A Bond as a Form of Investment - Example

NAME: TUTOR: DATE: ©2015 BEA112 Principles of Finance Major Assignment 2015 Introduction. Investment in Government Bonds (10year bonds). A bond is a form of investment where there is a promise by the issuer to repay the money with interest to the lender at a future date. It is an ‘IOU’ that requires the issuer of the bond to pay the investor a particular amount of cash at specified times of the year. The issuer then pays back the face value of the bond at the end of the maturity period. A bond gets issued for a specified period. 10-year bonds, for instance, have a maturity period of 10 years from the date of issue. Once issued, investors can trade on them at prevailing market prices that typically fluctuate. Figure 1: The basics of bonds Unlike other forms of investments, when a bond reaches its maturity, the holder of the bond will get paid the nominal price of the bond and thus it is considered a less risky type of investment. Government bonds have the lowest forms of risks associated with bonds i.e. credit risk and liquidity risks. For that reason, risk-averse investors prefer government bonds compared to corporate bonds. Case Study Analysis; Australian Mining Firm. Correlation Correlation is a description of the linear relationship between two variables. It can be described numerically by use of coefficients that represents the strength of the relationship. In the case above, the correlation estimation was done by use of correlation coefficients that can get determined as follows; Where: is the correlation coefficient. and are variables 1 and 2 respectively (individual 10yr bonds). and are the respective mean values of the bond yields. Analysis was performed using Ms Excel (10 year bond.xls) by use of the function CORREL that returns a simple correlation coefficient between two data sets. For example; =CORREL(B2:B192,C2:C192) returns 0.85 which represents the correlation between Australia’s and Canada’s yield. The results got tabulated as follows;  Aus Can Ger Swis S. A UK Fra Jap Spa Port Gre Thai Ind Kor NZ Tai Italy US Australia Canada 0.85 Germany 0.93 0.95 Swiss 0.91 0.94 0.99 S. Africa 0.55 0.69 0.65 0.67 UK 0.94 0.88 0.94 0.91 0.47 France 0.89 0.91 0.98 0.96 0.68 0.89 Japan 0.84 0.68 0.81 0.82 0.42 0.78 0.80 Spain 0.31 0.31 0.41 0.37 0.46 0.27 0.54 0.33 Portugal -0.21 -0.28 -0.20 -0.25 0.03 -0.29 -0.03 -0.13 0.70 Greece -0.53 -0.57 -0.53 -0.57 -0.17 -0.62 -0.39 -0.40 0.38 0.87 Thailand 0.70 0.70 0.72 0.73 0.67 0.58 0.71 0.73 0.35 -0.13 -0.37 India 0.12 0.11 0.14 0.18 0.64 -0.06 0.21 0.16 0.39 0.27 0.18 0.50 Korea 0.80 0.83 0.87 0.88 0.83 0.70 0.87 0.73 0.47 -0.08 -0.35 0.83 0.49 NZ 0.97 0.91 0.95 0.94 0.61 0.94 0.90 0.79 0.25 -0.31 -0.61 0.73 0.14 0.83 Taiwan 0.62 0.79 0.75 0.78 0.91 0.55 0.75 0.55 0.38 -0.13 -0.33 0.81 0.58 0.89 0.70 Italy 0.51 0.47 0.61 0.58 0.52 0.46 0.73 0.57 0.89 0.57 0.25 0.49 0.41 0.65 0.45 0.51 US 0.91 0.96 0.96 0.95 0.70 0.89 0.91 0.78 0.29 -0.30 -0.60 0.80 0.22 0.87 0.95 0.81 0.47 Av yield (%) 5.12 4.19 3.38 2.22 9.04 4.17 3.92 1.24 4.37 5.26 7.89 4.48 7.96 4.56 5.56 2.41 3.90 4.44 S.D 1.05 1.23 1.34 1.07 1.76 0.75 1.18 0.41 0.99 2.30 6.41 1.16 1.45 1.63 1.04 1.32 1.00 1.13 Figure2: Table of Correlations The correlation coefficients between pairs of the selected countries ranged from -0.62 to +0.99. UK and Greece had the most negatively correlated yields whereas Germany and Swiss had yields that were highly positively correlated. Some pairs also had produced correlation coefficients close to zero. For instance, South Africa – Portugal and France – Portugal had correlation coefficients of 0.03 and -0.03 respectively therefore evidence of a minimal relationship in variable changes. Values between 0.5 and 1 or between -0.5 and -1 represents a strong linear relationship with the yield on 10-year bonds. The reasons for the high correlation could be; Similar Economies: - in 2013 for instance, Germany and Switzerland had close consumer prices inflation rates of 1.6% and -0.4% respectively. It, therefore, meant that inflation being a factor affecting yields of government bonds had an almost similar effect in both countries. Geographical proximity: - Australia and New Zealand had a coefficient of +0.97, which can get attributed to their geographical closeness. Investors could be owning both bonds thus making similar decisions regarding whether to buy or sell. Economic crises: - the recently increased uncertainty about the Greek sovereign debt and concerns over risky economic conditions have resulted to investors resorting to other safer global financial assets. A good example is a correlation between Greece and the UK, which stood at -0.62. Investors would naturally consider Greece as a riskier investment compared to the UK thus in trying to attract the shy investors, the Greek 10 year bond had an increased yield. The UK bond, on the other hand, would be in high demand pushing its yield down to even out increased demand. For that reason, the two bonds had a high negative correlation. Investor overreaction: - sometimes, bond markets are characterized by high fluctuations of trading