Factors Affecting the Bond Investment - Example

Introduction: Modern portfolio theories explain investment process in two steps. The first step is to analyze the security to assess the risk and return characteristics of the available investment alternatives. The second step is to select the portfolio which involves choosing the best possible portfolio from the set of feasible portfolios (Chandra, 2008). Even before the development of any portfolio theory intuitive investors were knew the benefit of diversification which is reflected in the traditional adage “do not put all your eggs in one basket”. Generally investors are risk averse, hence at first they do not want to take any risk and if they take risk then they want compensation for that. However, they still try to diversify the risk by investing in different securities with various risk and return profiles. Investments in bonds or fixed income securities play a central role in diversifying the risk of a portfolio. Especially, in the current situation when equity market is going through historic level of price movements due to global crisis, the bonds are preferred over equity by most investors (Brière et al. May2009). And that has led the yields of bonds to the historic low levels. Two-year Treasury bonds yield less than 1%. The 30-year bond was, as recently as January 2nd, yielding less than 3%. James Montier of Société Générale cites figures showing that ten-year Treasury yields have averaged just over 4.5% since 1798. Today they offer just 2.5% (Buttonwood, 2009). Investors have long realized that the relative attractiveness of bonds with different maturities and coupons depends not only on expected movements in the future interest rates but also on the uncertainty surrounding these moves. This linkage suggests a relationship between the level of interest rate volatility and the shape of yield curve (Litterman et al. 1991). This report assesses the investment strategy that a moderate investor with an amount of 5,000,000 GB Pounds should adopt for three months period starting from 1st Feb 2009 to 1st May 2009. At first 10% amount of the fund is invested in one bond based on its risk and return profile and then rest amount is invested in other bonds to make the portfolio diversified. Investment Requirements: Followings are the investment requirements: The investment objective is to achieve a balance between Income and Capital Growth The client does not require immediate access to his funds and is classified in terms of risk appetite as a ‘moderate’ investor There is a sum of £5,000,000 available for investment Investment Options: Before selecting the investment options the investor needs to consider following things: Investment horizon: Since the investment horizon in the current case is just for 3 months so, equity is not an option. Equity is considered to be a long term investment option. So, bonds are the only option available with the investor. Risk Aversion of Investor: The investor has moderate risk appetite, so he/she can go for investment in medium to long term maturity bonds which are more volatile than short term maturity bonds. But as the investment period is just for three months it would not be feasible to invest in long term maturity bonds as there may be more volatility in their return. So, considering these two factors for investment short term and medium term maturity UK government bonds are analyzed. Factors Affecting the Bond Investment: Following factors are analyzed (Data for analysis is taken from internet; (Digital Look, 2009)) to select the most appropriate bond option for the investor (Litterman et al., Common Factors Affecting Bond Returns, 1991): Coupon: Prices with low-coupon bonds are more sensitive to interest rate changes than prices of high-coupon bonds. So, higher coupon bonds are desirable in current situation. Yield to Maturity: Bond prices are more sensitive to yield changes when the bond is initially selling at a lower yield (Cloutier, 2009). Expiry Date: This reflects whether the bond is short, medium or long term. Prices of long term bonds are more sensitive to interest rate changes than prices