Bonds Flashcards
(17 cards)
1994 Bond debacle
part 1
The 1994 bond market debacle, also known as the “Great Bond Massacre,” was a sharp and sudden decline in bond prices that occurred in late 1994. This downturn caused significant losses for bondholders and was largely attributed to the Federal Reserve’s decision to raise interest rates to combat inflation.
Key Features of the 1994 Bond Debacle:
Trigger:
The Federal Reserve’s six consecutive rate hikes, starting in February 1994, were a major factor in the crisis.
Global Impact:
The crisis wasn’t limited to the United States; it spread to other developed nations like Europe and Japan.
Losses:
Bondholders experienced losses estimated at over $1 trillion.
Rising Interest Rates:
The yield on the 30-year U.S. Treasury bond surged, and mortgage rates also increased significantly.
Market Volatility:
The bond market experienced a period of high volatility as investors reacted to the changing interest rate environment.
Decline in Bond Prices:
As interest rates rose, the value of existing bonds with lower yields decreased, leading to a sell-off.
bond market crisis 1994
part 2
The 1994 bond market crisis, or Great Bond Massacre, was a sudden drop in bond market prices across the developed world.
It began in Japan and the United States (US), and spread through the rest of the world. After the recession of the early 1990s, historically low interest rates in many industrialized nations preceded an unexpectedly volatile year for bond investors, including those that held on to mortgage debts.
Over 1994, a rise in rates, along with the relatively quick spread of bond market volatility across international borders, resulted in a mass sell-off of bonds and debt funds as yields rose beyond expectations. This was especially the case for instruments with comparatively longer maturities attached. Some financial observers argued that the plummet in bond prices was triggered by the Federal Reserve’s decision to raise rates by 25 basis points in February, in a move to counter inflation.
At about $1.5 trillion in lost market value across the globe, the crash has been described as the worst financial event for bond investors since 1927.
bond market crisis 1994
from when genius failed page 42
-by leveraging one security investors had potentially given up control of all of their other securities
- this verity/sate of being is well worth remembering: the securities might be unrelated, but the same investors owned them, implicitly linking them in times of stress
-when armies of financial soldiers were involved in the same securities, borders shrank
-the concept of diversification would merit rethinking, ppl blame losses on a sudden evaporation of liquidity–> but the key s that when marekts plunge, investors are stunned to find that there are not enough buyers to go around.
-there cannot be liquidity for the community as a whole, the mistake is in thinking that markets have a duty to stay liquid or that buyers will always be present to accommodate sellers
- the real culprit in 1994 was leverage, if you aren’t in debt you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant
- but a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business
bond market crisis 1994
from when genius failed page 43
part 2
leverage always gives rise to the same brutal dynamic, and its dangers cannot be stressed too often
- in this case LONg term was very very lucky byc its spreads widened before it invested much of its capital, adn once opportunities did arise, long term was one of a very few firms in a position to exploit th egeneral distress, and its trades were good trades
-they weren’t risk free or soo good that the fund could leverage indiscriminately but by adn large they were intelligent and opportunistic
-thus long term capital started to make money on them almost immediately
30 year treasury bonds 1
from when genius failed
treasury bonds of all durations are of course issued by US government to finance the federal budget
- some $170 B of them trade each day and they are considered the LEAST risky investments in the world
-but a funny thing happens to a 30 year treasury bonds 6 months or so after they are issued:investors stuff them into safes and drawers for long-term keeping
30 year treasury bonds 2
off the run
-with fewer left in cirulation after 30 yr treasury bonds are issued after 6 months, the bonds become harder to trade
- meanwhile the treasury issues a new 30 yr bond which has its day in teh sun, on wall street the older bond which has about 29.5 yrs left to mature is known as OFF THE RUN= the shiny new model is ON THE RUN
being less liquid the off-the-run bond is considered less desirable and begins to trade at a slight discount that is you can purchase it for a little less or at what amounts to a slightly higher interest yield
- if you are an arbitrageur that is when the spread opens you would say
- in 1994 Long term capital noticed this spread was unusually wide bc feburary 1993 the bond was issued was trading at a yield of 7.36 % the bond issued 6 months later in august was yielding only 7.24 %
- in 1994 Long term capital noticed this spread was unusually wide bc feburary 1993 the bond was issued was trading at a yield of 7.36 % the bond issued 6 months later in august was yielding only 7.24 %…..
