CHAPTER TWELVE

Bonds: Analysis and Strategy

CHAPTER TWELVE

Bonds: Analysis and Strategy

Cleary / Jones Investments: Analysis and

Management

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

To explain why investors buy bondsTo explain why investors buy bonds To discuss major considerations in managing To discuss major considerations in managing

a bond portfolioa bond portfolio To explain what is meant by the term To explain what is meant by the term

structure of interest rates structure of interest rates To differentiate between passive and active To differentiate between passive and active

strategies for managing a bond portfoliostrategies for managing a bond portfolio To describe how both conservative and To describe how both conservative and

aggressive investors build a fixed-income aggressive investors build a fixed-income portfolioportfolio

Why Buy Bonds?Why Buy Bonds?Why Buy Bonds?Why Buy Bonds?

Attractive to investors seeking Attractive to investors seeking steady income and aggressive steady income and aggressive investors seeking capital gainsinvestors seeking capital gains

Promised yield to maturity is Promised yield to maturity is known at the time of purchaseknown at the time of purchase

Can eliminate risk that a rise in Can eliminate risk that a rise in rates decreases bond price by rates decreases bond price by holding to maturityholding to maturity

The Case Against The Case Against Buying BondsBuying Bonds

The Case Against The Case Against Buying BondsBuying Bonds

Don’t hold bonds unless investing Don’t hold bonds unless investing strictly for incomestrictly for income– Capital appreciation negative Capital appreciation negative

Alternative:Alternative: a combination of cash a combination of cash investments and stocksinvestments and stocks

Investors should consider whether Investors should consider whether they could build better portfolios they could build better portfolios that do not include bondsthat do not include bonds

Buying Foreign BondsBuying Foreign BondsBuying Foreign BondsBuying Foreign Bonds

Why?Why?– Foreign bonds may offer higher returns Foreign bonds may offer higher returns

at a point in time than alternative at a point in time than alternative domestic bondsdomestic bonds

– DiversificationDiversification Can be costly and time-consumingCan be costly and time-consuming

– Illiquid marketsIlliquid markets– Transaction costs and exchange rate Transaction costs and exchange rate

riskrisk

Understanding the Bond Understanding the Bond MarketMarket

Understanding the Bond Understanding the Bond MarketMarket

Benefits from a weak economyBenefits from a weak economy– Interest rates decline and bond prices Interest rates decline and bond prices

increaseincrease Important relationship is between Important relationship is between

bond yields and inflation ratesbond yields and inflation rates– Investors react to expectations of Investors react to expectations of

future inflation rather than current future inflation rather than current actual inflationactual inflation

Term Structure of Interest Term Structure of Interest RatesRates

Term Structure of Interest Term Structure of Interest RatesRates

Term structure of interest ratesTerm structure of interest rates– Relationship between time to maturity Relationship between time to maturity

and yieldsand yields Yield curvesYield curves

– Graphical depiction of the relationship Graphical depiction of the relationship between yields and time to maturity between yields and time to maturity for bonds that are identical except for for bonds that are identical except for maturitymaturity

Default risk held constantDefault risk held constant

Term Structure of Interest Term Structure of Interest RatesRates

Term Structure of Interest Term Structure of Interest RatesRates

Upward-sloping yield curveUpward-sloping yield curve– typical, interest rates rise with maturitytypical, interest rates rise with maturity

Downward-sloping (or inverted) yield Downward-sloping (or inverted) yield curvescurves– Unusual, predictor of recession?Unusual, predictor of recession?

Term structure theoriesTerm structure theories– Explanations of the shape of the yield Explanations of the shape of the yield

curve and why it changes shape over curve and why it changes shape over time time

Expectations TheoryExpectations TheoryExpectations TheoryExpectations Theory Long-term rates are an average of Long-term rates are an average of

current short-term rates and those current short-term rates and those expected to prevail over the long-expected to prevail over the long-term periodterm period– Average is geometric rather than Average is geometric rather than

arithmeticarithmetic If expectations otherwise, the shape If expectations otherwise, the shape

of the yield curve will changeof the yield curve will change Forward rates are rates that are Forward rates are rates that are

expected to prevail in the futureexpected to prevail in the future

Liquidity Preference Liquidity Preference TheoryTheory

Liquidity Preference Liquidity Preference TheoryTheory

Rates reflect current and expected Rates reflect current and expected short rates, plus liquidity risk premiums short rates, plus liquidity risk premiums

Liquidity premium to induce long term Liquidity premium to induce long term lendinglending– Implies long-term bonds should offer higher Implies long-term bonds should offer higher

yieldsyields Interest rate expectations are uncertainInterest rate expectations are uncertain

Preferred Habitat TheoryPreferred Habitat TheoryPreferred Habitat TheoryPreferred Habitat Theory

Investors have preferred maturitiesInvestors have preferred maturities– Borrowers and lenders can be induced Borrowers and lenders can be induced

to shift maturities with appropriate risk to shift maturities with appropriate risk premium compensationpremium compensation

– Shape of yield curve reflects relative Shape of yield curve reflects relative supplies of securities in each sectorsupplies of securities in each sector

Most market observers are not firm Most market observers are not firm believers in any one theorybelievers in any one theory

