Chapter 9: Bond and money markets Flashcards
How do you use SYSTEM T to determine the characteristics of any investment?
For characteristics of any investment: SYSTEM T Security (default risk) Yield (real or nominal, expected return) Spread (volatility of the market) Term (short, medium or long) Expenses or Exchange rate Marketability Tax
Discuss the the key aspects of cash on deposit.
- Cash on deposit
- Covers call deposits, notice deposits
and term deposits - Cash can be placed on deposit:
With the depositor having instant access to withdraw the capital deposited – call deposit – as short as overnight
With the depositor having to give a period of notice before withdrawal – notice deposit – form subset of term deposit
For a fixed term with no access to capital sum earlier than the maturity of the deposit – term deposit or fixed-term deposit – terms up to a year but can be longer
- Rate of interest paid by the borrower can be
Fixed for the term of the deposit
Fixed for an initial period
Variable from day to day
- Borrower may have to give notice of any change in interest rates
- Fixed term deposit at fixed-interest rate throughout the term – all cashflows are certain and known in advance
- Instant access or call account with variable interest – amounts and timing of cashflows will be completely unknown
Discuss the key aspects of the money markets.
- The money markets
- Types of instrument
- Characterised by being highly liquid and being short term (year or less)
- Treasury bills, certificates of deposit, commercial paper and bills of exchange
- Types of instrument
2.2. Key players in the money markets
Clearing banks
- Money markets dominated by clearing banks
- Use them to lend excess liquid funds and to borrow when need short-term funds
- These loans and deposits are very short term (often overnight)
- Interbank rates usually taken as benchmark for short-term interest rates
Central banks
- Lenders of last resort
- Stand ready to provide liquidity to banking system when required
- Use their operations in the money markets to establish the level of short-term interest rates
- Central bank money market operations involve the sale or purchase of Treasury and other eligible bills
- When CB sells treasury bills it will receive cash from money market
- Makes cash scarcer and drives up interest rates
- When CB buy back treasury bills, it will pay out cash
- Reduces interest rates as interest rates represent price of using money
Other institutions
- Other financial institutions and non-financial companies also lend and borrow short-term funds in the money market
Discuss the investment characteristics of cash on deposit and money markets using SYSTEM T.
Characteristics of cash on deposit and money markets
- Security
Depends on issuer – money lent to US govern more secure than deposit with small company in developing country
Will be very good due to short-term nature of the instruments AND default is very rare
- Yield – nominal vs real
Income from cash on deposit and money market investments will approximately equal prevailing short-term interest rates set by monetary authorities
Can vary considerably over time
Instruments issued at discount and redeemed at face value – provide a known nominal return
Tend to give positive real return
Because short-term interest rates tend to be higher when inflation is higher
Expect short-term interest rates to be 2% or 3% p.a. above inflation or else to incentive to save
- Yield – expected return relative to other assets
Close to being risk-free – very little risk of default but does depend upon issuer
Thus, expected returns from money market investments are lower than almost every other type of investment
Does not mean they will give lower actual return
- Spread – volatility of capital values
Nominal values of cash on deposit and MM investments are fixed in cash terms,
as they are short term and there is very little volatility in market value
- Term
Short term – distinctive feature
Less than one year and often much shorter
- Expenses
Expenses of dealing in and managing cash on deposit and MM instruments is minimal
- Exchange rate – currency risk
Available in wide range of currencies
Possible fluctuations in exchange rates
Movements in exchange rates would be expected to compensate for differences in interest rates between countries over term
Currency movements are very difficult to predicts – substantial risk of getting less than expected return
- Marketability
Highly marketable – with exception of call and term deposits
But they are unquoted – traded through an interbank money market rather than through the stock exchange
- Tax
Total return treated as income for tax purposes
What are the attractions of cash on deposit and money market instruments?
