Fixed Income Portfolios (Ch9) Flashcards
Why are bonds considered safe, give two reasons?
- fixed coupon payments
- easy to value based on term structure
which type of bonds provide low correlations with other bonds and offer diversification benefits?
high yield bonds
when is the bond trading at a premium/discount?
- premium: when price > PV of bond
- discount: when price
what does it mean if the bond price is the same as the PV of the bond?
coupon rate = discount rate
what is the difference between duration and maturity?
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.
what is the formula for Macauly duration?
(sum of PV(CF)xt)/(sum of PV(CF))
what is the formula for modified duration?
Mac dur/ (1+ytm)
what is the duration of a zero coupon bond?
duration = maturity
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?
less, CF received earlier.
The higher the coupon pmt the low the duration.
what impact does a high ytm have on duration?
it decreases the duration.
what does the modified duration show?
an approximation of interest rate sensitivity of the bond
How can a retail investor invest in bonds? why do they invest this way?
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.
what are the main source of returns from bonds?
mostly from distributions, only a small amount form capital gains.
how are bonds and equities correlated in different market conditions?
good market conditions: slight positive correlation
bad market conditions: slight negative correlation
disaster market: strong negative correlation
What are three main roles of a bond in a clients portfolio?
- diversification
- providing current income and liquidity
- hedging against inflation (indexed bonds) and deflation (nominal bonds)
what are 3 types of risk associated with bonds?
- principle/default risk
- reinvestment risk
- inflation risk
what is reinvestment risk?
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)
what is a term structure and why does it usually slope upward?
plot of yields against time
investors demand higher rates for longer term investments as they are more risky
What does a term structure shift refer to?
an equal increase or decrease in rates of all maturities
What does a term structure twist refer to?
a rotation in the term structure creating either a steeper of flatter curve
What does a term structure butterfly refer to?
when the middle maturity rates rise or fall relative to the short and long maturity rates
What is a bullet FIS investment strategy?
concentrating on a single intermediate-maturity bond
What is a barbell FIS investment strategy?
buying a combination of short and long-maturity bonds so that the weighted average of the duration is equal to the intermediate bond
which investment strategy out preforms the other when the term structure twists and flattens?
the barbell
which investment strategy out preforms the other when the term structure twists and steepens?
the bullet
which investment strategy is favoured when volatility increases?
the barbell
which investment strategy is favoured when volatility decreases?
the bullet
which investment strategy requires a higher yield to be attractive?
the bullet
why does convexity in the term structure matter? when does convexity increase?
the higher the convexity the higher the return, regardless of the yield shift.
Convexity increases as maturity increases (more rapidly than durations does)
how are bonds correlated with inflation and interest rates
BONDS
negative correlation with interest and inflation( when they increase, bond value decreases)
over which time horizon do the capital gains and reinvestment impacts balance out?
when the duration is equal to time horizon
does reinvestment or capital gains impact dominate over the short term horizon?
short term horizon (investment horizon of bond
does reinvestment or capital gains impact dominate over the long term horizon?
long term horizon (investment horizon of bond > duration of portfolio) = reinvestment
if you have a bond with a long term investment horizon, would you prefer interest rates to increase or decrease?
increase - higher reinvestment rate
how are real bond returns correlated with inflation?
strong negative correlation
are bonds or stocks better hedges against inflation? why?
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?
