Chapter 9 - Bonds and Money Markets Flashcards
What are the main forms of cash on deposit (3)?
What types of interest rates can be paid by the borrower (3)?
Call deposits (instant access) Notice deposits (period of notice before withdrawal) Term deposits (no access before maturity)
Fixed for the term
Fixed for an initial period
Reviewed periodically/regularly
What are the main types of MM instruments?
Treasury bills - Issued by government
Certificates of deposit - Issued by commercial bank
Commercial paper - Issued by large institution
Bills of exchange - Issued by individuals?
(see slides for more information)
What does SYSTEMT stand for?
Security
Yield (real vs nominal, and relative to other assets)
Spread
Term
Expenses and Exchange rate (where applicable)
Marketability
Tax
List the key players in money markets (3) and discuss their roles.
Clearing banks
- Use MM instruments to lend excess liquid funds and borrow short-term funds
- Interbank rates taken as benchmark for short-term interest rates
Central banks
- LOLR, and so provides liquidity to the banking system through MM to establish levels of short-term interest rates
Other institutions
- Can also lend and borrow in the short term through MM instruments
Discuss the characteristics of cash on deposit and MM instruments.
Security
- Depends on the issuer
- Generally good due to short-term
Yield - real vs nominal
- Approximately equal to short-term interest rate (can vary over time)
- Provide known nominal return in the case of bills (issued at a discount and redeemed at par)
- Generally positive real return since short-term interest rates tend to be higher when inflation is higher. (Not always the case)
Yield - relative to other assets
- Very little risk of default
- Expected returns lower than almost every other type of investment
Spread
- Very little volatility due to short-term and because they are fixed in cash terms.
Term
- Short term, no longer than one year
Expenses
- Minimal dealing and management cost due to simple structure and good marketability
Exchange rate
- Available in wide range of currencies
- Movements in exchange rates expected to compensate for differences in interest rates offered (theoretically)
Marketability
- Highly marketable
- Unquoted
- Call and term deposits are not tradeable
Tax
- Normally treated as income for tax purposes
Discuss the main reasons that long-term institutional investors (e.g. insurers) would hold money market instruments and cash deposits.
Liquidity reasons:
- Meet a major, known, short-term outgo
- Maintain minimum level of liquidity if there is a high degree of uncertainty around the timing of outgo (e.g. general insurers). Prevents from forced sale of assets at a reduced price.
- Temporary attractive investment opportunities may arise which require liquidity.
- May have recently received a large inflow of cash which have not been invested in other assets yet.
- Can maintain nominal value of capital during periods of risk aversion.
Economic circumstances:
- Rising interest rates will depress bond and equity prices (explain why and see p. 8) which will make MM more attractive if investor can predict increase in short-term interest rates.
- Start of an economic recession will result in poor performances from stock markets
Fears government borrowing will increase, which will increase supply of bonds (price decrease), but interest rates may be expected to decrease (price increase for bonds due to lower GRY) - so lots of uncertainty regarding bond values
Cash would give a reasonable income stream combined with no risk of capital loss - Depreciation of domestic currency
May expect interest rates to be raised to encourage overseas investment and protect domestic currency.
Cash investment in overseas MM may seem attractive, despite lower interest rates. - General economic uncertainty makes MM appealing to risk averse investors due to stability.
What assumptions are made when calculating the GRY of a fixed-interest bond?
Bond held until redemption
Reinvest coupons at same rate
No expenses, tax or default risk
Discuss the characteristics of a fixed-interest government bond.
Security
- Absolute security of income and capital - virtually no risk of default
Yield - real vs nominal
- Expected nominal returns and cashflows known at the outset
- May differ due to early sale of bond and coupons may be reinvested at a different rate to risk discount rate
- Uncertain real return, especially in the long-run
Yield - compared to other assets
- Low risk investments
- Expected returns lower than equities in the long-run
- Bonds perform well when bonds are held and GRY is falling, or if bonds are purchased when GRY is too high (mispriced)
Spread
- Can be quite large with longer-dated and illiquid bonds
- Problem when displaying solvency or during forced sale of bonds at low price
Term
- Varies
- From less than 5 years to undated
Expenses
- Very low
- Margins between buying and selling lower than for corporate bonds
Exchange rate
- If investing in overseas bonds
Marketability
- Excellent marketability
- Can deal in large quantities without affecting the price
Tax
- Depends on Tax regime, but in SA
- Individuals tax on income and capital
- Institutions pay uniform rate on income and capital
- Some institutions may be exempt, e.g. pension funds
Discuss the characteristics of a fixed-interest corporate bond.
Security
- Much less secure than government bonds
- Depends on security offered, the company involved and the term
Yield - real vs nominal
- Expected nominal returns and cashflows known at the outset
- May differ due to early sale of bond and coupons may be reinvested at a different rate to risk discount rate
- Uncertain real return, especially in the long-run
Yield - compared to other assets
- Higher GRY than government bonds due to lower marketability and liquidity, as well as extra perceived default risk.
- Yield margins will be lower for larger issues and larger corporations with high credit ratings.
- Expected returns lower than equities in the long-run
- Bonds perform well when bonds are held and GRY is falling, or if bonds are purchased when GRY is too high (mispriced)
Spread
- Tend to be more volatile than government bonds
Term
- Varies
- From less than 5 years to undated
Expenses
- Margins between buying and selling higher than for government bonds
- May also be research and negotiation costs as bonds likely OTC
Exchange rate
- If investing in overseas bonds
Marketability
- Much less marketable due to smaller size
Tax
- Depends on Tax regime, but in SA
- Individuals tax on income and capital
- Institutions pay uniform rate on income and capital
- Some institutions may be exempt, e.g. pension funds
What is the yield margin? What does its size depend on?
Excess yield available on corporate bonds compared with similar government bonds.
Depend on security and marketability of debt.
Will be lower during economic peaks and risk of default is low.
Will also reflect the differences in tax treatment.
What is an index-linked bond?
Interest payments and final capital repayment are linked to an index which reflects inflation. Therefore return is known in real terms.
How can the nominal yield on a conventional government bond be broken down?
Nominal = risk free real yield + expected future inflation + inflation risk premium
What is the inflation risk premium? What factors influence the IRP?
Inflation risk premium reflects the additional yield required by investors for bearing the risk of uncertain future inflation - that future inflation is higher than expected.
It is determined by the degree of uncertainty which will depend on various factors:
- Term of the bond
- Political and economic stability
It will also be affect by the relative demand for fixed return securities and those with a guaranteed real return:
- Require real return - higher IRP
- Require nominal return - lower/no IRP
What is a monetary risk premium?
Require higher return from ILB for risk inflation is less than expected, in the case that a nominal return is required.
How can the market’s expectations for inflation be observed from bond yields?
From equation for nominal yield (if we assume IRP is negligible), the difference between real bond yields (yield on ILB) and nominal bond yields (yield on conventional bond) will reflect expected inflation.
