Fixed Income Portfolios (Ch9)

Question 1

Why are bonds considered safe, give two reasons?

Answer 1

• fixed coupon payments

- easy to value based on term structure

Question 2

which type of bonds provide low correlations with other bonds and offer diversification benefits?

Answer 2

high yield bonds

Question 3

when is the bond trading at a premium/discount?

Answer 3

• premium: when price > PV of bond

- discount: when price

Question 4

what does it mean if the bond price is the same as the PV of the bond?

Answer 4

coupon rate = discount rate

Question 5

what is the difference between duration and maturity?

Answer 5

maturity is the time until the bond matures, i.e. face value is paid.
duration is the weighted-average period of time before the cash flows involved are received.

Question 6

what is the formula for Macauly duration?

Answer 6

(sum of PV(CF)xt)/(sum of PV(CF))

Question 7

what is the formula for modified duration?

Answer 7

Mac dur/ (1+ytm)

Question 8

what is the duration of a zero coupon bond?

Answer 8

duration = maturity

Question 9

is duration alway greater or less than the maturity for a bond with coupon pmts? what effects with a higher coupon pmt have on the duration?

Answer 9

less, CF received earlier.

The higher the coupon pmt the low the duration.

Question 10

what impact does a high ytm have on duration?

Answer 10

it decreases the duration.

Question 11

what does the modified duration show?

Answer 11

an approximation of interest rate sensitivity of the bond

Question 12

How can a retail investor invest in bonds? why do they invest this way?

Answer 12

through mutual funds, because bonds are usually traded over the counter in lots of $1 million, retail investors do not have the liquidity to invest directly.

Question 13

what are the main source of returns from bonds?

Answer 13

mostly from distributions, only a small amount form capital gains.

Question 14

how are bonds and equities correlated in different market conditions?

Answer 14

good market conditions: slight positive correlation
bad market conditions: slight negative correlation
disaster market: strong negative correlation

Question 15

What are three main roles of a bond in a clients portfolio?

Answer 15

• diversification
• providing current income and liquidity
• hedging against inflation (indexed bonds) and deflation (nominal bonds)

Question 16

what are 3 types of risk associated with bonds?

Answer 16

• principle/default risk
• reinvestment risk
• inflation risk

Question 17

what is reinvestment risk?

Answer 17

when interest decreases = price of bond increases (reinvest coupon at a lower rate)
when interest increases = price of bond decreases (reinvest at a higher rate)

Question 18

what is a term structure and why does it usually slope upward?

Answer 18

plot of yields against time

investors demand higher rates for longer term investments as they are more risky

Question 19

What does a term structure shift refer to?

Answer 19

an equal increase or decrease in rates of all maturities

Question 20

What does a term structure twist refer to?

Answer 20

a rotation in the term structure creating either a steeper of flatter curve

Question 21

What does a term structure butterfly refer to?

Answer 21

when the middle maturity rates rise or fall relative to the short and long maturity rates

Question 22

What is a bullet FIS investment strategy?

Answer 22

concentrating on a single intermediate-maturity bond

Question 23

What is a barbell FIS investment strategy?

Answer 23

buying a combination of short and long-maturity bonds so that the weighted average of the duration is equal to the intermediate bond

Question 24

which investment strategy out preforms the other when the term structure twists and flattens?

Answer 24

the barbell

Question 25

which investment strategy out preforms the other when the term structure twists and steepens?

Answer 25

the bullet

Question 26

which investment strategy is favoured when volatility increases?

Answer 26

the barbell

Question 27

which investment strategy is favoured when volatility decreases?

Answer 27

the bullet

Question 28

which investment strategy requires a higher yield to be attractive?

Answer 28

the bullet

Question 29

why does convexity in the term structure matter? when does convexity increase?

Answer 29

the higher the convexity the higher the return, regardless of the yield shift.
Convexity increases as maturity increases (more rapidly than durations does)

Question 30

how are bonds correlated with inflation and interest rates

Answer 30

BONDS

negative correlation with interest and inflation( when they increase, bond value decreases)

Question 31

over which time horizon do the capital gains and reinvestment impacts balance out?

Answer 31

when the duration is equal to time horizon

Question 32

does reinvestment or capital gains impact dominate over the short term horizon?

Answer 32

short term horizon (investment horizon of bond

Question 33

does reinvestment or capital gains impact dominate over the long term horizon?

Answer 33

long term horizon (investment horizon of bond > duration of portfolio) = reinvestment

Question 34

if you have a bond with a long term investment horizon, would you prefer interest rates to increase or decrease?

Answer 34

increase - higher reinvestment rate

Question 35

how are real bond returns correlated with inflation?

Answer 35

strong negative correlation

Question 36

are bonds or stocks better hedges against inflation? why?

Answer 36

stocks, real stock returns seem to be uncorrelated with inflation, even though bond and stock nominal returns are similarly correlated with inflation, this is due to the difference in volatility in the assets?