Chapter 3- The bond market Flashcards
What is a bond?
A bond is a debt security
- when you buy a bond you are lending money to the government, municipality, company or other entity known as the issuer
Coupon interest rate
The stated annual interest rate on the bond. It is usually fixed for the life of the bond
Current yield
The coupon interest payment / current price of the bond
Face amount/ nominal value
The maturity value of the bond. The holder of the bond will receive the face amount from the issuer when the bond matures. Face amount is synonymous with par value.
Indenture
The contract that accompanies a bond and specifies the terms of the loan agreement. It includes management restrictions, called covenants.
Market rate
The interest rate currently in effect in the market for securities of like risk and maturity. The market rate is used to value bonds.
Maturity
The number of years or periods until the bond matures and the holder is paid the face amount.
Par value
The same as the face amount
Yield to maturity
The yield an investor will earn if the bond is purchased at the current market price and held until maturity.
Why include stocks in your portfolio?
- over time, common stocks, as an asset class, have outperformed all other major asset classes
- stocks have a history of delivering strong long-term capital gains
- individual stocks in a diversified portfolio can reduce the overall risk of that portfolio
Variables that affect bond value
- Maturity
- Interest rate
- Price
- Yield
- Risks
- Taxable status
- Types of bonds
Maturity for short/medium/long term bonds
Short term: maturities of up to 4 years
Medium term: maturities of 5-12 years
Long term: maturities of 12 years or more
Fixed interest rate
Stays the same until maturity
Example:
Buy a $1000 bond with 3% fixed interest rate and you will receive a $30 every year (coupon) until maturity. At maturity you will receive the $1000 back.
Floating interest rate
Adjustable to prevailing market rates
Floating rate = reference rate + spread
Payable at maturity interest rate
Receive nopayments(!!) until maturity. At that time you receive the principal plus the total interest earned compounded at the initial interest rate.
Short- term interest rates (bonds)
Set by Central Banks to regulate the economy
–> known as monetary policy
What influences the long-term interest rates?
- Demand and supply of money in the economy
- (Expected) Inflation!! (positive correlation)
- Government’s monetary and fiscal policies (short term interest rate)
- Stage in the business cycle
- Expectations
Real interest rate formula (Fisher equation)
Real interest rate = Nominal interest rate - (expected) inflation
if > 0 : purchasing power goes up
if < 0 : purchasing power goes down
Interaction between ST and LT interest rate
Long-term interest rates are largely a function of the effect the bond market believes current short-term interest rates will have on future levels of inflation.
ECB can increase the short-term rate:
To limit inflation
If the market thinks this measurement is sufficient it will slow down the rise of the LT- rate( this will slow down the economy)
- If it is seen as insufficient by the market, the LT- rate will continue to rise (because expected inflation is still higher)
ECB can lower the short-term rate:
To create inflation (increase spending)
- LT rate will only begin to rise if the spending (governments, investment, consumption) rises (when expected inflation increases)
Price- the amount you pay for the bond:
Newly issued bonds (primary market) will pay close to their face-value (at 100%)
Traded bonds fluctuate (on the secondary market) in response to the changing interest rates.
Sold at premium/ above bar
Bonds traded higher than their face value
Sold at discount/ under par
Bonds traded lower than their face value
Sold at par
Bonds traded at their face value
Inverse relation
One of the most important relationships in finance is that interest rates and bond prices move in opposite directions.
When interest rates goes up –> bond prices go down
When interest rates goes down –> bond prices increase
Inverse relation in general
When interest rates rise, prices of already outstanding (‘old’) bonds fall to bring the yield of older bonds into line with higher-interest newly issued bonds
*When interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on newly issued bonds
–> Inverse relation interest and price !
Bond duration
A way of measuring how much bond prices are likely to change if and when interest rates move.
It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.
- The longer the maturity date and the lower the coupon payment (=high duration), the more sensitive a bond is for interest rate changes.