Market Segmentation Market Segmentation TheoryTheory

Market Segmentation Market Segmentation TheoryTheory

Investors confine their activities to Investors confine their activities to specific maturity sectorsspecific maturity sectors

Investors are unwilling to shift from Investors are unwilling to shift from one sector to another to take one sector to another to take advantage of opportunitiesadvantage of opportunities

Risk Structure of RatesRisk Structure of RatesRisk Structure of RatesRisk Structure of Rates

Yield spreads Yield spreads – Relationship between yields and the Relationship between yields and the

particular features on various bonds particular features on various bonds Yield spreads are a result ofYield spreads are a result of

– Differences in: quality, coupon rates, Differences in: quality, coupon rates, callability, marketability, tax callability, marketability, tax treatments, issuing countrytreatments, issuing country

Passive Bond StrategiesPassive Bond StrategiesPassive Bond StrategiesPassive Bond Strategies

Investors do not actively seek out Investors do not actively seek out trading possibilities in an attempt to trading possibilities in an attempt to outperform the marketoutperform the market– Bond prices fairly determinedBond prices fairly determined– Risk is the portfolio variable to controlRisk is the portfolio variable to control

Investors do assess default and call riskInvestors do assess default and call risk– Diversify bond holdings to match Diversify bond holdings to match

preferencespreferences

Buy and holdBuy and hold– Choose most promising bonds that meet Choose most promising bonds that meet

the investor’s requirementsthe investor’s requirements– No attempt to trade in search of higher No attempt to trade in search of higher

returnsreturns IndexingIndexing

– Attempt to match performance of a well Attempt to match performance of a well known bond indexknown bond index

– Indexed bond mutual fundsIndexed bond mutual funds

Passive Bond StrategiesPassive Bond StrategiesPassive Bond StrategiesPassive Bond Strategies

Active Bond StrategiesActive Bond StrategiesActive Bond StrategiesActive Bond Strategies

Requires a forecast of changes in Requires a forecast of changes in interest ratesinterest rates– Lengthen (shorten) maturity of bond Lengthen (shorten) maturity of bond

portfolio when interest rates are portfolio when interest rates are expected to decline (rise)expected to decline (rise)

Horizon analysisHorizon analysis– Projection of bond performance over Projection of bond performance over

investment horizon given reinvestment investment horizon given reinvestment rates and future yield assumptions rates and future yield assumptions

Identify mispricing among bonds, then Identify mispricing among bonds, then swapswap– Substitution swap, pure yield pickup swap, Substitution swap, pure yield pickup swap,

rate anticipation swap, intermarket spread rate anticipation swap, intermarket spread (sector) swap(sector) swap

Interest rate swapsInterest rate swaps– Exchange a series of cash flowsExchange a series of cash flows– Convert from fixed- to floating-rateConvert from fixed- to floating-rate– Primarily used to hedge interest rate riskPrimarily used to hedge interest rate risk

Active Bond StrategiesActive Bond StrategiesActive Bond StrategiesActive Bond Strategies

ImmunizationImmunizationImmunizationImmunization Immunization is a hybrid strategyImmunization is a hybrid strategy Used to protect a bond portfolio against Used to protect a bond portfolio against

interest rate riskinterest rate risk– Price risk and reinvestment risk cancelPrice risk and reinvestment risk cancel

Price risk results from relationship Price risk results from relationship between bond prices and rates between bond prices and rates

Reinvestment risk results from Reinvestment risk results from uncertainty about the reinvestment rate uncertainty about the reinvestment rate for future coupon incomefor future coupon income

ImmunizationImmunizationImmunizationImmunization

Risk components move in opposite Risk components move in opposite directionsdirections– Favourable results on one side can be Favourable results on one side can be

used to offset unfavourable results on the used to offset unfavourable results on the otherother

Portfolio immunized if the duration of Portfolio immunized if the duration of the portfolio is equal to investment the portfolio is equal to investment horizonhorizon– Like owning zero-coupon bondLike owning zero-coupon bond

Building a Fixed-Income Building a Fixed-Income PortfolioPortfolio

Building a Fixed-Income Building a Fixed-Income PortfolioPortfolio

If conservative investorIf conservative investor– View bonds as fixed-income securities that View bonds as fixed-income securities that

will pay them a steady stream of income with will pay them a steady stream of income with little risklittle risk

– Buy and hold government bondsBuy and hold government bonds Conservative investor should considerConservative investor should consider

– Maturity, reinvestment risk, rate expectations, Maturity, reinvestment risk, rate expectations, differences in coupons, indirect investingdifferences in coupons, indirect investing

Building a Fixed-Income Building a Fixed-Income PortfolioPortfolio

Building a Fixed-Income Building a Fixed-Income PortfolioPortfolio

If aggressive investorIf aggressive investor– View bonds as source of capital gains View bonds as source of capital gains

arising from changes in interest ratesarising from changes in interest rates– Government bonds can be bought on Government bonds can be bought on

margin to further magnify gains (or losses)margin to further magnify gains (or losses)– Seek the highest total returnSeek the highest total return

International bondsInternational bonds– Direct or indirect investment Direct or indirect investment