Chapter 9: Bond and money markets Flashcards
List the 4 common investment classes
- Cash on deposit
- Money market instruments
- Fixed-interest bonds
- Index-linked bonds
What is the useful acronym to help understand the characteristics of any investment?
SYSTEM T:
* Security
* Yield
* Spread
* Term
* Expenses
* Marketability
* Tax
Describe the 3 types of cash on deposit
- Call deposit: The depositor has ‘instant access’ to withdraw the capital deposited
- Notice deposit: The depositor has to give a period of notice before withdrawal
- Term deposit / Fixed-term deposit: the depositor has no access to the capital sum for a fixed term.
What are money market instruments?
Money market instruments are characterised by being highly liquid and being short term, usually with a term of one year or less.
Discuss the key players in the money market
- Clearing banks: Clearing banks use money markets to lend excess liquid funds and to borrow when they need short-term funds.
- Central bank: Central banks, as lenders of last resort, stand ready to provide liquidity to the banking system when required and also use their operations in the money markets to establish the level of short-term interest rates. Their money makret operations involve the sale or purchase of Treasury and other eligible bills.
- Other institutions: Other financial institutions and non-financial companies also lend and borrow short-term funds in the money market.
Why would it not be appropriate for long term institutions such as life insurance companies and pension funds to hold a high proportion of their assets in the form of cash on deposit and money market instruments?
- It usually gives a lower expected return than other assets
- It may not match the liabilities
Long-term institutional investors generally hold cash only:
* as liquidity to meet expected outgoings or
* temporary, when taking a view that values of other assets are likely to fall.
What are the economic conditions that make cash temporarily attractive to long-term institutional investors or to other investors seeking to maximise returns?
- Generally rising interest rates which will depress both bond and equity markets
- The start of a recession if it is thought that equity markets will suffer from lower growth and bonds might suffer from an increase in the government’s deficit
- Weakness of the national currency making cash investments in other currencies attractive.
Discuss the bond market
“Bond” is an alternative term for a fixed-interest or index-linked security.
Bonds are described by:
* the type of organisation issuing the security, such as government bonds, local authority bonds, corporate bonds and so on.
* the nature of the bond
The most important distinct types of bond market are:
* the markets in government bonds, listed in their country of origin
* the markets in corporate bonds, listed in their country of origin
* the markets in overseas government and corporate bonds, listed in any country other than the ‘home’ country.
Discuss fixed-interest bonds
A body such as an industrial compnay, a public body, or the government of a country may raise money by issuing a fixed-interest security, normally in bonds of a stated nominal amount.
The characteristics of such a security are that the holder of a bond receives a lump sum of specified amount at some specified future time together wiht a series of regular level interest payments until the payment of the lump sum.
The fixed lump sum payment is called the redemption of the bond; it is paid on the redemption date and is normally of the original nominal amount.
The basic features of corporate bonds are similar to those of government bonds.
Government securities generally provide the most secure and marketable fixed-interest investment in a particular currency.
Therefore, investors will require a higher yield on other forms of debt.
The size of the yield margin depends on both the security and the marketability of the debt.
Relatively low security and marketability will mean a large margin, whereas a large secure issue will trade at a small yield margin to the closest equivalent government bond.
What is the gross redemption yield of a bond?
It is the return the investor would expect to get on a bond if they held it until redemption.
This assumes that they could reinvest the coupons at exactly the same rate, and it ignores expenses, tax and default risk.
Equivalently, it can be defined as the yield that equates the price of the bond with the discounted value of the interest and capital proceeds on the bond.
Discuss index-linked bonds
This is a security where the cash amount of the interest payments and the final capital repayment are linked to an ‘index’ which reflects the effects of inflation.
Such bonds provide a return in real terms.
The actual payments from an index-linked bonds are dependent on future inflation. Without knowing future inflation rates, we cannot calculate redemption yields from index-linked bonds.
The convention for quoting yields on index-linked bonds is to assume a fixed rate of future inflation and then to calculate the real yield in excess of this assumed inflation rate.
How can the nominal yield on conventional government bonds be expressed?
nominal yield = risk-free real yield + expected future inflation + inflation risk premium.
Outline the situations when index linked bonds will appear relatively more attractive to an investor than conventional bonds
- When the investor needs to match real liabilities and hence requires inflation prediction
- When the ivnestor expects the future inflation to be higher than that currently predicted in the market
- When the investor expects the inflation risk premium to be higher than that currently predicted in the market.
List 10 investment and risk characteristics of conventional government bonds
- Income = Coupon that is fixed in nominal terms
- Capital = Redemption amount that is fixed in nominal terms
- The yield is fixed in nominal terms. The real yield is eroded by actual inflation
- The expected yield is lower than for equities and property
- Variability in capital values is lower for short term bonds than for long term bonds
- Tax treatment depends on the territory
- Very marketable if in a developed country
- Very low default risk if issued by a developed country. Almost non-existent
- Term: Short, medium, long, irredeemable
- Very low dealing costs if a developed country
List 9 investment and risk characteristics of money market instruments
- Liquid
- Short term
- Generally very low defualt risk due to the short term
- Low expected yield compared to other assets
- Return expected to more broadly in line with inflation
- Stable market values due to short term
- Very low dealing expenses
- Usually taxed as income
- Marketable
