Tough time with Fixed Income

CFA Level I
#1

Basic stuff like the below:

Which pair of features will be most likely to increase a bond’s duration compared to an otherwise identical bond?

A is not right because of the lower rating.

B is not right because of the higher yield to maturity. I think im getting confused with Yield to Maturity and Maturity, and Yield. is YTM and yield the same?

A) Lower rating and coupon rate. B) Higher yield to maturity and longer maturity. C) Greater liquidity and a higher rating.

Answer is C

Both greater liquidity and a higher rating will tend to increase the bond’s price and decrease its yield to maturity. Other things equal, a bond with a lower yield to maturity will have greater duration (interest rate risk).

So only Maturity is postively related to interest rate risk. Interest rate risk = duration. Whats a good way to remember everything else. Everything else is inverse?

#2

Longer maturity = longer duration.

Higher YTM = shorter duration.

Higher coupon = shorter duration.

If you understand Macaulay duration, this stuff is easy to remember. If you don’t understand Macaualy duration, blame CFA Institute: they removed the explanation of Macaulay a few years ago (not wisely, in my opinion).

#3

S2000 you are the man. I’m getting confused with Ratings. Higher rating, would increase the bonds price, and lower the yield.

But a lower rating… I thought… would also increase the bond price. If a rating gets lowered, wouldnt bond buyers want a higher price for it???

Is there a difference between yield to maturity and yield for bonds?

#4

If a rating gets lowered, bond buyers would not be willing to pay as much for the bond due to the increase in perceived credit risk and would therefore want a lower price.

#5

ok, so then the bond price goes down, yield goes up. And higher yield = lower duration. Thank you.

#6

Thanks.

With a lower rating, buyers want a higher yield; hence, a lower price.

Generally, no; when people talk about a bond’s yield, they generally mean yield to maturity.

(They can mean other things – current yield, yield to worst, and so on – but generally if they mean something other than YTM they’ll be explicit.)

#7

Thanks, one thing that i should have known is… High Yield Bonds = Junk Bonds = Bonds with low rating. So price would be down also.

THANKS

#8

One follow up question:

6 months ago, investor purchased a bond rated BB+. TOday the bond rating is changed to BBB -. The most likely effect of this rating change is

A; Decreased call risk

B: increased interest rate risk

C. an increase in yield to maturity

2 of these are correct right? But one is more correct than the otheR?

#9

The upgrade from BB+ (speculative grade) to BBB– (investment grade) should lead to a decrease in YTM. At a lower YTM the bond will have a higher effective duration and more interest rate risk.

This is their reasoning… Isn’t it a down grade and not upgrade also?

#10

i havent slept alot… BBB- > BB+

#11

It definitely is an upgrade from junk to investment grade. Investors will accept a lower yield from high quality bonds but will demand for higher yield from junk bonds to compensate them for higher risks.

#12

You’re not alone in this for sure. I don’t actually have an insomnia but I am having trouble sleeping at the usual time these past couple of days. The good thing is it will be over soon…

#13

One follow up question: 6 months ago, investor purchased a bond rated BB+. TOday the bond rating is changed to BBB -. The most likely effect of this rating change is A; Decreased call risk B: increased interest rate risk C. an increase in yield to maturity 2 of these are correct right? But one is more correct than the otheR? Higher credit rating leads to lower yield, thus, higher interest rate risk. A is not correct because when yield decreases, the market price of the bond increases. This results to an increased call risk as issuers would be able to call the bonds at lower (exercise) price than what the market charges. C is definitely incorrect.

#14

Sorry, why Higher YTM = Shorter Duration ?

#15

The easiest way to see it is to draw a price vs. YTM graph for a bond. At the right end the price drops a lot more slowly than at the left end: lower duration at the right end.

(Yes, I know that (modified) duration isn’t the slope of the price vs. YTM graph, but it’s close enough to give the right visualization.)

From Macaulay duration: as YTM increases, the present value of more distant cash flows decreases more than the present value of nearer cash flows (because they’re being discounted for more years); thus, the near-term coupon dates have higher weights than the more distant dates, and the weighted-average time to receipt of cash – Macaulay duration – is shorter.

#16

I got it. Thank you so much !

#17

My pleasure.

#18

i am a big fan of S2000Magician…you are really a magician…

#19

You flatter me.