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
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
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
16
14
10
8
6
4
2
0
19
57
19
60
19
63
19
66
19
69
19
72
19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
19
99
20
02
Percentage
12
Year
Yields
CPI
Page 3
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
16
14
12
Percent
10
1990
1994
8
1998
2004
6
4
2
0
1 mth
3 mths
6 mths
1 yr
2 yrs
5 yrs
7 yrs
10 yrs
30 yrs
Term
Page 4
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
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
Yield Spreads
25
Per cent
20
15
10
5
Canadas
Ja
n00
Ja
n02
Ja
n98
Ja
n96
Ja
n94
Ja
n90
Ja
n92
Ja
n88
Ja
n84
Ja
n86
Ja
n82
Ja
n80
Ja
n78
0
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
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
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. DURp = W1 DUR1 + W2 DUR2 + … +
Wn DURn
Page 9
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
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
