Bond valuation and portfolio management Flashcards
(37 cards)
What factors affect bond valuations?
1.) Interest Rates
2.) Default Risk -
(Possibility that the borrower defaults, more common in corporate bonds)
3.) Tax effects -
(Capital gains tax etc)
4.) Option characteristics
What does YTM stand for?
Yield to maturity
What is the term structure or yield curve of a bond?
The yield curve plots different yields (interest rates) against differing maturities.
What is the YTM
The interest rate that makes the PV of the bond cash flows equal to the current price
What is a zero coupon bond
When you buy the bond at a discount today and get the face value of the bond back at a later day
What are the 4 main bond theories related to interest rates and bonds?
> Pure expectations
Liquidity preferences
Segmented markets
Preffered habitat
In the theory of pure expectation, why is the yield of all bonds the same?
Investors are risk neutral, meaning there is no reward for holding more risky bonds. Thus, bond values are ultimately comprised of price and yield. If a bond is expensive but has bad yield, it is demanded less decreasing price until the yield is equal to that of other bonds and vice versa. This means in essence that all bonds would theoretically have the same return as risk is not being taken into account.
In practice, does the theory of pure expectations hold?
Through research by Dimson, Marsh and Staunton. Empirical evidence suggests long term bonds have higher average return than on short term bonds - thus it does not hold.
In the theory of pure expectations, what can the term structures tell us?
Because the timeframes (risk) of the bonds is ignored. By looking at the yields at future maturities it is a pure prediction of what investors think interest rates will be.
In the theory of liquidity preferences, why are future yields on maturities not a pure prediction of future interest rates?
Because the yields of the bonds are reflective of the risk/opportunity cost of the reduced liquidity due to holding the bond for longer meaning the future IR are not the only marker for future bond maturities.
What is the concept of liquidity preference?
Investors preferring short term bonds than long term bonds. Hence the proven higher returns on longer maturities due to there needing to be a larger incentive for investors to take them on (liquidity premium)
What does the empirical evidence that shows higher returns on longer maturities published by dimson, marsh and Staunton suggest about pure expectations and liquidity preference?
That liquidity preference is more prevelant then pure expectations
What is the concept of segmented markets?
Different parts of the bond markets operate somewhat independently due to preferences, contraints or regulations that keep investors within certain “segments” of the market
What are some of the key features of the segmented market theory?
1.) Investor preferences - May have strong preferences for certain maturities
2.) Limited Substitutability - Bonds of different maturities are not perfect substitutes, investors wont easily switch between long and short term maturities.
3.) Some institutions are restricted by law or policy to only invest in certian types of bond (eg. banks may prefer short maturities due to liquidity requirements)
4.) Since demand and supply are determined independently, the yield curve may reflect segmented preferences rather than future IR expectations
What is default risk
The chance that you dont recieve the coupon or the face value of the bond due to the bond issuer not being able to fulfill its obligations
How is default risk measured?
Ranked by agencies like Moody’s or S&P in terms of credit ratings. AAA-D
What did the ECB do during covid to ensure financial stability?
They guaranteed all European government issued bonds
Why does a government’s bond’s credit rating being downgraded make it more expensive to issue new debt
Investors require higher yields due to the increased risk of taking the bond on. Additionally, falling bond price due to falling demand means yields are higher and makes future borrowing more expensive as they must match these yields when issuing new bonds.
What problems arise from privately owned companies controlling credit ratings?
There is a suggestion of conflict of interest due to the company being paid by the same people that are requesting bond ratings. This became a prevalent in the 2008/09 crash.
What factors affect the default risk?
- Coverage ratios - earnings/various fixed costs
- Leverage ratios - extent of borrowing
- liquidity ratios - how much cash does the company have access to
- Profitability ratios
Use of analysts to evaluate company prospects.
What is a call option
The right to buy an asset/bond at future date for an agreed future price
Give an example of an investor who don’t pay taxes
A pension fund
How can a call option work for a bond issuer?
When issuing the bond, the issuer adds a call option where they can buy back the bond (or part of the bond) for an agreed price at the future date. This would be exercised in the case that the value of the bond is more than the agreed price.
What is a sinking fund?
A fund in which the issuer buys back proportions of the fund every year
