Chapter 14: Bond Markets Flashcards
4 Main types of corporate bonds
- Mortgage debentures
Secured with a fixed charge on a specified security. - Debentures
Secured against the assets of the company (usually with a floating charge) - Unsecured loan stock
Not secured on any assets. - Subordinated debt
Ranks behind all other classes of bond for repayment.
Yield curve
A graph showing term to redemption on the x-axis, and yield on the y-axis.
Typically the yield is the gross redemption yield.
What is the relationship between the price of a bond and the gross redemption yield?
If bond prices go up, gross redemption yields go down, and vice-versa.
This is because the coupon payments and redemption payments on the bond are fixed.
Therefore, as the price you have to pay for those fixed payments goes up, the yield that you can get will go down.
4 Main theories that influence the level and shape of the conventional government yield curve
- Market segmentation theory
- Expectations theory
- Liquidity preference theory
- Inflation risk premium theory
Market segmentation theory
Yields at each term to redemption are determined by supply and demand from investors with liabilities of that terms.
Expectations theory
Describes the shape of the yield curve as being determined by economic factors (e.g. future inflation) which drive expectations of future short-term interest rates.
Liquidity preference theory
In general, investors prefer liquid, shorter dated assets to illiquid, longer dated assets.
Therefore, investors require a liquidity risk premium to compensate them for investing in longer-dated stock.
According to this theory, the yield curve should be more upward sloping than that predicted by pure expectations theory alone.
Inflation risk premium theory
Investors with real liabilities will require and inflation risk premium on a conventional bond to compensate them for the risk that inflation erodes the real return that can be earned on that bond.
Longer-dated bonds carry more risk of inflation erosion, and so the inflation risk premium can be expected to increase with term to redemption
What is a real yield?
The yield that you would expect to earn on top of inflation.
What is the relationship between the nominal yield on a conventional bond and the real yield on an index-linked bond?
If assets are fairly priced, the nominal yield on a conventional bond should be equal to:
the real-yield on an index-linked bond,
plus expected inflation,
plus an inflation risk premium.
Why might you invest in conventional bonds rather than index-linked bonds?
You would invest in conventional bonds if you expected the price of conventional bonds to rise relative to index-linked bonds.
This would happen if you expected the yield on conventional bonds to fall relative to index-linked bonds.
E.g. if you expected inflation to fall, or the inflation risk premium to fall.
What is the running yield on a bond?
The income yield.
= coupon / current price
What is the running yield on an equity?
= dividend / current price
What is the running yield on a property?
= rent / current price
