Bonds and Debt Securities

Bonds

• Bonds are long-term debt securities issued by corporations and governments to raise capital.
• Investors pay the initial cost (face value) and receive periodic interest payments (coupon) and the face value back at maturity.
• Types of bonds include:
  • Zero-coupon bonds: no interest payments, only face value at maturity.
  • Convertible bonds: can be converted into a predetermined number of stocks.
  • Indexed bonds: coupon rate is tied to inflation.
  • Callable bonds: issuer can buy back the bond from the investor.
  • Perpetual bonds: no maturity date.
  • Treasury bonds: issued by the federal government.
  • Municipal bonds: issued by state or local governments.

Bond Pricing and YTM

• YTM (Yield to Maturity) reflects the market's required return on the bond.
• If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
• If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
• Changes in market interest rates affect YTM and bond prices.

Relationship Between YTM, Coupon Rate, and Time to Maturity

• Premium bond: coupon rate is higher than YTM, sold at a price above face value.
• Discount bond: coupon rate is lower than YTM, sold at a price below face value.
• When YTM decreases, the bond price increases, decreasing the effective annual return.
• When YTM increases, the bond price decreases, increasing the effective annual return.

Characteristics of Bonds

• Par value bond: coupon rate equals YTM.
• Discount bond: coupon rate is lower than YTM.
• Premium bond: coupon rate is higher than YTM.

Strips

• Strips are separate trading of registered interest and principal securities.
• Investors can sell components of their bonds.
• Common in Treasury bonds (federal government).
• The total of the PV of interest and principal cashflows should equal the bond's face value price.

Arbitrage

• If PV Bond = PV of all Strips, no arbitrage opportunities present.
• If PV Bond > PV of all Strips, arbitrage opportunities are present.
• If PV Bond < PV of all Strips, arbitrage opportunities are present.

Risks

• Reinvestment risk: occurs when interest rates go down, and investors can reinvest coupons at a higher market yield.
• Price risk: occurs when interest rates go up, and investors are forced to sell before maturity.
• Inflation risk: inflation erodes bond returns, especially if investors are subject to price risk.
• Liquidity risk: investors may suffer losses if they need to sell their bond before maturity at a low price.

Bonds

• Bonds are long-term debt securities issued by corporations and governments to raise capital.
• Investors pay the initial cost (face value) and receive periodic interest payments (coupon) and the face value back at maturity.
• Types of bonds include:
  • Zero-coupon bonds: no interest payments, only face value at maturity.
  • Convertible bonds: can be converted into a predetermined number of stocks.
  • Indexed bonds: coupon rate is tied to inflation.
  • Callable bonds: issuer can buy back the bond from the investor.
  • Perpetual bonds: no maturity date.
  • Treasury bonds: issued by the federal government.
  • Municipal bonds: issued by state or local governments.

Bond Pricing and YTM

• YTM (Yield to Maturity) reflects the market's required return on the bond.
• If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
• If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
• Changes in market interest rates affect YTM and bond prices.

Relationship Between YTM, Coupon Rate, and Time to Maturity

• Premium bond: coupon rate is higher than YTM, sold at a price above face value.
• Discount bond: coupon rate is lower than YTM, sold at a price below face value.
• When YTM decreases, the bond price increases, decreasing the effective annual return.
• When YTM increases, the bond price decreases, increasing the effective annual return.

Characteristics of Bonds

• Par value bond: coupon rate equals YTM.
• Discount bond: coupon rate is lower than YTM.
• Premium bond: coupon rate is higher than YTM.

Strips

• Strips are separate trading of registered interest and principal securities.
• Investors can sell components of their bonds.
• Common in Treasury bonds (federal government).
• The total of the PV of interest and principal cashflows should equal the bond's face value price.

Arbitrage

• If PV Bond = PV of all Strips, no arbitrage opportunities present.
• If PV Bond > PV of all Strips, arbitrage opportunities are present.
• If PV Bond < PV of all Strips, arbitrage opportunities are present.

Risks

• Reinvestment risk: occurs when interest rates go down, and investors can reinvest coupons at a higher market yield.
• Price risk: occurs when interest rates go up, and investors are forced to sell before maturity.
• Inflation risk: inflation erodes bond returns, especially if investors are subject to price risk.
• Liquidity risk: investors may suffer losses if they need to sell their bond before maturity at a low price.

