Bond Pricing and Fund Management - Essay Example

Bond Pricing and Fund Management Part A The forward rates on bonds Table forward rate computation The forward rate is an implied rate, which is calculated from the current interest rates of various bond maturities1. From Table 1 above, the forward rates of these bonds have been around 1% for the periods considered except on the 25th and 35th periods whose rate was negligible. From these results, it can be deduced that these bonds are not very risky; hence there will be no a significant variation in their future values. What does the term structure tell us about the future spot rates? Figure 1graphical representation of spot rate From the above curve, different treasury bonds with varying coupon rates have been accounted for. As such, a substantial concept on the amount of returns that an investor can earn from an investment, as well as the future changes as a result of economic risk associated with that particular investment can be established. For this reason, the above curve facilitates a significant comparison in bonds values. Part B Term structure of interest rates theories The term structure of interest rates is also the yield curve and is a central element in modern financial and monetary economics. It is the variation of the bonds’ yield with identical risk profiles with these bonds’ terms2. The yield curve shows the relationship between bonds yield to maturity and the effective maturity. Bonds with longer maturities are considered to have higher yields. However, there are also opinions that the yield curve may be flat showing that the yield curve remains the same irrespective of the bonds’ maturity. Also, in some cases, bonds with short-term maturities have their yield curves inverted implying that they are higher than those of long-term bonds3. Notes that the bonds’ yield curve is influenced by several factors among them the fiscal policies, inflation, economic conditions, tax policies, foreign exchange rates, expected forward rates, bonds’ credit rating and foreign capital inflows as well as outflows. The term structure of interest rates bears three identifiable features. They include higher volatility of yields on short-term bonds than long-term bonds; change in yields of various bonds move in the same directions; and the long-term bonds have higher yields. Several theories have been advanced to explain these characteristics. They are broadly classified as the market segmentation theory and expectations theories, which are the preferred habitat theory, the liquidity premium, and the pure expectation theory. Market segmentation theory Given that bonds have some set durations, sellers and buyers frequently have preferred maturities. The bond buyers prefer maturities that coincide with when they need money or with their liabilities while the bond sellers want maturities that coincide the anticipated income streams4. The market segmentation theory thus recognizes that investors and sellers have their preferred habitats dictated by their liabilities’ nature. The theory further states that the yield curve is influenced by the demand and supply for bonds of different maturities. Under this theory, the bond market is divided into short term, medium term and long term segments. The dissimilitude that subsists among these segments in terms of supply and demand causes the difference in the prices of bonds, and, therefore, yields. A bond with a particular maturity may have differences in its demand and supply largely because of the current interest rates as well as the expected future interest rates. In case the current interest rates are high, the future rates are expected to decrease, thereby causing an increase in the demand for long-term bonds by investors as they will be willing to lock in high rates while supply decreases since bond issuers would not be willing to be locked into the rising rates5. On contrary, when current rates are low, the investors will avoid the long-term bonds to avoid being locked into the low-interest rates. This is the case as the rise in the bonds prices will drop due to rising interest rates. On the other hand, issuers of the bonds would want to lock in low rates causing an increase in the supply for long term debts. Therefore, higher supply and lower demand for long-term debts make their prices drop, thereby increasing their yield. Pure expectation theory According to 6This theory posits that it is only the expected future short-term rates that affect the forward rates, and there are no other systematic factors. It also states that, the various term bonds can better be seen as a series of one period bonds, where yields of every period bond are equal to that period’s expected short-term interest rate. According to this theory, when it is expected that the future interest rates will rise, the yield curve slopes upwards and the longer-term bonds pay higher yields. On the other hand, when it is anticipated that the future interest rates will drop, the long-term bonds yield is lower than that of short-term bonds leading into an inverted yield curve7. This theory assists in explaining the higher volatility of yields on short-term bonds than long-term bonds and the change in yields of various bonds move in the same directions features of the term structure of interest rates. Liquidity premium theory There are several factors that