BONDS PDF

# Monetary vs. Fiscal Policy ## Monetary - Managed by central banks - Main purpose: control inflation, stabilize currency, support unemployment - Uses: - Interest rates - Open market operations - Reserve requirements - Short-term effects: - Alters borrowing costs / money supply,...

# Monetary vs. Fiscal Policy ## Monetary - Managed by central banks - Main purpose: control inflation, stabilize currency, support unemployment - Uses: - Interest rates - Open market operations - Reserve requirements - Short-term effects: - Alters borrowing costs / money supply, affects spending / investment / inflation - Long-term effects: - Sustained inflation control, price stability / employment levels / economic growth ## Fiscal - Controlled by government - Main purpose: influence economic growth, demand, public debt - Uses: - Adjusts spending - Taxes - Short-term effects: impacts GDP & unemployment (boost / reduce) quickly by changing gov spending / taxes - Long-term effects: - Affects national debt / economic structure/ growth potential, allocating resources (ie infrastructure / welfare programs) ## Bonds ### What are Bonds? - **Definition:** Fixed income investments where investors lend money to entities - repaid with interest over a set period, investors tend to be governments / corporations - **Purpose:** Used by entities to raise capital for projects, operations, refinancing debt - **Structure:** - Fixed interest rate (coupon) - Fixed term to maturity, when principal (face value) is repaid ### Types of Bonds - **Government Bonds:** Issued by federal governments to fund national projects, low risk, lower yields (returns investors earn on abond) - **Corporate Bonds:** Issued by companies, higher risk, higher yields (than gov) - **Municipal Bonds:** Issued by local governments to finance community projects, interest often tax free - **International Bonds:** Issued by foreign corps, include currency risk: exchange rates risk / potential financial loss due to currency fluctuating ### Bonds Pricing - **Formula:** Bond price = Present value of future coupon payments + present value of principal payments - **Discount rate:** Bonds yield to maturity (YTM), used discount future cash flows - **Price-Yield Relationship:** Bond prices fall, as yields rise and vice versa ### Yields - **Definition:** Returns an investor earns from a bond - **Current yield:** Annual interest payment / current bond price - **Yield to maturity (YTM):** Total return if bond is held to maturity, accounting for all payments & price - **Yield to call (YTC):** Return if bond is called before maturity applicable to callable bonds - **Purpose:** Help investors cover potential profitability ### Coupon Rate - **Definition:** Fixed interest rate paid annually - **Expressed:** As % of the bond's face value - **Types:** - **Fixed rate:** Constant payments - **Floating rate:** Variable payments tied to an interest rate benchmark (coupon changes over time / bondholder receives fluctuations with market interest rate) ### Bond Rating - **Purpose:** Assess credit quality, risk of default - **Rating Agencies:** Moody's, Standard & Poor's, Fitch - **Categories:** - **Investment Grade:** (low risk): - AAA: Highest quality, minimum risk - AA: High quality, some risk - A: Very High quality, low risk - BBB: Medium quality. Acceptable risk - **High yield (Junk Bonds):** (higher risk / return): - BB: Lower quality, higher risk - B: Significant risk of default - CCC: Very high risk of default - CC: Extremely high risk of default - C: Near default, very high risk - D: Default or in bankruptcy - Default: borrower fails to meet debt obligation ### Interest Rate Risk - **Definition:** Risk that bond prices will fall as interest rates rise - **Impact:** - Long-term bonds: more sensitive, so prices fluctuate easily - Short-term bonds: less affected as they mature sooner / less exposed to interest rate changes - **Mitigation:** Choose shorter duration bonds, floating-rate bonds ### Credit Risk - **Definition:** Risk that bond issuer will default on its payment - **Factors:** Affected by: - Issuer's financial health - Economic conditions - Industry outlook - **Higher Risk credit:** Investors willing to accept higher risk of default in return for high returns ### Duration - **Definition:** Measure of a bond's price sensitivity to interest rate changes - **Calculation:** Weighted average time receive all cash flows - **Duration & Interest Rates:** Duration ↑ sensitivity to rate changes (1 % rate change = 1% effect on duration) ### Convexity - **Definition:** Describes how duration changes as interest rate changes - **Purpose:** Captures non-linear price change, provides more accurate measure of interest rate sensitivity - **Importance:** Measures sensitivity beyond what is predicted by duration - ↑ Convexity: bond price ↑ more when interest rate ↓ - ↓ Convexity: bond price ↓ less when interest rate ↑ - Offers greater price stability ### Callable & Convertible Bonds - **Callable bonds:** Bonds that can be repaid early before due date, dove when interest rates go down, so company borrows money at a lower rate - **Convertible Bonds:** Can be converted into stock of the company that issued them, offers bondholders the chance to own part of the company if the stock prices go up ### Bond Valuation & Market Dynamics - **Market influences:** Bond prices fluctuate due to: changes in interest rates, inflation expectations. credit rating changes, when interest rates ↑, new bonds offer better returns, so older bonds with lower returns become less valuable - **Valuation drivers:** - Lower interest rates ↑ bond prices - Higher // // ↓ // // - Economic outlook // // // - Issuer stability // // // - **Helps determine bond price / yield** - **Reflects how much investors are willing to pay for bond**