Bonds: Raising Long-term Capital

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Questions and Answers

What is the primary purpose of bonds issued by corporations and governments?

To issue stocks

To provide dividends

To raise short-term capital

To raise long-term capital (correct)

What type of bond does not make periodic interest payments?

Callable bond

Convertible bond

Zero-coupon bond (correct)

Indexed bond

What happens to the bond's price when the market interest rate rises?

The bond's price increases

The bond's price decreases (correct)

The bond's price becomes undefined

The bond's price remains the same

What type of bond is issued by a state government or government agency?

Municipal bond Signup and view all the answers

What happens to the bond's price when the yield to maturity (YTM) decreases?

The bond's price increases Signup and view all the answers

What happens to the bond price when interest rates decrease?

It increases, and the effective annual return increases Signup and view all the answers

What type of bond is sold at a price below its face value?

Discount Bond Signup and view all the answers

What happens to the total PV of strips if the market is efficient and securities are priced correctly?

It equals the bond's face value price Signup and view all the answers

According to the Pure Expectations Theory, what determines long-term interest rates?

Investors' expectations of future short-term interest rates Signup and view all the answers

What does an inverted yield curve typically suggest?

Investors expect slower economic growth or a recession in the future Signup and view all the answers

Which of the following statements is true about a flat yield curve?

It is only observed when the economy is changing, either heading down or upwards sloping. Signup and view all the answers

What does a negative forward rate imply?

A mispricing in the bond market. Signup and view all the answers

According to the Liquidity Preference Theory, what is the main reason why investors require a higher return for investing in longer-term bonds?

Because they are taking on more reinvestment risk. Signup and view all the answers

What is the relationship between Macaulay's Duration and the Time to Maturity (TTM) of a bond?

As TTM increases, Macaulay's Duration increases. Signup and view all the answers

What is the main difference between Macaulay's Duration and Modified Duration?

Macaulay's Duration is a measure of interest rate risk, while Modified Duration is a modified version of Dmac adjusting for the bond's yield. Signup and view all the answers

What is the implication of a positive relationship between a bond's duration and price sensitivity to interest rate changes?

Bonds with higher duration are more sensitive to interest rate changes Signup and view all the answers

What is the effect of a 1% increase in yield on a bond's modified duration?

It approximately decreases by the same percentage as the modified duration Signup and view all the answers

What is the relationship between convexity and a bond's yield to maturity?

Convexity is lower for bonds with higher yield to maturity Signup and view all the answers

What is the goal of active duration management?

To modify the portfolio allocation to increase or decrease its duration Signup and view all the answers

What is the benefit of convexity for bond investors?

It provides more gains when yields decrease and less losses when yields increase Signup and view all the answers

Study Notes

Bonds

Bonds are used to raise long-term capital by corporations and governments
When you invest in bonds, you pay the initial cost and receive coupon (interest) periodically, and the face value of the bond when it matures
Types of bonds:
- Zero-coupon bonds: no coupon payments, only receive face value at maturity
- Convertible bonds: can be converted into a predetermined number of stocks in the future
- Indexed bonds: coupon rate is related to movements in inflation
- Callable bonds: issuer can buy the bond back from the investor in the future
- Perpetual bonds: last forever
- Treasury bonds: issued by the federal government
- Municipal bonds: issued by state governments or government agencies

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)
Interest rate changes affect YTM: when market interest rates rise, YTM increases, and bond prices fall; when market interest rates fall, YTM decreases, and bond prices rise

Characteristics of Bonds

Par value bond: coupon rate = YTM
Discount bond: coupon rate < YTM
Premium bond: coupon rate > YTM

Strips

Separate trading of registered interest and principal securities
Investors can sell components of their bonds
Common in Treasury bonds
The total 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 lower market yield
Price risk: occurs when interest rates go up, and investors are subject to price risk if they need to sell before maturity
Inflation risk: inflation causes bond prices to decrease, decreasing the return of bonds
Liquidity risk: occurs when investors need to sell their bonds before maturity and cannot get a reasonable price

Pure Expectations Theory

Assumes the current yield curve reflects investors' expectations of future short-term interest rates
Predicts future short-term rates based on current long-term rates
If the market expects short-term rates to increase, the yield curve will slope upwards; if the market expects short-term rates to decrease, the yield curve will slope downwards

Yield Curve Shape

Normal (upward-sloping): short-term yields are lower than long-term yields
Inverted (downward-sloping): short-term yields are higher than long-term yields
Flat: rarely seen, only when the economy is changing

Discount Factors, Spot Rates, and Forward Rates

Discount factor: determined from the market price and cashflows of a bond
Spot rate: market price and cashflows of a bond
Forward rate: market expectations of interest rates in the future
Use forward rates to hedge risk and indicate what the market thinks will happen in the future

Arbitrage Opportunity - Negative Rates

A negative rate implies mispricing
Buy the underpriced bond and sell the overpriced bond

Interest Rates

High interest rates: decrease in bond prices
Low interest rates: increase in bond prices
The shape of the yield curve is determined by participants' expectations of future movement in interest rates

Liquidity Preference Theory, Market Segmentation Theory, and Preferred Habitat Theory

Liquidity Preference Theory: investors are compensated for time but get extra if they invest for longer
Market Segmentation Theory: investors will never change their preference, supply and demand shift the yield for each market segment
Preferred Habitat Theory: investors have preferred time maturity to bonds, but if they see other opportunities, they may take it

Macaulay's Duration and Modified Duration

Macaulay's Duration: measures the sensitivity of a bond's price to changes in interest rates
Modified Duration: adjusts Macaulay's Duration for the bond's yield
Implications of Duration:
- Positive relationship between a bond's duration and price sensitivity to interest rate changes
- Positive relationship between Time to Maturity and Duration
- Negative relationship between the coupon rate and duration
- Two bonds with the same Modified Duration have the same percentage price change sensitivity to yields

Convexity

Measures the sensitivity of a bond's duration to changes in interest rates
Captures the non-linear relationship between a bond's price and yield
Properties:
- Convexity is higher for bonds with lower coupon rates
- Convexity is higher for bonds with lower YTM
- Convexity is higher for bonds with higher Time to Maturity
Using convexity with duration can provide a more accurate estimate of price changes in response to interest rate movements

Duration and Convexity Summary

Duration and Convexity have a positive relationship
Convexity is good: gives you more gains when yields decrease and gives you less losses when yields increase
Duration is not good: when duration increases, you have more interest rate risk; when duration decreases, you have less interest rate risk

Active and Passive Trading Strategies

Active Trading Strategies: require investors to forecast yield curve changes or divest depending on the prediction
Passive Trading Strategies: require little from the investor, aiming to Buy & Hold bonds until maturity
Duration Management: increase or decrease portfolio duration based on forecasted changes in rates

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Description

Learn about bonds, a type of investment that raises long-term capital for corporations and governments. Understand how bonds work, including coupon payments and maturity value.