activities and tend to be based on short-term and rush decisions that investors obtain from news regarding declining yields of government bonds. It leads to erosion of investor confidence who then pull investments from countries deemed unstable so as to avoid suffering losses. At times, investors react at the same time thus causing the bond prices to decrease significantly and may even bear higher losses. (Fukuda, et al., Feb 2012). Portfolio Recommendation Given $100million to invest in a financial instrument for the next ten years. Portfolio 1: Diversified but Highly Correlated 50% in Japanese and 50% in Greek bonds. It represents a diversified portfolio because the Japanese 10-year bond had the lowest yield but relatively stable over the entire analyzed period. The stability is due to it being inflation indexed. The Greek bond, however, promised the highest yield especially in February 2012 but was the most unstable. Portfolio 1, therefore, aims to base success on the stability of Japanese bond while taking advantage of the high yields offered by the Greek bond. If the company invests the entire $100million in portfolio one, therefore, At maturity, the company will receive principal amount plus last coupon i.e. It would receive the lump-sum since both bonds are available for trading in the market thus highly liquid. When compared to investing the entire amount in the Japanese bond, the company would receive lower monthly coupons; It therefore is a diversified and economical portfolio with the following correlation trend; Figure 3: Correlation trend Aug 99 - Jun 2015. The bond yields were highly correlated either negatively of positively for most parts of the analysis period except between Jan 2011 and Jan 2012. Therefore assuming current European trends (Greece debt crisis) continues for the next five years, the portfolio will remain diversified. However, the risk of default by the Greek portion of the portfolio could make it an uncertain investment. As a result of the high correlation, fluctuations in Greece bond yields would significantly affect the Japanese government bonds through various channels (Fukuda, et al., Feb 2012). For example, there is a chance of instability in foreign bond markets. It would raise market uncertainty associated with holdings of both international and local assets, (Fukuda, et al., Feb 2012). The risk value associated with portfolio one will slightly increase due to the volatility of the Greece 10-year bond. It, therefore, makes the portfolio high-risk, high-return type. Portfolio 2: Diversified and no Correlation 80% South Africa bond and 20% in Portugal bond. It is the most diversified investment and completely safeguards from any form of Japanese risk. The two bonds do not have any linear relationship and shocks in one do not affect the performance of the other. The portfolio guarantees returns even under economic crises. It implies that turmoil in government bonds markets of Portugal would cause less contagion to South African market. The two countries are in different continents therefore even with economic crises in the euro zone the SA bond remains productive. Investing the entire $100 million; Figure 4: Correlation trend SA-Portugal Aug 99-Jun 15 The trend in correlation shows a shift into high correlation. At maturity, the company will receive principal amount plus last coupon i.e. It would receive the lump-sum since both bonds are available for trading in the market thus highly liquid. When compared to investing the entire amount in the Australian bond, the company would receive lower monthly coupons; Of the two portfolios, I would advise the company to invest in portfolio 2. It offers a better hedge against adverse conditions and risks in the Japanese economy. Both the 10 year bonds making up portfolio two are available for trading in the market thus highly liquid. References 1. Sherris, M. (1995). Interest Rates Risk Factors in the Australian Bond Market. Macquarie University. School of Economic and Financial Studies. 2. Dungey, M., Martin, V. L., & Pagan, A. R. (2000). A multivariate latent factor decomposition of international bond yield spreads. Journal of Applied Econometrics, 15(6), 697-715. 3. Calvo, G. A., & Guidotti, P. E. (1989). Indexation and maturity of government bonds: A simple model. International Monetary Fund, Research Dept. 4. Deacon, M., & Derry, A. (1994). Estimating market interest rate and inflation expectations from the prices of UK government bonds. Bank of England Quarterly Bulletin, 34(3), 232-240. 5. Richards, A., & Gugiatti, M. (2003). Do collective action clauses influence bond yields? New evidence from emerging markets. International Finance, 6(3), 415-447. 6. Neely, C. J. (2010). The large scale asset purchases had large international effects (pp. 1-45). Federal Reserve Bank of St. Louis, Research Division. 7. http://www.bloomberg.com/markets/rates-bonds/government-bonds 8. http://www.tradingeconomics.com/bonds-list-by-country , 9. http://www.rba.gov.au/chart-pack/exchange-rates.html 10. http://www.ecb.int/stats/html/index.en.html 11. http://research.stlouisfed.org/fred2/ Read More