INVESTMENTS: Analysis and Management Third Canadian Edition INVESTMENTS: Analysis and Management Third Canadian Edition W. Sean Cleary Charles P. Jones Prepared by Khalil Torabzadeh University of Lethbridge

Chapter 12 Bonds: Analysis and Strategy

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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?

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Figure 12-1(a) Long Canada Bonds Total Return Index (1938 – 2007)

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Figure 12-1(b) Long Canada Bonds Total Annual Returns (1938 – 2007)

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Why?  Foreign bonds may offer higher returns at a point in time than alternative domestic bonds  Diversification However, can be costly and time-consuming  Liquid markets  Transaction costs and exchange rate risk Buying Foreign Bonds

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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)

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Figure 12-2 Inflation, T-Bill Yields, and Long-Term Canada Bonds

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Figure 12-3 Canada Yield Curve (April 22, 2008)

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Yield Spreads Over Time Yield Spread among bonds may be positive or negative at any time Of particular interest is the yield spread between the yields on corporate and government bonds, typically averages about 1 percent Another important yield spread is the one between the yields on Canadian and US bonds and money market instruments

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Implied Forward Rates

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Figure 12-5 Yield Spreads

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Figure 12-6 Canada –US Interest Rate Spreads

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 Bond Strategy Passive Strategy o Buy and Hold o Indexing Active Strategy o Forecasting Changes in Interest Rates o Indentifying Mispricing Among Securities

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 (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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 12 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

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