part 2
this is 12 basis points less
but why did the spread exist? some institutions were just silly and bureitcatic arbitrary demand of institutiions, willing to pay a premium ofr on the run paper
long term calls this a snap trade= a trade when two bond usually snapped tgoether after only a few months
in effect, Long term capital would be collecting a free for its willingness to won a less liquid bond
-why this is interesting- a lot of their trades were liquidity providing but it did not occur to these “brilliant “ guys that tended to buy the less liquid security in eery market, its assets were not entirely independent of one another the way one dice roll is independent of the next
actually bc tehy were doing this their assets would be susceptible to falling in unison if any time came when literally everyone wanted to sell them
what is a spread again?
In finance, “spread” generally refers to the difference between two prices, rates, or yields. It can be the gap between the bid and ask prices of an asset, the difference in yields between two securities, or the disparity in rates charged by different lenders. For example, the bid-ask spread for a stock is the difference between what someone is willing to buy it for (bid price) and what someone is willing to sell it for (ask price).
Here’s a more detailed breakdown:
- Bid-Ask Spread: This is the most common use of the term “spread” in trading. It’s the difference between the price a trader is willing to pay to buy (bid price) and the price they are willing to sell for (ask price). This spread is influenced by market liquidity and volatility.
- Yield Spread: This refers to the difference in yields between two different types of securities, often those with similar maturities but different credit qualities. For example, a yield spread might compare the yields of corporate bonds versus Treasury bonds. Widening spreads can indicate increased risk aversion or concerns about economic health.
- Option Spread: In options trading, a spread refers to a strategy where you buy and sell options contracts with different strike prices and/or expiration dates. These strategies are designed to profit from a directional move or a change in volatility.
- Credit Spread: This is similar to yield spread, but specifically refers to the difference in yields between bonds of different credit ratings but similar maturities. Bonds with lower credit ratings typically have higher yields to compensate investors for the increased risk of default.
- Term Spread: This is the difference in yields between bonds of different maturities but similar credit quality. For example, a term spread might compare the yields of short-term and long-term government bonds.
- Liquidity Spread: This refers to the difference in yield between two bonds that are otherwise similar but differ in their liquidity. A less liquid bond will typically have a higher yield to compensate investors for the difficulty of selling it quickly without impacting the price.
- Spread Trading: This is a trading strategy where you simultaneously buy and sell related securities (often futures contracts or options) to profit from the spread between them. You aim to profit from the spread widening or narrowing, not necessarily from the price movement of the individual securities.
what is a spread again part 2
A spread in trading is the difference between the buy (offer) and sell (bid) prices quoted for an asset. The spread is a key part of CFD trading, as it is how both derivatives are priced. Many brokers, market makers and other providers will quote their prices in the form of a spread
long term calls this a snap trade=
long term calls this a snap trade= a trade when two bond usually snapped tgoether after only a few months
in effect, Long term capital would be collecting a free for its willingness to won a less liquid bond
a lot of their trades were liquidity providing but
eugene fama on bond arbitrage and LTCM
Schole’s thesis advisor, found in his research that stocks were bound to have extreme outliers, which couldn’t be explained by random distribution.
Real-life markets are inherently more risky than models, because they are subject to discontinuous price changes. He became even more concerned when Long-Term eventually moved into equity.
yield on a bond
The yield on a bond is the rate of return an investor can expect to earn from owning the bond, considering both the interest payments and any potential gain or loss from changes in the bond’s market price. It’s essentially a measure of the bond’s total return over its life.
Yield represents the annual return an investor can expect from an investment, expressed as a percentage of the investment’s cost.
It’s a crucial metric for evaluating the attractiveness of a bond as an investment.
Yield is influenced by factors like the bond’s coupon rate, its market price, and the time until maturity
Price and yield are inversely related and as the price of a bond goes up, its yield goes down.*
yield on a bond 2
-Bond yield is the return an investor realizes on an investment in a bond.
