Hi!
I am struggling with bonds and i would really appreciate if someone could sum up high level points for me and other for the exam in 5 days!
I mean we buy bonds compared to equities in declining markets, but in declining markets we buy high level bonds compared to those yielding low yield ! points like these, could somebody please please summarize with short explanations!!!
Many Thanks,
in the simplest of forms… think of it this way: in declining market conditions rates are falling therefore prices of bonds will increase you want to gain from price increase so hold bonds… in increasing mkt conditions rates are rising therefore prices of bonds falling you want to avoid bonds, also hold equities for inflation risk (good inflation hedge)… Things get complicated when S/T and L/T interest rates are moving at different pace (twists vs shift in yield curve) then you are talking about Convexity and Key Duration Management is how you manage your Change Price VS Effective Duration…
FI is one of my weak points too so anyone else wants to correct me or add please do so
In declining markets, yields go up up, because market conditions are declining they raise yield and even monetary policies are relaxed leading to higher interest rates!? isn’t it so ?
Yields Yes, Interest No… remember Yields and Interest rates are two different things…Yields go up because price has gone down… for example a yield pick strategy for active management looks for low price or high yield potential securities…
I could totally be wrong as I said FI is also my Weak Area… let me know if you figure I am wrong… or anyone else who wants to help…
You got it. Yields are up because prices are down. Interest rates are down, Price is up. Should be an inverse relationship between rates and price.
Just to key in a little more, in declining markets we expect interest rates to go down. 1) Monetary policy comes in and reduces rates on the short end of the curve; 2) Long term bond rates go down due to bond rates being linked to Expected inflation, which in turn is also linked to GDP growth. GDP Growth down = Expected inflation down = Interest rates move down. Another way to conceptually think of this is think of a shift of the entire YC Down, LT bonds have higher duration, thus will get a higher price adjustment over short term.
One thing not mentioned in this thread, is you want to AVOID risky corporate bonds during a declining market. Spreads (Difference between treasury and risky corporate) should go high during a decline, thus resulting in a loss (Investors require a higher rate, or think of them selling risky bonds). Remember, if we think spreads are going to widen we don’t want to be holding the asset with the higher rate (Corporate risky)
Theres also cyclical vs non-cyclical bonds… Cyclical underperform during economic slowdown
During a market downturn, two things happen: interest rates go down and spreads go up. Interest rates go down primarily because of monetary policy (the Fed adjusts short term rates down). Spreads go up because there is now more default risk for riskier corporate bonds.
A bond has two sources of value: the current trading value (as reflected by the price) and the value of future payments (as reflected by the yield).
It’s further useful to categorize bonds into old and new issues. Old issues have a variable price because their coupons are locked in. New issues have a variable yield because their prices are locked at par (at the time of issuance).
So we can consider 4 categories of bonds to highlight what happens during a market downturn.
Risk Free Treasuries (New Issues): For a new issue, the yield is the coupon rate paid on the bond and the the price is par. Because market interest rates have gone down, the yield has gone down. There’s no need to offer a 2.5% coupon rate when the interest rate the market will accept is at 2%. A new issue becomes an old issue as soon as it starts trading on the secondary market (as soon as it’s issued, basically). Once it becomes an old issue, the yield is no longer the same as the coupon rate, since the yield is affected by the fluctuating trading price.
Risk Free Treasuries (Old Issues): Old issues need to have the same yields as new issues since they are the same class of assets (risk free bonds). In order to sell the treasuries you have on hand, you’re going to have to price it in a way that it’s competitive to the new issues. Thus, because lower interest rates means lower yields on new issues (aforementioned), old issues must also have lower yields. Since the coupon is fixed, the price of the bond must go up to ensure the yield decreases. So, in a declining market, old issues of treasuries see lower yields and higher prices. You would purchase treasuries because you expect interests rates to decline even further, which would mean the price of the treasury increases even more, which you can then sell at a profit.
Risky Corporate (New Issues): Unlike treasuries, corporate bonds have a default risk that increases as the economy suffers. As the market suffers a downturn, the company’s business may sour and it may not be able to pay its bond obligations. As a result, the company must offer a high coupon rate on its bonds to attract investors, despite the decrease in interest rates. Since coupon rate = yield for new issues, spreads (corporate yield - treasury yield) increases. Spreads increase more for riskier bonds than they do for lower risk bonds because riskier bonds have to offer a higher yield to offset their higher default risk. Another way of saying this is bonds that are more risk-free like a treasury will have a yield that closely tracks the treasury yield (decreasing), whereas bonds that are more risky will have a yield that diverges strongly from the treasury yield (decreasing slower or increasing).
Risky Corporate (Old Issues): Old issues of corporate bonds will also have to match the yield (and spread) of new issues. Suppose a BB bond issued last year is yielding 7% when the economy was stronger and new BB bonds issued are paying 9% to account for higher default risk in a bad economy. All else being equal, the old issue will also have to match the 9% yield. Since coupon payments are static, the bond price must go down. As a result, if you had owned this bond, the value of your bond portfolio just decreased if you were to trade it now. You would avoid these risky bonds during a slowdown in the economy because their yields will diverge from the treasury yield (spread increases) and depending on their credit rating, may even increase to the point that prices go down.
Mark it