2.2 - asset classes: debt

explain the top arrow part of this bond

nominal/par/maturity/redemption value

explain the second arrow part of this bond

redemption/maturity date

explain the third arrow part of this bond

coupon

explain the bottom arrow part of this bond

the issuer

what is to default

if they can’t pay back the nominal value by the redemption date

what is the relationship between price and interest rates

inverse

what is a gilt

uk government bond

has the UK ever defaulted on their bonds

no

has the US ever defaulted on their bonds

yes

who is considered a market maker in gilt trading

GEMM - gilt edged market maker

is GS considered a GEMM

yes

what do GEMMs have to do

provide two way prices during the MQP, like any other market maker

what is an MQP

mandatory quoting period

why are gilts issued

to fill the PSNCR

what is the PSNCR

public sector net cash requirement:

the gap between tax revenue and gov spending

who tracks the PSNCR and therefore issues these gilts

the DMO - the debt management office

how are gilts issued

the DMO ‘auctions’ them

how often is the coupon paid on a gilt

semi annually

so on this example, what would the coupon be and when

$2.50 every 6 months

how many cashflows are in a 3 year gilt

7 - two per year then the one at the end repaying the face value

when are gilts settled

T+1

how long is the ex-coupon period with a gilt

7 business days

3 classifications of gilts

short dated

medium dated

long dated

short dated means…

…7 years or less remaining life

medium dated means…

…more than 7 to 15 years remaining life

long dated means…..

….more than 15 years remaining life

in an exam if they don’t tell you then assume the nominal value is…

…£100

what is the formula for a flat yield

basically benefit over cost of the bond

2 things that flat yield doesn’t take into account

capital gains (^price of bond)

income tax to be paid on cashflows

since it doesn’t take into account these things, who are flat yields mainly used by

income seeking (no cap. gain) non taxpayers

flat yield other terms

ciric:

current yield

income yield

running yield

interest yield

coupon yield

what is the yield to maturity formula

.

how do you calculate the yearly gain/loss due to capital gains/losses

diff between nominal value and bond prices, divided by maturity time (so u can put it for each year)

what does this not consider

time value of money - but that’s fine its just an estimate then

so since it doesn’t consider that, the gains/losses appear…

…bigger than they are

yield to maturity (YTM) other terms

IRR - internal rate of return

GRY - gross redemption yield

what does yield to maturity not take into account

tax

what version of GRY takes tax into account

NRY - net redemption yield

NRY will always be __________ than GRY

smaller

so who uses GRY more

non tax paying long term investors

and who uses NRY more

taxpaying long term investors

what is reinvestment risk

the risk that you will have to reinvest your coupons at a rate lower than the original investment (so like if interest rates have fallen in the economy)

what is a callable bond

gives the issuer the right to repay the bond before its maturity date

when might an issuer use a callable bond

if market rates fall, they might call the bond early and issue new bonds at this cheaper rate of borrowing

how does this relate to investment risk

if your bond is called early then you have to find somewhere else to put your money but since market rates have fallen you will be reinvesting at a worse rate

what is a cuttable bond

the bondholder can make the issuer repay the bond early

when might you use a puttable bond

if market rates rise, so you want to get rid of this bond and reinvest your money somewhere else at a higher rate

how do we calculate the present value of a bond’s cashflow

by discounting like this

how do we calculate the price of a bond

doing the present value thing for all cashflows and the principal payment at the end then adding them all up

what are the two parts of bond risk

coupons

redemption

smaller coupon =

higher risk, bc your money will take longer to come back to you

longer redemption time =

more risk, because your money will take longer to come back to you

what can you use to remember this

crocodile analogy

what is the Macaulay duration

the average timing of the bonds payments (example pictured)

how is the Macaulay duration calculated

sum of: (discounted cashflow x the year its meant to be for) ALL OVER the bond price

the orange bit in the picture

what can the Macaulay duration be used for

immunisation

what is immunisation

matching asset and liability durations to reduce the risk from interest rate changes

give an example of immunisation

if you had a payment to make in 2.81 years you’d use that bond we just were working with to fund it, rather than finding a bond with maturity 2.81 years

what is modified duration

estimates how sensitive a bond’s price is to interest rate changes

aka the volatility (risk) of the bond

how do we calculate modified duration

Macaulay duration divided by 1+r

r being the original interest rate

so what is the modified duration in this example (assume interest rates were 5%)

2.81/1.05 = 2.68

so if your modified duration is 2.68, what does that mean

interest rate rises by 1 percentage point, bond price falls by 2.68 percentage points

and vice versa

annotate and explain this graph

.

what day count convention is used for accrued interest

actual/actual

what is considered to be the accrual period

FROM: the day after the last coupon payment

TILL: settlement (T+1)

(basically how long the line on the graph goes up)

if they don’t give you a settlement date in an exam just use the…

…trade day

solve this question on accrued interest

.

what is a spread

the difference between the yield available on different instruments or markets

how are spreads expressed

in basis points

what can spreads often be measured against

a benchmark

3 common types of benchmark

gov bonds

swap rates

published reference rates

3 published reference rates to be aware of

LIBOR

SONIA

SOFR

what does a normal yield curve look like

measures GRY against term to maturity

what are the two reasons why the yield curve looks how it does

liquidity preference theory

expectation theory

3 parts of the yield curve

money markets (short term)

belly of the curve (mid term)

long term

explain the liquidity preference theory

you pay a premium for more liquidity, so yields are lower in the money markets which are more liquid and vice versa

explain the expectation theory

determines the curvature of the curve:

money markets = moved by expectations on monetary policy

belly = moved by supply + demand

long term = moved by expectations of growth + inflation

what else determines long term interest rates

what people expect short term interest rates to be in the future

so when would there be an upwards sloping curve like we have seen

when people expect interest rates in the future to rise

(bc then there would be an opportunity cost of doing one long term investment at current lower rates, so the reward is made higher to make up for that)

so when is there a flat yield curve

when ppl expect rates to stay roughly the same

and then when is there a downwards sloping yield curve

when people expect future rates to fall

what else can you call a downwards sloping yield curve

an inverted yield curve

what is market segmentation

splitting the market into the 3 sectors we have established (short, mid and long term)

what does inflation do to the value of your investments

erodes the value

so what do people therefore do

use index linked bonds

what is an index linked bond

coupon payments + principal are adjusted in line with RPI

what is RPI

a measure of inflation that is UK specific

what are the other two measures of inflation

CPI - EU wide measure
PPI - ‘factory gate’ measure

what is the lag in applying RPI for pre 2005 issues

8 months

what is the lag in applying RPI for post 2005 issues

3 months

what does STRIPS stand for

separate trading of registered interest + principal of securities

so what can you do to a gilt according to this

strip it - separate the cashflows of a bond so that they can be bought and sold individually

why strip a gilt

catch matching/dedication:

you can choose exactly when you want to receive your money (turns it into like a zero coupon bond basically)

who does the stripping

GEMMs

who designates certain gilts as strippable

the DMO

how do must gov bonds settle

T+1

what are the exceptions to T+1 settlement

French bonds —> T+2

German bonds —> T+2

US t-bills —> trade date

when are most coupons paid for gov bonds

semi-annually

what are some exceptions to the semi-annual rule

French bonds —> annual

German bonds —> annual

US t-bills —→ no coupon paid

what do Japan call bonds that are 10+ years long

‘super-long’