Bonds Essay CJ Flashcards
(15 cards)
What is A bond (Intro)
fixed income security issued by governments and corporations valued by discounting expected future cash flows into a present value using a fitting discount rate
What does the pv reflect (intro)
compensation investors require for the tvm and risk
Interest rates
Inverse relationship with bonds occurs because bonds fixed coupon payments become less attractive when new bonds offer higher yields, leading to a drop in bonod price.
Pure expectations
proposes that long-term interest rates reflect the market’s expectations of future short-term rates. For example, an upward-sloping curve implies that rates are expected to rise (Fama, 1984).
Liquidity preference
(Keynes, 1930) argues that investors prefer short-term bonds due to lower risk and greater flexibility, so they require a premium to hold longer-term securities. This added premium causes the yield curve to slope upwards, even when future short-term rates are expected to remain stable.
Duration and Convexity
Duration - weighted average time to recieve cash flows
Convexity - adjusts for the non - linearity in price - yield relationships.
Default risk
Issuer fails to make timely coupon payments or repay principal at maturity. Higher risk = higher yield, lowers price.
Credit ratings
High rating = low default risk and lower yields.
Low rating (junk bonds)= high risk, higher yields. Ratings are from AAA to D and are given by agencies like Moodys, Fitch and S&P.
Problems with credit ratings
Backward looking(Portnoy 1999) Mass downgrades in rating causes sharp declines in bond values. 2008 Financial crisis when mortgage backed securities that were rated AAA got downgraded and as a result billions were lost and people turned to more quantitative models such as Altmans Z score.
Option characteristics
callable - allow issuers to redeem bonds before maturity, typically when interest rates fall. Higher yield to compensate.
Putable - investor can force issuer to payback early. Lower yield as investor has more protection.
Convertible - can be exchanged for a fixed number of the issuing company’s shares, usually at the investor’s choice. It combines the steady income of a bond with the potential upside of equity, making it attractive when investors expect the company’s stock to rise.
Tax effects
Muncipal bonds in US, offer tax free interest which increases after tax value to investors in high tax brackets. Bonds with tax advantages may trade at lower yields, but true value to investors depends on individual tax circumstances.
Tax equivalent yield
tool for comparing after - tax return on taxable and tax - exempt bonds.
Macro factors (bonus)
Quantitative easing and tightening impacts yield curves and investor demand. large-scale fiscal policy can increase the supply of bonds, pushing down prices if demand does not keep pace.
Inflation (bonus)
When inflation is expected to rise, investors demand higher nominal yields to maintain their real return, leading to lower bond prices. Conversely, falling inflation expectations support bond prices.
Liquidity (bonus)
How easily a bond can be bought or sold without significantly affecting its price. Illiquid bonds may carry a liquidity premium to compensate investors for the additional risk and potential difficulty in exiting the position. Liquidity risk is particularly important during financial crises or periods of market stress, when trading conditions deteriorate.