- Inappropriate for long-term institutions to hold high proportion of their assets in form of cash on deposit or money market instruments
- This is supported by the fact that cash:
Usually gives lower expected return than other assets
May not match liabilities
Long-term institutions (life insurance and pension funds) hold cash only:
- As liquidity to meet expected outgoings
- Temporarily, when taking a view that values of other assets are likely to fall
Main advantages:
- Holding cash and money market instruments for liquidity
- Economic circumstances in which cash and money market instruments are attractive
What are the attractions of cash on deposit and money market instruments - Holding cash and money market instruments for liquidity
Holding cash and money market instruments for liquidity:
- Known short- term commitments
Investor may have known major outgo within very short term
Short-term MM investment thus provides ideal match by term for liability
- Uncertain outgo
Institutions with high degree of uncertainty in their liabilities outgo want to maintain min level of liquidity to meet immediate liabilities that may arise
General insurers are example
Holding MM investments and cash protects general insurer against risk of being forced to sell assets at depressed prices should natural disaster occur and result in many claims
- Opportunities
Might like to maintain strong liquidity in order to take part in attractive investment opportunities that may arise
If opportunities available only for short period, then it is essential that investor has necessary liquidity
- Recent cashflow
Sometimes institutional investor may receive large cash inflows and will not purchase other assets immediately
Until funds are reinvested, the institution will have large cash balance
- Preservation of nominal value of capital and risk aversion
Highly risk-averse investors and investors who need to maintain monetary values of investment will hold larger proportion of cash investments than others
What are the attractions of cash on deposit and money market instruments - Economic circumstances in which cash and money market instruments are attractive
Economic circumstances in which cash and money market instruments are attractive
Economic conditions which might make cash temporarily attractive to long-term institutions or investors seeking to maximise returns are:
- Rising interest rates – depress bond and equity markets
- Start of a recession if it is thought that equity markets will suffer from lower growth and bonds suffer from increase in government’s deficit
- Weakening of national currency – making cash investments in other currencies attractive
1. Rising interest rates
if interest rate increasing, then GRY on fixed-interest bonds will increase & prices of fixed-interest bond will fall
equity markets might suffer fall in market value if interest rates increase – higher interest rate depress economic activity and reduce companies’ profits
if investor correctly anticipates increase in interest rate – choose to hold cash rather than suffer capital loss from fixed-interest bonds or equities
higher nominal income from higher interest rates might also be attractive
- Start of an economic recession
if recession starts THEN domestic stock market likely to perform badly
share prices unlikely to increase (companies struggle to keep profitability)
fear that government borrowing would increase
leading to larger supply of government fixed-interest bonds
and reductions in prices of fixed-interest bonds
Recessions often followed by reductions in short-term interest rates,
which could lead to lower GRY and higher prices for fixed-interest stocks
THUS, cash investments might be more attractive than bonds and equities at start of recession
Cash would give reasonable income stream and no risk of capital loss – unlike equities and fixed-interest investments which might fall in value
- Deprecation of domestic currency
If investor expects domestic currency to weaken, cash investments might be attractive because:
- Short-term interest rates raised by government to defend domestic currency – might make cash investments attractive as value of other assets expected to fall
- Cash investment in stronger currency would be attractive, even if interest rates abroad lower – domestic currency depreciated value in domestic currency of overseas cash would increase
4. General economic uncertainty
Stability of capital values will make cash investment attractive to risk-averse investors
This is enhanced in times of economic uncertainty
Over long term – cash would be expected to give lower return than riskier or less liquid investments
Discuss the key aspects of the fixed-interest government and corporate bonds (cashflows and GRY).
Fixed-interest (conventional) bonds
Industrial company, public body, or government of a country may raise money by issuing fixed-interest security (normally in bonds of stated nominal amount)
Central governments issue bonds to fund part or all of shortfall of income as compared to government expenditure
Government bonds form majority of domestic bond market
Regional government bodies issue bonds to raise finance on local level
Companies issue bonds as alternative to raising money via equity finance
Nominal refers to an amount of bond stock
Cashflows
Holder of bond receives lump sum of specified amount at some specified future time together with series of regular level interest payments until payment of lump sum
Fixed lump sum payment – redemption of bond – paid on redemption date
Lump sum = N.x (N-nominal amount held and x-redemption price)
Investor has initial negative cashflow to buy bond (price paid for bond),
single positive cashflow on redemption, and
series of smaller known positive cashflow on interest payment dates
timing and amounts of positive cashflows – still uncertainty due to credit risk
Gross redemption yield
return the investor would expect to get on a bond if they held it until redemption
assumes that they could reinvest coupons at exactly same rate, and it ignores expenses, tax and default risk
Or can be defined as yield that equates the price on the bond with the discounted value of interest and capital proceeds on bond
Price and gross redemption yield on bond are INVERSELY related – if price of bond increases then GRY will fall
Discuss the investment characteristics of fixed-interest government bonds using SYSTEM T.
Fixed-interest government bonds: investment and risk characteristics
- Security:
Issued by reputable government offer absolute monetary security both of income and capital
Virtually no risk of default
- Yield – real vs nominal
If government bonds held till redemption – monetary amounts of income and capital are known and fixed – so
expected nominal returns known at outset
The actual return might be uncertain:
o If n-year bond bought to meet n-year liability, coupon payments reinvested on terms that are not known at outset
o If plans to sell before redemption, sale price not known at outset
o Real return (in excess of inflation) uncertain – inflation higher than expected then real returns from conventional bonds lower than anticipated
- Yield – expected return relative to other assets
Low risk so low return
Scenario where conventional bonds do well:
o Holding conventional bonds when redemption yields are falling -produced capital gain if bond is sold
o Buying when GRY are high – investors locking into high nominal yield (but yields are high for reason e.g. expect high inflation)
- Spread – volatility of capital values
Market values will fluctuate when there is change in supply and demand
Large shifts in market value possible with less liquid, long-dated stocks
Risk of falling market values problem for:
o Investors that need to prove financial strength by reference to market value of assets
o Investors who have to sell at lower market prices – required to meet liability earlier than anticipated
- Term
Short (<5)
Medium-dated (5-15)
Long dated (>15)
Undated or irredeemable (no redemption date)
- Expenses
Dealing cost very low – margins between buying and selling prices narrower than for corporate bonds
- Exchange rate – currency risk
Government bonds issued by many countries
So, there will be a currency risk for an investor investing in bonds denominated in one currency but has liabilities denominator in another
- Marketability
Excellent – investors can deal in large quantities with little impact on price
- Tax
Will depend on tax regime of the country
In SA, individual investors are taxed on income and on capital gains
Institutional investors pay uniform rate of tax on total return
Some institutions might be exempt from tax on bonds (pension funds)
Discuss the investment characteristics of fixed-interest corporate bonds using SYSTEM T.
