CHP 14 Flashcards
Bond is another term for fixed interest or index-linked security. These are traded on the bond market.
Bonds are described by:
- The organization issuing the security – e.g. government bonds, local authority bonds, corporate bonds etc.
- Nature of the bond – e.g. fixed interest, index-linked etc.
Most important distinct types of bond markets are:
• Markets in gov bonds, listed in their country of origin
• Markets in corporate bonds, listed in their country of origin
• Markets in overseas gov and corporate bonds.
Overseas bonds may be denominated in the national currency – additional currency risk – or in the currency of the country they are marketed in.
- Fixed interest (or conventional bonds)
Industrial company, public bodies or governments can float a loan in the market. In many instances this takes the form of a fixed interest security. This is issued in bonds of stated nominal amount.
- Fixed interest bonds cfs
The holder of the bond will receive a regular stream of payments (coupons) and a redemption amount, this is in return for a single negative cashflow at the outset.
1.4. Corporate bonds
Investment risk characteristics
Higher risk than government bonds thus higher expected yield - marketability, security, lower volume
The size of the yield margin depends on the security and marketability of the debt.
Main types of corporate bonds
- Debentures – loan secured against the assets of the company, lenders rank above other creditors.
- Unsecured loan stock – not secured by any assets of the borrower.
- Subordinated debt – debt ranks below another class (senior debt) for repayment
Assessing security of corporate debt
Often a credit rating is used as an indication of probability of default. Credit ratings are very reliable and often used.
- Index-linked bonds
2. 2. Cashflows
Some investors are attracted by a security where the cash amount of interest payments and final capital repayment are linked to an index which reflects the effects of inflation.
The exact nominal amounts of the cashflows are not known in advance, but the amount in real terms is known.
The amounts are usually calculated on a lagged index due to time it takes to calculate indices.
- The yield curve
The yield curve is a plot of yield against term to redemption.
Usually gross redemption yield on coupon paying bonds – other yields can be used.
3.2. Expectations theory
Describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for future short-term interest rates. E.g. use forward rates to calculate redemption yields.
3.3. Liquidity preference theory
Based on the general belief that investors prefer liquid assets over illiquid assets. Investors require a greater return to commit funds for longer, long-dated stocks are less liquid than short dated stocks and thus should have higher yields.
Liquidity theory states that the yield curve should have a slope greater than that predicted by expectations theory or should at least be upward sloping.
3.4. Inflation risk premium theory
When bonds are longer dated and the coupons are fixed, there is a risk that the real return of the investment will be lower than what was expected. Thus, investors require a higher yield. For this reason the yield curve will slope upwards due to the inflation risk premium on top of the pure expectations and the longer dated the more inflation risk is present.
3.5. Market segmentation theory (preferred habitat theory)
Yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
Principle buyers of short term bonds are banks, which compare their yields with short term interest rates.
Major investors of long-term bonds are pension funds and life assurance companies whose main objective is to protect against future inflation. The two areas of the bond market may move independently.
4.1. Theories of the real yield curve
This curve is of real yields on index-linked bonds against term to maturity.
It is determined by supply and demand (like the conventional yield curve). Thus it can be viewed as being determined by investors’ view on future real yields modified according to market segmentation and liquidity preference theory.
The government’s funding policy will also influence the shape of the curve.
4.2. The relationship between real and nominal yields
Nominal yield on conventional bonds can be expressed as:
Nominal yield = risk-free yield + expected future inflation + inflation risk premium
Inflation risk premium reflects the additional yield required by investors with real liabilities for bearing the risk of uncertain future inflation.
The size of the premium is determined by the degree of uncertainty and the balance between the amount of investors requiring fixed return vs. real return.
If the inflation risk premium is ignored, the difference between nominal and real yields gives an estimate of the market’s expectations for inflation.
