Chapter 12. Page 1. Bonds: Analysis and Strategy. Learning Objectives. INVESTMENTS: Analysis and Management Second Canadian Edition

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1 INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones Chapter 12 Bonds: Analysis and Strategy Learning Objectives Explain why investors buy bonds. Discuss major considerations in managing a bond portfolio. Explain what is meant by the term structure of interest rates. Differentiate between passive and active strategies for managing a bond portfolio. Describe how both conservative and aggressive investors build a fixed-income portfolio. Page 1

2 Why Buy Bonds? Attractive to investors seeking steady income and aggressive investors seeking capital gains Promised yield to maturity is known at the time of purchase Can eliminate risk that a rise in rates decreases bond price by holding to maturity The Case against Buying Bonds Don t hold bonds unless investing strictly for income Capital appreciation negative Alternative: a combination of cash investments and stocks Investors should consider whether they could build better portfolios that do not include bonds Buying Foreign Bonds Why? Foreign bonds may offer higher returns at a point in time than alternative domestic bonds Diversification However, can be costly and time-consuming Illiquid markets Transaction costs and exchange rate risk Page 2

3 Domestic vs. Foreign vs. Eurobonds Domestic Domestic Issuer (e.g. Canadian issuer in Canada) Issued domestically (e.g. in Canada for Canadian issuer) Payments in domestic currency (e.g. CDN $ in Canada) Foreign Issued outside domestic country Issued by domestic company Pays in foreign currency (i.e. in country where issued) Eurobond Issued in Euromarket (any country outside domestic one) By domestic company (e.g. Canadian company) Pays in domestic currency (e.g. Pays Canadian dollars in Europe) Understanding the Bond Market Benefits from a weak economy Interest rates decline and bond prices increase Important relationship is between bond yields and inflation rates Investors react to expectations of future inflation rather than current actual inflation Changes in CPI and L-T Canada Bond Yield Percentage Year Yields CPI Page 3

4 Term Structure of Interest Rates Term structure of interest rates Relationship between time to maturity and yields Usually measured by yields on federal government T-bill and bonds Yield curves Graphical depiction of the relationship between yields and time to maturity for bonds that are identical except for maturity Default risk held constant Term Structure of Interest Rates Upward-sloping yield curve typical, interest rates rise with maturity Downward-sloping (or inverted) yield curves Unusual, predictor of recession? Term structure theories Explanations of the shape of the yield curve and why it changes shape over time Yield Curves Yield Curves Percent mth 3 mths 6 mths 1 yr 2 yrs 5 yrs 7 yrs 10 yrs 30 yrs Term Page 4

5 Expectations Theory Long-term rates are an average of current short-term rates and those expected to prevail over the long-term period Average is geometric rather than arithmetic If expectations otherwise, the shape of the yield curve will change Forward rates are rates that are expected to prevail in the future Liquidity Preference Theory Rates reflect current and expected short rates, plus liquidity risk premiums Liquidity premium to induce long term lending Implies long-term bonds should offer higher yields Interest rate expectations are uncertain Preferred Habitat Theory Investors have preferred maturities Borrowers and lenders can be induced to shift maturities with appropriate risk premium compensation Shape of yield curve reflects relative supplies of securities in each sector Most market observers are not firm believers in any one theory Page 5

6 Market Segmentation Theory Investors confine their activities to specific maturity sectors Investors interact to determine rates in the market (e.g., 5-year rates / 10-year rates, etc) Investors are unwilling to shift from one sector to another to take advantage of opportunities Risk Structure of Rates Yield spreads Relationship between yields and the particular features on various bonds Yield spreads are a result of Differences in: quality, coupon rates, callability, marketability, tax treatments, issuing country (e.g., government versus corporate, investment grade versus junk debt) Yield Spreads The difference in yield between debt instruments that are similar except for one feature e.g. Corporate vs. Government 10 year, 8% bonds e.g. Canada Bonds vs. US bonds 30 year, 6% Spreads related to default risk, such as the government-corporate spread tend to narrow during good times and widen during bad times Page 6

7 Yield Spreads Per cent Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Canadas Corporates Passive Bond Strategies Investors do not actively seek out trading possibilities in an attempt to outperform the market Bond prices fairly determined Risk is the portfolio variable to control Investors do assess default and call risk Diversify bond holdings to match preferences Passive Bond Strategies Buy and hold Choose most promising bonds that meet the investor s requirements No attempt to trade in search of higher returns Indexing Attempt to match performance of a well known bond index Indexed bond mutual funds Page 7

8 Active Bond Strategies Requires a forecast of changes in interest rates Lengthen (shorten) maturity of bond portfolio when interest rates are expected to decline (rise) Horizon analysis Projection of bond performance over investment horizon given reinvestment rates and future yield assumptions Active Bond Strategies Identify mispricing among bonds, then swap Substitution swap, pure yield pickup swap, rate anticipation swap, intermarket spread (sector) swap Interest rate swaps Exchange a series of cash flows Convert from fixed- to floating-rate Primarily used to hedge interest rate risk Interest Rate Swaps (1) Substitution substitute one bond for a very similar one, if it appears to be priced more attractively (2) Pure Yield Pickup replace a lower yielding bond with a higher yielding one (3) Rate Anticipation if expect rates to fall, swap into bonds with higher durations, etc. (4) Intermarket Spread (sector) switches due to beliefs re. changes in yield spreads Page 8

9 Immunization Immunization is a hybrid strategy Used to protect a bond portfolio against interest rate risk Price risk and reinvestment risk cancel Price risk results from relationship between bond prices and rates Reinvestment risk results from uncertainty about the reinvestment rate for future coupon income Immunization Risk components move in opposite directions Favourable results on one side can be used to offset unfavourable results on the other Portfolio immunized if the duration of the portfolio is equal to investment horizon Like owning zero-coupon bond Immunization Designed to protect a bond (fixed income) portfolio against interest rate risk, both (1) Reinvestment risk and (2) Price Risk Match your desired holding period with the duration (not maturity) of your bond portfolio. Note: Duration (portfolio) is the weighted average of the individual bond s durations included in that portfolio. i.e. DUR p = W 1 DUR 1 + W 2 DUR W n DUR n Page 9

10 Building a Fixed-Income Portfolio If conservative investor View bonds as fixed-income securities that will pay them a steady stream of income with little risk Buy and hold government bonds Conservative investor should consider Maturity, reinvestment risk, rate expectations, differences in coupons, indirect investing Building a Fixed-Income Portfolio If aggressive investor View bonds as source of capital gains arising from changes in interest rates Government bonds can be bought on margin to further magnify gains (or losses) Seek the highest total return International bonds Direct or indirect investment International Bond Investing If you buy foreign bonds (or bonds denominated in other currencies) in addition to interest rate risk, etc. from that country, you face foreign exchange risk Must decide whether to hedge currency risk or not and if so how much should be hedged Note: If Canada dollar appreciates against the foreign currency you lose on the foreign bonds, and vice-versa Page 10

11 Copyright Copyright 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Page 11

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