-If you expect interest rates to rise, it may make sense to focus on shorter-duration investments
Duration is key in fixed-income portfolio managementfor the following three reasons:
1.It is a simple summary statistic of the effective average maturity of a portfolio.
2.It is an essential tool in immunizing portfolios from interest rate risk.
3.Duration is an estimate of the interest rate sensitivity of a portfolio.
Yield
The return you actually earn on the bond, based on:
- the price you paid
- the internt payment you receive
Current yield formula
yearly coupon payment/ price paid
Yield to maturity
- The convention used to calculate YTM varies across markets.
– YTM is the interest rate an investor would earn by investing every coupon payment from the bond at a constant interest rate until the bond’s maturity date. The present value of all of these future cash flows equals the bond’s market price.
– Used to compare bonds with expected returns of other investments
- YTM is the most used calculation method for bonds!!
Shortcomings of the YTM
- you’re supposed to hold the bond until maturity
- actualization against compounded interest rate, but the interest can change (reinvestment risk)
- this means that you reinvest each coupon at the exact same interest rate, but that isn’t realistic
If market rate (YTM) goes up/ down:
The price of the bond will do the opposite
If the price of the bond goes up/down
The bond yield will do the opposite
Factors that affect the yield curve
- Inflation
- Economic growth
- Interest rates
Yield curve
A yield curve gives you an overview of the interest rates at a certain moment for different maturities
The slope of the yield curve tells us how the bond market expects short-term interest rates
–> it is a snapshot of what the bond market thinks about the future inflation/ economic environment
Different shapes of yield curves
- Normal (upward)- economical expansion and rising stock exchanges
- Steep- typical for the beginning of economical expansion (after a recession); also indicates a revival of the stock exchanges
- Inverse- predicts an economical slowdown or recession. This comes along with sharp price drops on the stock market
- Flat- the transition from a normal to an inverse yield curve. It doesn’t guarantee an economic slowdown but the probability is high = very good indicator
Making investment decisions using the yield curve:
Flat/inverse- buy shares with a low beta (consumer stables)
Steep yield curve- buy shares with a high beta (cyclical)
Interest rate risk
The risk that bond prices will fall as interest rates rise (inverse relation)
Reinvestment risk
The risk that the coupon proceeds from a bond will be reinvested at a lower rate than the bond originally provided
Call option risk
Provisions that allow or require the issuer to repay the investors´principal at a specified date before maturity
Put option (risk)
Option of requiring the investor to sell the bonds, at a specified time, prior to maturity (not really a risk)
The three main categories of government bonds:
Bills -debt securities maturing in less than one year. E.g. US T-bills
Notes -debt securities maturing in one to 10 years.
Bonds -debt securities maturing in more than 10 years.
Sovereigns (government bonds)- 10 year bond interest rates
Gives you an idea about how expensive it is to borrow money on the market as a country
Corporate bonds
Issued by private and public corporations
Government bonds
Government (sovereigns): issued to raise money for schools, hospitals, highways, etc. In general, fixed-income securities are classified according to the length of time before maturity.
Domestic bonds
Borrow USD in the US as an American (=normal)
Foreign bonds
Borrow USD in the US as a non-American
Eurobonds
Borrow USD in Europe as a non-European
The (Global) Bond Market
- Underwritten by a multinational syndicate of (investment) banks and are placed mainly in countries other than the one in whose currency the bond is denominated
–Also known as an “international bond”
–Eurobonds are not traded on a specific national market.
–Developed in the 1960s and was early recognized as an efficient, low-cost and innovative market
–Avoids most national regulations and constraints and provides sophisticated instruments
Main goal: Find the cheapest way to issue bonds, by using subsidiairies!!
Covered bonds
Covered bonds are debt instruments secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default.
eg. Pfandbriefe (Germany) is backed by a pool of government bonds and prime mortgage loans(100% coverage); but alsoMBS,…
Unsecured bonds
Not backed by revenues, equipment, mortgage revenues etc (more risk)
Subordinated loans
Paid back after all other creditors (but before shareholders, more risky for investors)
Inflation linkers
Follows inflation index
