Fixed Income Instruments & Price + Yield of Bonds - Topic A Flashcards
Define ‘Bond’ (Fixed Income)
A bond is a security paying the investor fixed regular payments (coupons). The borrower (bond issuer, e.g. the govt for govt bonds) then repays the full/par value at a final date (maturity/redemption date)
Define ‘Yield To Maturity (YTM)’
The discount rate/IR/IRR at which the PV of future repayments of coupon and principal = current market price
What is the difference between nominal and real bonds in context?
Nominal = coupons/principal are fixed, real = inflation adjusts them upwards
What is the relationship between bond prices and yields?
Inverse relationship > if D for bonds falls (due to perceived risks of inflation/default rising), price falls and the yield rises to attract new buyers
Define ‘credit rating’
They represent the quality of risky bonds (AAA being the best, C being the worst in terms of promised payments, however BBB is better > ‘investment-grade bonds’)
Define ‘liquidity’
The ability to buy/sell with limited impact on market price
Define ‘credit spread’
The difference in yield between 2 debt securities (pay interest) of the same maturity but different credit quality
What do credit spreads show
The risk of default/liquidity (e.g. bonds of small issuers are difficult to sell > lower market P, higher CS)
What is the effect of risk on the price and yield of bonds?
Higher risk > lower price, higher yields to compensate for the risk, vice versa for lower risk bonds
How do the yields on different maturity bonds differ?
Longer maturity bonds = greater CS, higher risk, vice versa for shorter maturity bonds
What does an inverted yield curve show?
When inflation and IRs are high but expected to fall over time, the yield on longer maturity govt bonds are lower than on short maturity (downward sloping curve with yield on y-axis, maturity on x-axis)
Present evidence on differences in bond yields both over time and between instruments + what explains these differences?
AAA corporate bond yields stayed relatively constant at 3.5%, however the COVID-19 pandemic crashed down yields of bonds to 2% in 2020, with yields recovering and nearing 5% (FRED)
