Topic 3 - Term 2: Bonds: Valuation & Management

Question 1

Bond types:

1. fixed income securities
2. ?-coupon bonds
3. floating-rate bonds
4. ?-floating rate bonds
5. ?-?securities (IPS)
6. ?-? securities (ABS)

Answer 1

Bond types:

1. fixed income securities
2. zero-coupon bonds
3. floating-rate bonds
4. inverse-floating rate bonds
5. inflation-protected securities (IPS)
6. asset-backed securities (ABS)

Question 2

A zero-coupon bond:
- pay ? interest
- traded at a deep ?
=> profit is the difference between the purchase price and full ?? at maturity.

Answer 2

A zero-coupon bond:
- pay no interest
- traded at a deep discount
=> profit is the difference between the purchase price and full face value at maturity.

Question 3

Inverse-floating rate bond:
A bond with a variable coupon rate inversely tied to a reference rate.
Example: Coupon = 10% - EURIBOR
Negative coupon rate is possible, but usually has a floor at 0.

Answer 3

Inverse-floating rate bond:
A bond with a variable coupon rate inversely tied to a reference rate.
Example: Coupon = 10% - EURIBOR
Negative coupon rate is possible, but usually has a floor at 0.

Question 4

Inflation-Protected Securities (IPS)

The? valuerises with ?, as measured by theConsumer Price Index, while the interest rate remains ?.
Protects the investor against inflation by guaranteeing a real rate of return.
TIPS – Treasury Inflation Protected Securities.
Usually carry interest rates ? than other government or corporate securities, so they are not necessarily optimal for income investors.
Their advantage is mainly inflation protection, but if inflation is minimal, their utility ?.

Answer 4

Inflation-Protected Securities (IPS)

Thepar valuerises with inflation, as measured by theConsumer Price Index, while the interest rate remains fixed.
Protects the investor against inflation by guaranteeing a real rate of return.
TIPS – Treasury Inflation Protected Securities.
Usually carry interest rates lower than other government or corporate securities, so they are not necessarily optimal for income investors.
Their advantage is mainly inflation protection, but if inflation is minimal, their utility decreases.

Question 5

Asset-backed securities
? by a ? of ? such as loans, leases, credit card debt, royalties orreceivables.
For investors, asset-backed securities are an alternative to investing in corporate debt.
ABS have been created based on cash flows from movie revenues, royalty payments (Bowie Bonds) and aircraft leases.
Just about any ?-producing situation can be securitised into an ABS.
- Mortgage Backed Securities (MBS)

Answer 5

Asset-backed securities
Collateralised by a pool of assetssuch as loans, leases, credit card debt, royalties orreceivables.
For investors, asset-backed securities are an alternative to investing in corporate debt.
ABS have been created based on cash flows from movie revenues, royalty payments (Bowie Bonds) and aircraft leases.
Just about any cash-producing situation can be securitised into an ABS.
- Mortgage Backed Securities (MBS)

Question 6

2 main bond issuers:

• Government (Sovereign) bonds
• Corporate bonds

Answer 6

2 main bond issuers:

• Government (Sovereign) bonds
• Corporate bonds

Question 7

Government bonds:
Issued by governments, 
e.g. US Treasury
US Treasury bonds (> 10 yrs), note (1-10 yrs), bills (< 1 yr), UK Gilts.
- Very ? credit risk
- bid/ask is quoted as ? of par value.

Answer 7

Government bonds:
Issued by governments, 
e.g. US Treasury
US Treasury bonds (> 10 yrs), note (1-10 yrs), bills (< 1 yr), UK Gilts.
- Very low credit risk
- bid/ask is quoted as % of par value.

Question 8

US Treasury bills (T-bills):
- pay zero coupons
=> T-bills are quoted at a ? expressed as an annual rate based on a 360-day year.

Answer 8

US Treasury bills (T-bills):
- pay zero coupons
=> T-bills are quoted at a discount expressed as an annual rate based on a 360-day year.

Question 9

Corporate bonds:

• Issued by corporations.
• Relatively ? credit risk.

Answer 9

Corporate bonds:

• Issued by corporations.
• Relatively higher credit risk.

Question 10

Bond investors:
The bond market is dominated by ? trading (typically 90-95% of activity).

Major Participants - life insurance companies, commercial banks, pension funds, mutual funds.

Different institutions favour different sectors depending on:
Tax code
Institution’s liability structure

Answer 10

Bond investors:
The bond market is dominated by institutional trading (typically 90-95% of activity).
Major Participants - life insurance companies, commercial banks, pension funds, mutual funds.

Different institutions favour different sectors depending on:
Tax code
Institution’s liability structure

Question 11

The bond market is actually ? than the stock market.

Answer 11

The bond market is actually larger than the stock market.

Question 12

Investors can include bonds in their portfolios for ? benefits.
Bec bonds are not as risky and volatile as stocks.

