Question says the client is dependent on cash flows from a portfolio. Long term bonds offer the investor a longer and more certain income stream (at least in an upward-sloping market long-term bonds have higher yields). But longer term bonds have higher duration risk, so this reduces their certainty. All in all, do longer term bonds have more or less certain income streams?
longer term fixed bond offers coupons to the investor for a longer time - so it is a more certain income stream in that respect.
The duration risk arises from the yield curve - which makes the “final principal” payment less certain. Also it affects the reinvestment income from reinvesting the coupons. (which is higher)
So those are the multiple aspects
- Longer term = more fixed coupons for longer (CERTAIN)
- Longer term + upward sloping yield curve = CERTAIN loss of principal when the bond becomes due.
- Upward sloping yield curve = CERTAIN HIGHER reinvestment income
Now which impact is higher - would be something that is difficult to tell. But if you read the Fixed income reading - (SS 10 - where they talk about immunization etc). the effect of loss of principal at repayment of the bond is greater than the reinvestment income aspect.
Total return from bonds = Coupon Return + Reinvestment Return of coupons.
In the longer term bonds, uncertainity of the Reinvestment return is more (irrespective of whether Curve is upward sloping or not).
This is how I understood this concept!
If all you are worried about is matching cash flows then, long term, fixed coupon bonds should meet your requirements. They do have higher durations which will cause the market value of the bond to shift with changes in the yield curve, however you are holdng the bond to maturity and therefore are certain of the return you will earn on the bond. The principal amount you recieve at maturity will not change if the yield curve shifts. You will only realize the impact from the yield curve if you sell at market value prior to maturity.
All in all, I would say longer term bonds have more certain income streams.
cpk123, if principal of the bond is 100, then at maturity, you receive 100, no matter what yield curves have done. Not sure what you mean by final principal payment is less certain.
Ditto - I don’t think the final cash flow has any thing to do with yield curve
However,
investor is shooting for capital preservation in this case (depends on cash flows). So the question is should she invest in lt for the return objective
yes
what about duration risk? current yield curve is upward sloping, if the slope increases further say after 6months say 6% is now 8% for the same maturity and the reduced price, the investor is losing, because the mkt value of the security has declined - why? If it were that the investor is faced the choice now for same coupon and maturity, the investor is better off investing now as the same security is priced less, rather than had been committed to the original term.
Lets say the client needs to sell the bond for need of cash, she sells the bond with remaining cash flow, and receives an amount less than par as its price has reduced.
i believe this is what the qn regards as “duration risk of cashflows”
I’m certain nothing in finance is certain.
It always depends.
you are the investor. you invested in the bond. you will shell out the 100 to who you bought it from - but actual value that you get by trying to sell it will be lower (if rates have indeed gone up).