Active Trading Strategies

• Active management involves forecasting yield curve changes to make investment decisions
• Investors must predict changes in interest rates to adjust their portfolio

Passive Trading Strategies

• Passive management involves a "buy and hold" approach, where investors hold bonds until maturity
• minimal effort required from investors

Duration Management

• Investors can adjust their portfolio duration based on forecasts of interest rate changes
• Increase or decrease portfolio duration to respond to expected changes in interest rates

Rollover Strategy

• Invest in a bond with a shorter tenure than the investment time horizon
• Expect interest rates to increase, allowing for reinvestment in a higher-yielding bond
• Only works if interest rates are forecast to increase

Riding the Yield Curve

• Invest in a bond with a longer time to maturity (TTM) than the investment time horizon
• Only works for upward-sloping yield curves
• Take advantage of the bond's increasing value as its TTM decreases
• Sell before maturity for a capital gain

Barbell and Bullet Strategies

• Bullet strategy: invest in bonds with similar maturity dates
• Barbell strategy: invest in low-risk, low-maturity bonds and high-risk, high-maturity bonds
• Both strategies can profit from changes in interest rates, but the barbell strategy is more successful due to convexity
• The barbell strategy is superior in cases of parallel shifts and flattening curves, while the bullet strategy is superior in cases of steepening curves

Active Trading Strategies

• Active management involves forecasting yield curve changes to make investment decisions
• Investors must predict changes in interest rates to adjust their portfolio

Passive Trading Strategies

• Passive management involves a "buy and hold" approach, where investors hold bonds until maturity
• minimal effort required from investors

Duration Management

• Investors can adjust their portfolio duration based on forecasts of interest rate changes
• Increase or decrease portfolio duration to respond to expected changes in interest rates

Rollover Strategy

• Invest in a bond with a shorter tenure than the investment time horizon
• Expect interest rates to increase, allowing for reinvestment in a higher-yielding bond
• Only works if interest rates are forecast to increase

Riding the Yield Curve

• Invest in a bond with a longer time to maturity (TTM) than the investment time horizon
• Only works for upward-sloping yield curves
• Take advantage of the bond's increasing value as its TTM decreases
• Sell before maturity for a capital gain

Barbell and Bullet Strategies

• Bullet strategy: invest in bonds with similar maturity dates
• Barbell strategy: invest in low-risk, low-maturity bonds and high-risk, high-maturity bonds
• Both strategies can profit from changes in interest rates, but the barbell strategy is more successful due to convexity
• The barbell strategy is superior in cases of parallel shifts and flattening curves, while the bullet strategy is superior in cases of steepening curves

Relative Valuation

• Asset prices are compared to similar assets in the market
• Standardized prices create price multiples

Bond Pricing

• As time to maturity decreases, bond price increases
• As time to maturity increases, bond price decreases
• When YTM decreases, bond price increases, reducing effective annual return
• When YTM increases, bond price decreases, increasing effective annual return

Reinvestment Risk

• Reinvestment risk occurs when interest rates decrease and bond prices are at a premium
• Investors benefit from higher yields and can buy at a discount

Price Risk

• Price risk occurs when interest rates increase and bond prices are low
• Investors are affected if they need to sell before maturity
• Investors benefit from lower yields and higher bond prices

Inflation Risk

• Inflation decreases bond prices and ultimately returns
• Inflation risk is relevant when investors are subject to price risk

Liquidity Risk

• Liquidity risk occurs when investors need to sell before maturity
• Investors suffer losses due to selling at a discounted price

Pure Expectations Theory

• Pure Expectations Theory assumes the current yield curve reflects investors' expectations of future short-term interest rates
• Yield curve slopes upwards if interest rates are expected to increase and downwards if interest rates are expected to decrease

Yield Curve Shapes

• Upward-sloping yield curve indicates expected stronger economic growth and higher inflation
• Inverted yield curve indicates expected slower economic growth or recession
• Yield curve shape is determined by market expectations of future interest rate movements

Liquidity Preference Theory

• Investors are compensated for time and risk
• Investors face reinvestment risk if they don't need to sell and price risk if they must sell

Market Segmentation Theory

• Investors have specific preferences for bond maturity
• Supply and demand shift yields for each market segment

Preferred Habitat Theory

• Investors have preferred bond maturities and may take alternative opportunities
• Investors consider investment duration, price risk, and tolerance

Duration

• Duration measures a bond's price sensitivity to interest rate changes
• Duration increases with time to maturity
• Duration is higher for bonds with lower coupon rates and lower YTM
• Duration has a positive relationship with price sensitivity to interest rate changes

Convexity

• Convexity measures the sensitivity of a bond's duration to changes in interest rates
• Convexity captures the non-linear relationship between a bond's price and yield
• Convexity increases with lower coupon rates, lower YTM, and higher TTM
• Convexity provides a more accurate estimate of price changes in response to interest rate movements

Duration and Convexity

• Duration and Convexity have a positive relationship
• Convexity is beneficial, providing more gains when yields decrease and less losses when yields increase
• Duration increases interest rate risk, while convexity is beneficial