The yield matches the bond’s coupon rate when the bond is issued, though the yield often changes while the bond is outstanding. Bond yields can be derived in different ways, including the coupon yield and current yield
-A bond can be purchased for more than its face value, at a premium, or less than its face value, at a discount.
-The current yield is the bond’s coupon rate divided by its market price.
-Price and yield are inversely related and as the price of a bond goes up, its yield goes down.
why bonds are safe
Bonds are essentially a loan to bond issuers. They are considered safe investments. That’s because bond values don’t change the same way stock prices do. They offer investors a reliable stream of income and provide bondholders with a fixed form of income.*
Investors earn interest on a bond throughout the life of the asset and receive the face value of the bond upon maturity. Investors can purchase bonds for more than their face value at a premium or less than the face value at a discount. Whichever they buy will change the yield they earn on the bond.
Bonds are rated by services approved by the Securities and Exchange Commission (SEC) and ratings range from “AAA” as investment grade with the lowest risk to “D,” which are bonds in default, or junk bonds, with the highest risk.
The return realized by a bond investor is called the yield. There are a couple of different yield-related concepts.
The return realized by a bond investor is called the yield. There are a couple of different yield-related concepts.
Coupon Yield: This is the annual interest rate established when the bond is issued. This figure remains the same for the lifetime of the bond.
Current Yield: This figure depends on the bond’s price and its coupon (or its interest payment). So if the price of the bond changes, the bond’s yield also changes.
bond yield. vs bond price
Price and yield are inversely related. This means that as the price of a bond goes up, its yield goes down. Conversely, as the yield goes up, the price of the bond goes down.
for ex. If an investor purchases a bond with a face value of $1000 that matures in five years with a 10% annual coupon rate, the bond pays 10%, or $100, in interest annually. If interest rates rise above 10%, the bond’s price will fall if the investor decides to sell it.
If the interest rate for similar investments rises to 12%, the original bond will still earn a coupon payment of $100, which would be unattractive to investors who can buy bonds that pay $120 as interest rates have risen. To sell the original $1000 bond, the price can be lowered so that the coupon payments and maturity value equal a yield of 12%.
If interest rates fall, the bond’s price would rise because its coupon payment is more attractive. The further rates fall, the higher the bond’s price will rise. In either scenario, the coupon rate no longer has any meaning for a new investor. But if the annual coupon payment is divided by the bond’s price, the investor can calculate the current yield and get an estimate of the bond’s true yield.
Current Yield
=Annual Coupon Payment/
Bond Price
The current yield and the coupon rate are incomplete calculations for a bond’s yield because they do not account for the time value of money, maturity value, or payment frequency, and more complex calculations are required.
interest rates vs bond prices
Interest rates and bond prices have an inverse relationship; when interest rates rise, bond prices typically fall, and vice versa. This is because new bonds issued at higher interest rates become more attractive to investors, making existing bonds with lower interest rates less desirable, leading to a decline in their price.
Inverse Relationship: The fundamental principle is that bond prices move in the opposite direction of interest rates. When interest rates increase, bond prices tend to decrease, and when interest rates decrease, bond prices tend to increase.
Impact on Bond Prices:
Rising interest rates make new bonds more attractive to investors, as they offer higher coupon (interest) payments. This increased demand for new bonds often leads to a decrease in the prices of existing bonds with lower interest rates, as investors may prefer the newer, higher-yielding bonds. Conversely, falling interest rates make existing bonds with higher coupon rates more attractive, potentially leading to an increase in their prices.
Interest Rate Risk:
The risk associated with changes in interest rates is called interest rate risk. This risk is a significant factor for bond investors, as it can impact the price of their bonds and their overall returns.
Bonds and Inflation:
Inflation also plays a role in bond pricing. Higher inflation often leads to rising interest rates, which can negatively impact bond prices.
Example:
If a bond currently offers a 4% coupon rate, and market interest rates rise to 5%, investors may prefer to purchase new bonds offering the 5% rate. This can drive down the price of the existing bond to make its yield (the return an investor receives) competitive with the new bonds
