Chapter 9: Bond and money markets Flashcards
(13 cards)
What are the 3 ways in which cash be placed on deposit?
- With the depositor having “instant access” to withdraw the capital deposited (Call deposit)
- With the depositor having to give a period of notice before withdrawal (Notice deposit)
- For a fixed term with no access to the capital sum earlier than the maturity of the deposit (Term deposit / Fixed-term deposit)
The term deposit would be expected to offer the highest interest rate, to compensate the investor for the lack of flexibility relative to the notice and call deposits.
Discuss the key players in the money market
- Clearing banks: The money markets are dominated by the clearing banks, which use them to lend excess liquid funds and to borrow when they need short-term funds. These loans and deposits are usually very short term, often overnight. Interbank rates are usually taken as the benchmark for short-term interest rates.
- Central banks: Central banks, as lenders of last resort, stand ready to provide liquidity to the banking system when required and also use their operations in the money markets to establish the level of short-term interest rates. Central bank money market operations involve the sale or purchase of Treasury and other eligible bills.
- Other institutions: Other financial institutions and non-financial companies also lend and borrow short-term funds in the money market
List the investment and risk characteristics of money market instruments
- Security: Good, due to short term nature
- Yield: Generally gives a positive real return, as short-term interest rates can be expected to be above inflation, otherwise, there is no incentive to save.
The yields are however generally expected to be lower than other assets, since they are close to being risk-free. - Spread: Very little volatility due to short-term nature.
- Term: Short term
- Expenses: Very low dealing expenses.
- Exchange rate: Movements in exchange rates would be expected to compensate for differences in interest rates between countries over the term, but this is very unpredictable, so there is substantial risk of getting less than the expected return.
- Marketability: Highly marketable, except for call and term deposits.
- Tax: Usually taxed as income
Why do institutional investors not normally invest a large proportion of funds in money market instruments?
- Money market instruments give a lower expected return than other riskier assets
- Money market instruments are not a good match for long-term liabilities
- There is reinvestment risk - Proceeds will have to be reinvested on unknown terms
- Short term interest rates will move broadly in line with price inflation. However, money market instruments are not a good match if the investor has real liabilities linked to some other index
- Too large a proportion would result in a lack of diversification
- There may be a limited supply of money market instruments available
Why do institutional investors hold money market instruments?
Institutions mainly hold money market instruments for liquidity reasons:
* Protect monetary value
* Opportunities
* Uncertain liabilities
* Recently received cashflows
* Short term liabilities
Institutions may also hold cash because they feel that other assets are going to perform poorly:
* General economic uncertainty
* Recession expected
* Increase in interest rates expected
* Depreciation of domestic currency expected
Institutions may also hold money market instruments for diversification
What are bonds?
“Bond” is an alternative term for a fixed-interest or index-linked security.
Bonds are described by:
* the type of organisation issuing the security, such as government bonds, local authority bonds, corporate bonds and so on.
* the nature of the bond - fixed-interest or index-linked.
The most important distinct types of bond market are:
* the markets in government bonds, listed in their country of origin
* the markets in corporate bonds, listed in their country of origin
* the markets in overseas government and corporate bonds, listed in any country other than the “home” country.
Overseas bonds may be denominated in the national currency, in which case there is an additional currency risk, or may be denominated in the currency of the country in which they are marketed.
List the investment and risk characteristics of conventional government bonds
- Security: Very low default risk if issued by a developed country. Almost non-existent
- Yield: The yield is fixed in nominal terms. The real yield is eroded by actual inflation.
The expected yield is lower than for equities and property. - Spread: Variability in capital values are lower for short term bonds than for long term bonds.
- Term: Short, medium, long or irredeemable
- Expenses: Very low dealing costs if a developed country.
- Exchange rate: There will be a currency risk for an investor who is investing in bonds denominated in one currency but who has liabilities denominated in another.
- Marketability: Excellent marketability
- Tax: Tax treatment depends on the country. In South Africa, individual investors are taxed on income and capital gains. Institutional investors pay a uniform rate of tax on the total return.
Describe the cashflows of a conventional government bond from the perspective of the investor
Bond purchase:
* An initial negative lump sum cashflow equal to the price paid for the bond plus dealing expenses.
Coupon payments:
* A regular series of positive cashflows. The timing of the cashflows are known and the amount is known in monetary terms. The term of the payments is known in advance, except if the bond is callable (The borrower can repay the bond at any time)
Redemption payment:
* A single positive cashflow that is received at redemption. The timing is known, and the amount is known in monetary terms.
What are the major differences in investment and risk characteristics between government and corporate bonds?
- Security: Corporate bonds are generally much less secure than government bonds.
- Marketability: Corporate bonds are typically much less marketable than government bonds, primarily because the size of issue is smaller.
- Liquidity: The market values of corporate bonds tend to be more volatile / less predictable than the market values of government bonds
- Yields: The gross redemption yields on corporate bonds are higher than for similar government bonds, compensating for the lower marketability and liquidity and the perceived additional default risk.
What are index-linked bonds?
Index-linked bonds are securities where the cash amount of the interest payments and the final capital repayment are linked to an “index” which reflects the effects of inflation.
Describe the cashflows of an index-linked government bond from the perspective of the investor.
Bond purchase:
* A single negative lump sum payment that is equal to the price paid for the bond plus dealing expenses.
Coupon payments:
* A series of regular positive cashflows. The timing is known in advance and the amount is known in real terms. The term of payment is known, except if the bond is callable
Redemption payment:
* A single lump sum positive cashflow received at redemption. the timing is known in advance and the amount is known in real terms.
Write down the equation stating the link between nominal yields and real yields
Nominal yields = risk-free real yield + expected future inflation + inflation risk premium.
The inflation risk premium reflects the additional yield required by investors with real liabilities for bearing the risk of uncertain future inflation. The size of the premium is therefore determined by the degree of uncertainty as well as the balance between the numbers of investors requiring a fixed return and those requiring a real return.
Outline 3 situations when index-linked bonds will appear relatively more attractive to an investor than conventional bonds
- When the investor needs to match real liabilities and hence requires inflation prediction
- When the investor expects the future inflation to be higher than the currently predicted in the market
- When the investor expects the inflation risk premium to be higher than that currently predicted in the market.
