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INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones.

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Presentation on theme: "INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones."— Presentation transcript:

1 INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones

2 Chapter 12 Bonds: Analysis and Strategy

3 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. Learning Objectives

4 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 Why Buy Bonds?

5 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 The Case against Buying Bonds

6 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 Buying Foreign Bonds

7 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)

8 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 Understanding the Bond Market

9 Changes in CPI and L-T Canada Bond Yield

10 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

11 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 Term Structure of Interest Rates

12 Yield Curves

13 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 Expectations Theory

14 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 Liquidity Preference Theory

15 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 Preferred Habitat Theory

16 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 Market Segmentation Theory

17 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) Risk Structure of Rates

18 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 Yield Spreads


20 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

21 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 Passive Bond Strategies

22 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

23 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 Active Bond Strategies

24 (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 Interest Rate Swaps

25 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

26 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

27 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 2 + … + W n DUR n Immunization

28 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

29 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 Building a Fixed-Income Portfolio

30 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 International Bond Investing

31 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. Copyright

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