affect the forward rates other than the expected future short-term rates. It better explains the third feature of the term structure of interest rates8. This theory considers other risks that are related to long term bonds such the inflation risk and the interest rate risk. Increased risks lower the demand for long-term bonds leading to an increase in their yield, which is the risk premium aimed at compensating investors of these bonds for the increased risk9. Theoretically, the yield of the bond can be divided into the risk premium and risk-free yield. The risk premium becomes the liquidity premium and increases with the period of the bond. Therefore, the yield curve slopes upward irrespective of the expected movement of the future interest rates. Preferred habitat theory This approach equally adopts the idea that the term structure of interest rates reflects the anticipated movement of the future interest rates and a risk premium. Given the mismatch between the supply and demand for bonds in the long term durations, investors and issuers shift to maturities that show opposite imbalances. They will seek a risk premium that reflects the extent of price aversion or reinvestment risks. Under this theory, the nature of the yield curve depends on the risk premium and the expected future interest rates. Part C Factors Affecting Bond Yields Credit quality The yield that a bond pays is primarily influenced by the credit quality of the issuer10. According to 11, when investors invest in the bonds, they stand to suffer from the risk that the bond issuer might be unable to settle the borrowed money upon the maturity of the bonds. Bond issuers are thus rated so as to indicate their ability to pay the interest and principal amounts timely. The bonds that qualify as investment grade bonds have a credit rating of BBB or above while those below this are non-investment grade bonds and will thus call for a higher yield than the highly rated bonds12. Inflation expectations The rates charged on low-risk longer term bonds indicate the bond market outlook on inflation. On conditions that the inflation is expected to increase by the bond investors, the yields of the bond increases while their prices drop13. Current bond yields fluctuate with the changes in the expectations about the future inflation. Time to maturity Upon the maturity of the bond, the issuer has to repay the borrowed amount by redeeming it at face value. When the maturity of the bond approaches, the yield nears the coupon rate since the bond owners will not sell them at a larger discount because they will soon receive the bonds’ full face value upon their redemption14. In addition, investors will not be willing to pay substantial premiums because the approaching maturity date will not grant time to recover the price premiums through interest earnings. Interest rates According to15, the market interest rates significantly affect the bond’s yield. When interest rates are rising, the current bonds become less attractive to investors. Consequently, the demands for the bonds dip causing their prices to fall, hence attracting investors due to increased yields. On the other hand, whenever there is a drop in the interest rate, the yields of the existing bonds become more attractive. Callable bonds These are bonds that issuers can redeem early. Where a bond is trading at a premium due to a decrease in interest rates, the bond issuers can call and reissue them at lower rates16. This would, however, be bad news for investors who lose attractive bonds. When the call date for a callable bond nears and such a bond is selling at a premium, the price of the bond tends to drop, and the yield goes up. On the other hand, when they are trading at a discount, the issue of the call date has little impact as the bond issuer lacks incentive to call the bonds as interest rates have risen. References Adkins, W.D., Factors Affecting Bond Yields. [Online] Available at: HYPERLINK "http://finance.zacks.com/factors-affecting-bond-yields-2261.html" http://finance.zacks.com/factors-affecting-bond-yields-2261.html [Accessed 3 March 2015], 2015. Financial Times, Forward rate. [Online] Available at: HYPERLINK "http://lexicon.ft.com/Term?term=forward-rate" http://lexicon.ft.com/Term?term=forward-rate [Accessed 4 March 2015], 2015. George Washington University, Chapter 6 The Risk and Term Structure of Interest Rates. [Online] Pearson Addison-Wesley Available at: HYPERLINK "http://home.gwu.edu/~cdwei/chap_6.ppt" http://home.gwu.edu/~cdwei/chap_6.ppt [Accessed 4 March 2015], 2010. Munasib, A., Term Structure of Interest Rates: The Theories. [Online] Oklahoma State University–Stillwater Available at: HYPERLINK "http://spears.okstate.edu/home/munasib/MoneyBanking_3313/Handout/Handout03.pdf" http://spears.okstate.edu/home/munasib/MoneyBanking_3313/Handout/Handout03.pdf [Accessed 4 March 2015], 2015. Plaehn, T., Factors Affecting Bond Yields. [Online] Available at: HYPERLINK "http://budgeting.thenest.com/factors-affecting-bond-yields-26039.html" http://budgeting.thenest.com/factors-affecting-bond-yields-26039.html [Accessed 3 March 2015], 2014. Spaulding, W.C., Term Structure of Interest Rates. [Online] Available at: HYPERLINK "http://thismatter.com/money/bonds/term-structure-of-interest-rates.htm" http://thismatter.com/money/bonds/term-structure-of-interest-rates.htm [Accessed 4 March 2015], 2014. Read More