Bonds Flashcards
Valuation and Bond Portfolio Management (28 cards)
Format of Bond Valuation essay
-Introduce what a bond is
-Who issues bonds?
-Inflation liked bonds
-Factors affecting bond valuation
-YTM
-Interest rates + Duration and Convexity
-Term structure
-Default risk
-Rating agencies
-Tax
-Option characteristics
What is a bond?
-Debt security
-Fixed life
-Regular coupon payments
-Face value returned at maturity
-Zero coupon
-Only face value back
Who issues bonds?
-Government
-Transnational organisations
-Companies
-Dimson, Marsh and Staunton 2024
-USA has largest share of debt securities then China then Japan
-USA dominate government and corporate markets 39% (China 16% Japan 8% UK 4%)
Inflation linked bonds
-Coupon payments and face value adjusted to inflation
-GILTs are inflation linked
Factors affecting bond valuation
-YTM
-Term structure
-Default risk
-Rating agencies
-Tax
-Option characteristics
YTM
-Discount rate that makes present value of bonds cash flow equal to the current price
Interest rates
-Negative correlation
-New bonds offer higher coupons
-Old bonds become less attractive
Term structure
Relationship between interest rate and bond length
Default risk
Issuer might not make the coupon payments or face value at end of maturity
-Whats the probability of default?
-Bondholders don’t lose everything
-Claim on companies assets
-Recovery - Able to recover most cost flows
-Dimson, Marsh and Staunton 2024
-Defaults cluster over time
-First lien bonds recover 56% on average
-Junior subordinated about 14%
Rating agencies
Assign ratings based on issuers creditworthiness
-Helps gauge default risk
-Junk bonds (Bs, Cs, Ds) high risk
-Judged on bond offer / company accounts
-Funded by the companies they are rating
-May be unreliable
-Influence yields and secondary pricing
-Large institutions have mandates restricting investment to high rated bonds
-Sell at a loss if ratings fall
Tax
-Government bonds may be exempt i.e. Municipal, GILTs (looks expensive)
-Corporate bonds pay income tax (looks cheaper)
-Accrued interest
-Buying between coupon payments, you will need to pay accrued interest as well as full tax on next coupon
-Original Issue Discount
-Zero coupon are taxed imputed interest
-Tax liability before maturity
Option characteristics
-Call option
-Issuer can buy back bond at agreed price
-Sinking fund provision - company buys back proportion of bond every year to maturity
-Puttable - holder forces issuer to repurchase
-Convertable - convert into fixed number of shares
Pure Expectations theory
-Bonds only differ by maturity, same average returns
-No liquidity premium as yields
-No preference for long or short terms
-Predicts whether interest rates will go up in the future
-Dimson, Marsh and Staunton 2024
-Longer maturities generally offer higher expected returns
-Disproves Pure Expectations theory
Liquidity Preference theory
-Investors want premium for holding longer term bonds
-Upward sloping yield curve even if rates aren’t expected to rise
-Dimson, Marsh and Staunton 2024
-Long term should have higher average returns than short term
Market segmentation theory
-Different investors prefer different maturities
-Supply & Demand in each segment determine yields
Preferred habitat theory
-Only move maturity range if they get premium yield
Format of Bond Portfolio essay
-Introduce what a bond is
-Who issues bonds?
-What factors affect bond valuation
-Interest rate risk (Duration and Convexity)
-Managing interest rate risk
-Immunisation Strategies
-Passive / Active strategies to management
How to measure interest rate risk
-Duration - measure of a bonds interest rate sensitivity
-Good for small changes in interest
-Modified - % change in price per 1% change in interest
-Macaulay - weighted average time to receive bonds cash flows
-Convexity - measures curvature of the price-yield relationship
-Higher convexity bonds less affected by interest rate risk
-Benefit more / fall less
-Accurate for large changes in interest rates
Managing Interest rate risk
-Immunisation strategies
-Match bond cash inflows to liability cash outflows
-Immunise yourself from interest rate risk
-Match duration to liabilities
-Default risk could be a problem
-Dependent on how reliable liability estimates are
-Buy bonds with similar duration to liabilities or varied duration
-Dependent on how accurate durability measure is
Single liability immunisation
Goal - meet series or future payments
Strategy - match portfolio duration to liability date
-Best for zero-coupon or bullet bonds
Multiple liability immunisation
Goal - meet series of future payments
Strategy - Cash flow matching and optimisation strategies
-Balance duration, convexity and cash flows
Contingent immunisation
Goal - active management strategy (beat the market)
-If management falls below threshold, switches to passive immunisation to protect capital
Factor investing
Houweling and Van Zundert 2017
4 main factors
-size, risk, value, momentum
-Multi factor approach improved performance
-Low correlation
-Though value and momentum have historically outperformed the market
Passive strategies
Buy-and-hold
-Vulnerable to interest rate change
Indexing
-Portfolio mirrors a bond index
