Chapter 14: Bond Markets

Question 1

“bond”

Answer 1

An alternative term for a fixed-interest or index-linked security.

Question 2

Bonds are described by (2)

Answer 2

• type of organisation issuing the security, ex. government, local authority, corporate
• nature of the bond - fixed interest/index-linked

Question 3

“gilts”

Answer 3

UK government bonds

Question 4

Fixed-interest / conventional bond

Answer 4

Gives an income stream and final redemption proceeds that are fixed in monetary terms

Question 5

Index-linked bond

Answer 5

Gives an income stream and final redemption proceeds that are linked to an inflation index.

Question 6

3 Types of bond markets

Answer 6

• government bonds
• corporate bonds
• overseas government and corporate bonds

Question 7

7 Investment and risk characteristics of conventional government bonds.

Answer 7

• very good security (if politically stable)
• yield (GRY) is fixed in nominal terms
• lower expected returns than equities over the long term
• market values can be volatile, especially for longer-term bonds
• mixture of terms’ short, medium, long, undated
• low dealing expenses
• highly marketable

Question 8

3 Types of corporate bonds

Answer 8

• Debentures
• Unsecured loan stock
• Subordinated debt

Question 9

Risk and investment characteristics of corporate bonds

Answer 9

Less:
- secure
- marketable
- liquid
than government bonds.
Consequently, they generally offer a higher yield to investors.

Question 10

4 Theories put forward to explain the shape of the yield curve

Answer 10

L - Liquidity preference theory
I - Inflation risk premium theory
M - Market segmentation theory
E - Expectations theory

Question 11

Expectations theory

Answer 11

Describes the shape of the yield curve is determined by economic factors, which drive the market’s EXPECTATIONS for future short-term interest rates

Question 12

Liquidity preference theory

Answer 12

Investors require an additional yield on less liquid (longer-term) bonds.

Question 13

Inflation risk premium theory

Answer 13

Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.

Question 14

Market segmentation theory

Answer 14

Yields at each term are determined by supply and demand at that term.
Demand comes principally from institutional investors trying to match liabilities.

Question 15

Real yield curve

Answer 15

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

Question 16

Approximate market expectation of future inflation

Answer 16

Difference between the conventional yield curve and the real yield curve.