L5 - Bonds and Term Structure of Interest Rates

Question 1

What are Bonds?

Answer 1

A bond is a debt instrument, issued by a borrower for a fixed period of time, paying interest known as a coupon which is fixed at issue date and is paid periodically until it is redeemed at maturity, at which time the principal amount is repaid

Question 2

What are the different types of Bonds?

Answer 2

Bonds come in a variety of forms:

• Straight, plain vanilla or bullet bonds
• Zero coupon bonds –> no coupons are paid but the bond is given at a discount, so you are told you will make a nominal value at a future date and the only money you make is the capital gain from the dicount value it was issued at
• Floating-rate or variable-rate bonds –> Coupon is linked to a short-term interest rate e.g. LIBOR
• Index-linked bonds –> linked to a index fund, inflation, linked with gold, silver,
• Convertible bonds –> transferred into shares

Question 3

How can we classify bonds?

Answer 3

By place of issue:

• Domestic bonds –> UK company issuing in the UK
• Foreign Bonds –> domestic company issuing bonds to other countries (Japan = samurais, US = yankee bonds, UK = bulldog bonds)
• Eurobonds –> bonds issued in a currency of a country, but issued outside of it

by Issuer:

• Central governments and government agencies
• State and local government
• Companies
• Supranational institutions (eg. World Bank)

Question 4

What does the Bond rating Scale look like?

Answer 4

• get worse the further you go down

AAA - the best quality , minimal credit risk, minimum risk of default

BB - is when a company faces adverse economic, financial or business and negative impact their ability to pay debt

CCC - the business is only paying debt because it faces favourable economic, financial and business conditions

C - companies most likely going to default - you are dealing with subordinate debt –> differing level of debt get paid first e.g. senior debt

D - is in default

Investment grade bonds –> many pension funds are only allowed to invest in high quality bonds

Question 5

What happened to Ford’s credit rating?

Answer 5

• The credit rating agency downgraded Ford from Baa2 to Baa3, adding that the outlook is negative.
• The downgrade “reflects the erosion in thecompany’s global business position and the challenges it will face implementing its fitness redesign programme”, Moody’s said in a statement, referring to chief executive Jim Hackett’s restructuring plan.
• Yields on the company’s recently issued bonds maturing in 2025 rose 6 basis points to 4.78 per cent.
• If Bond credit rating is falling and they are becoming more speculative, investors would require a higher rate of return

Question 6

What are the current types of Gilts offered?

Answer 6

• Bond issued by the UK government
• Government Gilts are paid twice per year

Current types of Gilts:

• Conventional gilts, for example: 1 1/2% (split between two payments)Treasury Gilt 2047 –> These are covential bond and make up 70-75% of all bonds issued by the government
• Index-linked gilts –> coupon rate link to inflation, based on RPI
• Gilt Strips (Separate Trading of Registered Interest and Principal Securities)

Question 7

What are some Historic types of Gilts?

Answer 7

• Undated gilts –> perpentuities that very all redeemed in 2015
• Doubled-dated convential gilts –> there is an interval date, the government can redeem the bond at any point between the starting and maturity date by just giving three months notice
• Floating Rate gilts –> coupon related to some short-term interest rate

Question 8

What is a Gilt Strip?

Answer 8

”Strips” is the acronym for Separate Trading of Registered Interest and Principal Securities. “Stripping” a gilt refers to breaking it down into its individual cash flows, which can be traded separately as zero-coupon gilts.

For example, a three-year gilt will have seven individual cash flows: six (semi-annual) coupon payments and a principal repayment all quoted at a discount (only profit capital gain). Gilts can also be reconstituted from all of the individual strips.

The strip market began in the UK on 8 December 1997 and all strippable gilts are currently conventional fixed coupon instruments.

Question 9

What are Long, Medium and Short Gilts?

Answer 9

Long Gilts –> 15 years +

Medium Gilts –> 7-15 years

Short Gilts –> 3- 7 years

Ultra short Gilts –> 0-3 years

Question 10

In general what are treasury bills?

Answer 10

short-term zero coupon bonds issued for 1/3/6 months and can be issued up to 1 year

• Also issued at a discount

Question 11

How do you calculate the Present value of Perpetual Bonds?

Answer 11

PV = C/r

PV - present value of bond

C - the coupon rate × nominal (par) value of the bond

r - discount rate

Question 12

What is the relationship between the price of a bond and the interest rate?

Answer 12

When the interest rate rises the price of a bond falls

Question 13

How do you calculate the Present Value of Coventional Bonds?

Answer 13

• the first part is the annuity payment and the second part is the present value of the Principal/Par value when repaid at maturity

Question 14

How do you calculate Interest yield?

Answer 14

Interest yield (also known as the flat yield, income yield and running yield) –> give a quick valuation of what you would get from that bond

Coupon /Current Market Price

• this has alot of drawback firstly, it doesnt take into account the time value of money and we do not take into consideration the capital gain/loss on the bond

Question 15

How do you calculate Redemption yield?

Answer 15

(also know as yield to maturity)

• takes into account both the capital gain/loss and the time value of money

The discount rate such that the present value of all the cash inflows from the bond (interest plus principal) is equal to the bond’s current market price –> the IIR of a bond

• Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity

Question 16

Why are investors holding negative yield bonds?

Answer 16

• because interest rates are so low, prices of bonds are high
• They dont have an alternative, multi million dollar companies dont have a savings account and they might see stock as to risky so they are buying these bonds to hold their money, it kind of like they are paying someone to do it (negative yield)

Question 17

How does Price Yield Relate to Maturity?

Answer 17

• As the redemption yield increase the price of the bond decreases
• if there is a change in interest rate, the high change in the price of bonds are those that still paying coupon for a long time to a distance maturity date

Question 18

What are Spot Rates?

Answer 18

Spot interest rate for maturity of X years refers to the yield to maturity on a zero-coupon bond with X years till maturity. They are used to (a) determine the no-arbitrage value of a bond, (b) determine the implied forward interest rates through the process called bootstrapping and (c) plot the yield curve.

• Used because interest rates can change due to different maturity, inflation or other economic factors whereas yield to maturity just uses one discount rate
• so the spot rate treats each coupon payment period as a zero coupon bond and calulate the present value as the sum of all coupon payments discounted at their respective spot rate

Question 19

When does the redemption rate not work?

Answer 19

• Say we have 4 different gilts with 3 different coupons and 3 different redemption dates
• they will all have different redemption yields due to their different maturity and coupon rates
• But say if you lend the money to the government for half a year and gilts pay out semi-annually, the required rate of return of those bonds should the same regardless of their coupon rate

Question 20

How do you calculate the Present value of a bond using the Spot Rate?

Answer 20

• each different spot rate is like the interest rate you would be willing to lend to the government for, so the interest rate may get higher the longer into the future is it because you expect more for giving up that money
• Last fraction has C+V on the as the numerator

Yield to maturity is simply the annual discount rate that is equilvent to the discounting for all the spot rates in that each period

Question 21

What is the term structure of interest rates?

Answer 21

The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. When graphed, the term structure of interest rates is known as a yield curve, and it plays a central role in an economy

• for long maturity dates lenders demand different interest rates

Question 22

What is the spot rate of interest?

Answer 22

the spot rate is an interest rate fixed today on a loan that is made today