of short term bonds. However, as the maturity increases, interest rate risk increases but at a decreasing rate. To maintain an optimum level of volatility investor should consider short to medium term bond. Duration: Duration serves two purposes in bond analysis. First it reflects the average maturity of the bond’s promised cash flow which can be considered as effective maturity of the bond. Second, it reflects the sensitivity of a bond to interest rate changes. Ideally, an investor should choose a bond with a duration equal to his/her investment horizon to minimize the re-investment risk (Cloutier, Use Duration And Convexity To Measure Risk , 2009). Investment Period Yield: This yield reflects the average return that investor would get from investing in a bond for three month period at given price and redemption value. Historical Daily Volatility: This volatility is calculated by taking past one year data for each bond and by calculating daily return standard deviation for those data. This factor would give the idea of historical price movements of bonds. Historical Daily Return: This factor reflects the historical daily return for a bond. A higher value would be desirable. Investment Period Daily Volatility: It is calculated for the three month period starting from 1st Feb to 1st May 2009. This would reflect the bond’s price movement during the investment period. A moderate price movement is desirable. Investment Period Daily Return: This reflects the daily return for a bond during the investment period. Investment Period Total Return: This value gives the total return during the investment horizon based on the price at which bond was bought, the value of bond at redemption and any income from coupon payment during the investment period. Change in Price per Unit of Change in Yield: This value best reflect the sensitivity of the bond price with respect to change in yield. Higher the value in negative side, higher price sensitivity and which reflects higher volatility (Ross, et al. 2005). That means if there will be a change in yield of 1% then the price would decrease by higher amount. Return in £: This gives the pound terms for the investment period return. Loss of Fund for 1% Increase in the Yield: It gives the value that would be lost if there is an upward movement in the yield. Ratio of Return to Volatility: This value is the ratio of Return in £ to the fund lost per unit increase in the yield. The return per unit of volatility for a bond is best reflected by this ratio (van Pallander, 2008). On the basis of these factors ten bonds are analyzed presented in the following table: Bond Type 5¼% UK Treasury Strip 2012 Principal 4½% UK Treasury Strip 2013 Principal 3¼% Treasury Gilt 2011 4¾% Treasury Stock 2010 4¼% Treasury Gilt 2011 6¼% Treasury Stock 2010 5¼% Treasury Gilt 2012 4¾% Treasury Stock 2015 4½% UK Treasury Strip 2019 Principal 4¾% Treasury Stock 2020 charts Coupon 5.25% 4.50% 3.25% 4.75% 4.25% 6.25% 5.00% 4.75% 4.50% 4.75% Yield to Maturity 2.13% 2.46% 1.59% 0.54% 0.99% 0.72% 1.88% 2.69% 3.90% 3.83% Expiry date 7-Jun-12 7-Mar-13 7-Dec-11 7-Jun-10 7-Mar-11 25-Nov-10 7-Mar-12 7-Sep-15 7-Mar-19 7-Mar-20 Duration 3.10 3.74 2.73 1.31 2.00 1.73 2.86 5.70 8.14 8.70 Investment Yield 10.30% 9.62% 5.89% 2.69% 4.72% 2.45% 4.71% 14.52% 24.80% 15.99% Past Daily Volatility 0.31% 0.37% 0.22% 0.16% 0.22% 0.20% 0.27% 0.42% 0.78% 0.56% Past Daily Return 0.04% 0.10% 0.06% 0.01% 0.02% 0.01% 0.02% 0.03% 0.06% 0.02% Investment Period Volatility 0.22% 0.28% 0.20% 0.09% 0.15% 0.13% 0.21% 0.54% 0.99% 0.79% Investment Period Daily Return 0.02% 0.02% 0.01% -0.01% 0.00% -0.01% 0.00% 0.04% 0.08% 0.05% Investment Period Return 1.16% 1.15% 0.68% -0.44% 0.18% -0.79% 0.00% 2.51% 4.50% 2.85% Price 92.36 90.14 103.2 104.92 105.62 109.24 108.33 108.57 66.74 106.41 Redemption Value 93.43 91.18 103.9 104.46 105.81 108.38 108.37 111.29 69.74 109.44 Change in Price per unit of Change in Yield -2.86 -3.37 -2.82 -1.37 -2.11 -1.89 -3.10 -6.19 -5.43 -9.26 Total return in £ 5792.55 5768.80 3391.47 -2192.15 899.45 -3936.29 0.00 12526.48 22475.28 14237.38 Loss of fund with 1% increase in Yield 15506.3 18696.1 13648.6 6552.2 