rates than original coupon rate.
strategies investors can use with fixed-income securities in order to reach their different investment objectives.
- Passive Strategies
- Trading on Forecasted Interest Rate Behavior
- Bond Swaps
Passive Strategies (investment objectives)
Characterized by a lack of input regarding investor expectations of changes in interest rates and or bond prices.
Typically do not generate significant transactions costs
Examples of some passive strategies:
- Bond immunization
- Buy-and-hold: replace bonds as they mature or are called, or when quality declines.
- Bond ladders
Bond ladders:
Set up “ladder” by investing equal amounts into varying maturity dates (i.e. 3-, 5-, 7- and 10-year)
As bonds mature, purchase new bonds with 10-year maturity to keep ladder growing
Provides higher yields of longer-term bonds and dollar-cost averaging benefits
Bond swap:
occurs when investor sells one bond and simultaneously buys another bond in its place
Can be executed to:
- Increase current yield or yield to maturity
- Take advantage of shifts in interest rates
- Improve the quality of a portfolio
- For tax purposes
May go by names such as “profit takeout”, “substitution swap” or “tax swap”, but they are all used for portfolio improvement.
Yield pickup swap
investor switches out of a low-coupon bond into a comparable higher-coupon issue in order to realize an instantaneous pickup of current yield and yield to maturity.
Such swap opportunities arise because of the yield spreads that normally exist between different types of bonds.
Must be careful of transaction costs.
Tax swap
Sell a bond that has declined in value, use the capital loss to offset other capital gains, and repurchase another bond of comparable credit quality.