Answer 12

Investors can include bonds in their portfolios for diversification benefits.
Bec bonds are not as risky and volatile as stocks.

Question 13

When we’re talking about price in finance, we mean the intrinsic value/ fair price of an asset.

Fair price = ?? of expected future ? discounted by investors’ ????

investors’ required rate of return = ?? of ? (the return we get when investing in sth else) = risk-free rate + risk premium.

Answer 13

When we’re talking about price in finance, we mean the intrinsic value/ fair price of an asset.

Fair price = PV of expected future cashflows discounted by investors’ required rate of return

investors’ required rate of return = opportunity cost of capital (the return we get when investing in sth else) = risk-free rate + risk premium.

Question 14

If bond price ? par value

=> ? = nominal yield

Answer 14

If bond price = par value

=> coupon = nominal yield

Question 15

If bond price # par value
=> ? yield = annual coupon / current market bond price
=> newspapers usually report current yield.

Answer 15

If bond price # par value
=> current yield = annual coupon / current market bond price
=> newspapers usually report current yield.

Question 16

Yield to maturity takes into account the time value of money, i.e. PV of a bond’s future coupon payments.

Answer 16

Yield to maturity (YTM) takes into account the time value of money, i.e. PV of a bond’s future coupon payments.

Question 17

YTM of zero-coupon bonds = ? rates

Spot rate is used to discount a single cashflow to be received in n periods in the future

Answer 17

YTM of zero-coupon bonds = spot rates

Spot rate is used to discount a single cashflow to be received in n periods in the future

Question 18

There is always an inverse relationship between bond price and interest rate/ yield.

Answer 18

There is always an inverse relationship between bond price and interest rate/ yield.

Question 19

Yield curves:
https://images.app.goo.gl/GLEtXW41q3eCBeMB7
Yield curves:
- A normal yield curve slopes upwards; however, once bonds reach thehighest maturities, the yield flattens and remains consistent.
Such a yield curve implies a stable economic condition, and prevails for the longest duration in a normaleconomic cycle.
- A steep curve implies a growing economy moving towards a positive upturn.
Such conditions are accompanied by higher inflation, which often results in higher interest rates.
- An inverted yield curve is strongly suggestive of a severe economic slowdown.
- A flat/humped yield curve implies an uncertain economic situation.
It includes conditions like the one after a high economic growth period leading to high inflation and fears of slowdown, or during uncertain times when the central bank is expected to increase interest rates.

https://images.app.goo.gl/GLEtXW41q3eCBeMB7

Answer 19

Yield curves:
- A normal yield curve slopes upwards; however, once bonds reach thehighest maturities, the yield flattens and remains consistent.
Such a yield curve implies a stable economic condition, and prevails for the longest duration in a normaleconomic cycle.
- A steep curve implies a growing economy moving towards a positive upturn.
Such conditions are accompanied by higher inflation, which often results in higher interest rates.
- An inverted yield curve is strongly suggestive of a severe economic slowdown.
- A flat/humped yield curve implies an uncertain economic situation.
It includes conditions like the one after a high economic growth period leading to high inflation and fears of slowdown, or during uncertain times when the central bank is expected to increase interest rates.

https://images.app.goo.gl/GLEtXW41q3eCBeMB7

Question 20

Yield curves theories:
1. Pure Expectation Theory
This theory assumes that the various maturities are substitutes and the shape of the yield curve depends on the market’s expectation of future interest rates. According to this theory, yields tend to change over time, but the theory fails to define the details of yield curve shapes.

2. Liquidity Preference Theory
   This theory is an extension of the Pure Expectation Theory. It adds a premium calledliquidity premiumor term premium. This theory considers the greater risk involved in holding long-term debts over short-term debts.
3. Segmented Market Theory
   Thesegmented market theoryis based on the separate demand and supply relationship between short-term securities and long-term securities. It is based on the fact that different maturities of securities cannot be substituted for one another.
   Since investors will generally prefer short-term maturity securities over long-term maturitysecuritiesbecause the former offers lower risk, then the price of short-term securities will be higher, and thus, the yield will be correspondingly lower.

Answer 20

Yield curves theories:
1. Pure Expectation Theory
This theory assumes that the various maturities are substitutes and the shape of the yield curve depends on the market’s expectation of future interest rates. According to this theory, yields tend to change over time, but the theory fails to define the details of yield curve shapes.

2. Liquidity Preference Theory
   This theory is an extension of the Pure Expectation Theory. It adds a premium calledliquidity premiumor term premium. This theory considers the greater risk involved in holding long-term debts over short-term debts.
3. Segmented Market Theory
   Thesegmented market theoryis based on the separate demand and supply relationship between short-term securities and long-term securities. It is based on the fact that different maturities of securities cannot be substituted for one another.
   Since investors will generally prefer short-term maturity securities over long-term maturitysecuritiesbecause the former offers lower risk, then the price of short-term securities will be higher, and thus, the yield will be correspondingly lower.