Fixed-interest corporate bonds: investment and risk characteristics
- Security
Much less secure than government bonds
Level of security depends on type of debt security, issuing company and term of bond
- Marketability
Much less marketable – because size of issue is smaller
- Liquidity
Market values of corporate bonds tend to be more volatile/ less predictable
- Yields
GRY higher than for similar government bonds
Compensating for lower marketability and liquidity and additional default risk
Lowest yield margins will be for larger issues from companies with high credit ratings
- Government securities generally provide most secure and marketable fixed-interest investment
- THUS, investors require higher yield on other forms of debt
- SA government carry lower credit rating than developed country issuers such as US, UK.
- This translates to higher borrowing costs for SA government as well as other SA issuers of debt
- Debt issued by larger multinational firm might be less risky
- Low security and marketability will mean LARGE margin
- Large secure issue will trade at a SMALL yield margin to closest equivalent government bond
- Yield margin – the excess of the yield available on corporate bonds over than on equivalent government bonds
- Yield margins will vary – lower when economic conditions are good and risk of default low
Discuss the key aspects of the index-interest bonds (cashflows and GRY).
Introduction
Security where cash amount of interest payments and final capital repayments are linked to an index which reflects effects of inflation
Provide return in real terms (returns protected against inflation)
Sizes of individual issues of government index-linked bonds very greatly -leading to difference in marketability
Generally, much smaller and less marketable than their conventional equivalents
Issues by non-government bodies relatively infrequent
Corporate index-linked bonds – same characteristics as conventional bonds – difference in marketability and security
Cashflows
Initial negative cashflow is followed by series of unknown positive cashflow and single larger unknown positive cashflow – all on specified dates
Known that amounts of future cashflows relate to inflation index
Cashflows known in real terms
Operation of index-linked security is such that cashflows do not relate to inflation index at time of payment – due to delays in calculating index
Also, borrower may need to know amounts of payments in advance
Leads to use of index from earlier period so amount to be paid is known in advance of payment date
Lag in the indexation
Because of lag – no inflation protection during last months before redemption
So, investor exposed to erosion of real value of investment if inflation is higher than expected during period
Yields
Actual payments dependent on future inflation
A fall in REAL yields not nominal yields that increases price
What are the main aspect that need to be looked at when comparing fixed-interest and index-linked bonds?
Comparison of fixed-interest and index-linked bonds
- The relationship between real and nominal yields
- The relative attractiveness of fixed-interest and index-linked bonds
- Increase in the values of fixed-interest bonds
- Increases in the values of index-linked bonds
How does the relationship between real and nominal yield compare for fixed-interest and index-linked bonds?
The relationship between real and nominal yields
- Nominal yield = risk-free real yield + expected future inflation + inflation risk premium + asset risk premium
- Inflation risk premium reflects additional yield required for bearing risk of uncertain future inflation
- Size of premium is determined by degree of uncertainty and balance between investors requiring fixed return and those requiring real return
- If require real return (e.g. have real liabilities)
Will be an inflation risk premium on fixed-interest bond
Investors require higher return from fixed-interest bonds (than index-linked) to compensate for risk of inflation being higher than expected and eroding real return on conventional bonds
- If require nominal return (have fixed liabilities)
Will not be inflation risk premium on fixed-interest bonds
Investors will require higher return from index-linked bonds (than fixed-interest) to compensate for risk of inflation being lower than expected and required nominal return not being achieved
- If inflation risk premium is ignored – difference between nominal and real yields gives estimate of market’s expectations for inflation
How does the relative attractiveness compare for fixed-interest and index-linked bonds?
The relative attractiveness of fixed-interest and index-linked bonds
Investors’ expectations for relative performance of different asset classes will depend on views of all factors that affect supply and demand
BUT, there are economic circumstances when index-linked bonds outperform conventional bonds and vice versa
What causes an increase in the values of fixed-interest bonds?
Increase in the values of fixed-interest bonds
Market values of fixed-interest bonds rise when nominal yield fall
Conventional bond yield will fall if investors’ expectations for future inflation fall OR if size of inflation risk premium falls
Small effects on real yields on index-linked bonds and so, minimal change in level of index linked prices
Lower future inflation expectation than that implied by difference between nominal and real yields = find conventional bonds relatively more attractive
Converse if investor is more pessimistic about inflation than the market = index-linked bonds more attractive