9985.7 8634.9 14314.2 28498.7 40678.6 43517.2 Ratio of return to volatility 0.3736 0.3086 0.2485 -0.3346 0.0901 -0.4559 0.0000 0.4395 0.5525 0.3272 By comparing all the bonds based on the above factors, we conclude that investor should invest in the 4¾% Treasury Stock 2015. It’s a medium term bond maturing on 7th March 2015. The bond has a moderate YTM, however its duration is a bit at higher side but since investor has moderate risk appetite so, he/she will be indifferent about this level as long as he/she is compensated for the higher volatility. At this level duration the price sensitivity of the bond with respect to per unit change in yield (1%) can be calculated as: Change in Price = – (Price * Duration * Change in Yield) Change in price = – 108.57 * 5.70 * 1% = – £6.19 This shows that a 1% increase in yield would amount to loss of £28500. The daily return per unit of volatility is at higher side suggesting the investor is duly compensated for each unit of risk he/she is taking. The total return the bond during investment period is 2.51% which amounts to £12550 by investing 10% of the total fund available i.e. £500,000. Portfolio Diversification: The rest of the amount i.e. £1000,000 can be invested in different other bonds to diversify the risk of investing in one bond. On the basis of above factors the investor should choose 5¼% UK Treasury Strip 2012 Principal and 4¼% Treasury Gilt 2011 to invest the remaining amount. Investment in these two bonds can be made on equal proportion. Hence, all three bonds would have an equal investment amount. In this case the portfolio’s duration can be brought down and hence the volatility can be minimized. Following table summarizes the portfolio information. Bond Type 5¼% UK Treasury Strip 2012 Principal 4¼% Treasury Gilt 2011 4¾% Treasury Stock 2015 Portfolio Proportion 33% 33% 33% 100% Return 1.16% 0.18% 2.51% 1.27% Price 92.36 105.62 108.57 101.1615 Duration 3.10 2.00 5.70 3.56 Change in Price per unit of Change in Yield -2.86 -2.11 -6.19 -3.60 Total return in £ 5792.55 899.45 12526.48 19218.48 Loss of fund with 1% increase in Yield 15506.26 9985.67 28498.63 53450.65 Ratio of return to volatility 0.37 0.09 0.44 0.36 Conclusion: Bonds can be useful in a very short investment period due to its lesser risky nature and other tax saving properties. The overall risk of a portfolio can be minimized by investing in government bonds. However, bonds themselves are not immune to risk. There is interest rate risk attached with the bonds and that can result in volatile price movement for bonds. The best way to measure the interest rate risk is duration of a bond. It shows the sensitivity of bond price with respect to yield change. While investing in bond it’s recommendable that the duration of bond portfolio should be close to investment period to remain immune from re-investment risk. References: 1. Brière, M., & Szafarz, A. (May2009). Crisis-Robust Bond Portfolios. CFA Digest , 24-25. 2. Buttonwood. (2009). Yielding to none. The Economist . 3. Chandra, P. (2008). Bond Prices and Yields. In P. Chandra, Investment Anlysis and Portfolio Management (pp. 316-367). New Delhi: Tata McGraw Hill. 4. Cloutier, R. (2009). How To Compare Yields On Different Bonds . Retrieved May 27, 2009, from Investopedia: http://www.investopedia.com/articles/bonds/08/bond-yield-convention-conversion.asp 5. Cloutier, R. (2009). Use Duration And Convexity To Measure Risk . Retrieved May 27, 2009, from Investopedia: http://www.investopedia.com/articles/bonds/08/duration-convexity.asp 6. Digital Look. (2009). Gilts. Retrieved May 27, 2009, from Digital Look: http://www.digitallook.com/market_home?page=bonds&sub_page=short_term&username=rahul_imt&ac=212164&tc= 7. Litterman, R., & Scheinkman, J. (1991). Common Factors Affecting Bond Returns. Journal of Fixed Income , 54-60. 8. Litterman, R., Scheinkman, J., & Weiss, L. (1991). Volatility and Yield Curve. The Journal of Fixed Income , 49. 9. Ross, S. A., Wetserfield, R. W., & Jaffe, J. (2005). Corporate Finance. New York: McGraw-Hill. 10. van Pallander, A. (2008). Fixed income attribution in the investment process. Finweek , 21. Read More