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Lecture 6:

Bonds:
- The issues of bonds that trade in the Aus. Market
- Commonwealth treasury (most important) Australian govt.
- State Govt.
- Non-Govt. issuers (biggest issuer)
Bond market enhance the flow-of-funds:
- Enables Wholesale borrowers to raise large sums for long term and
institutional investors to invest in long term securities with higher
returns and risks than money market securities
- Performs price discovery of long term interest rates (yield in the bond
market is semi annual compound rate, trading in treasury bonds reveal
default free interest rates, trading in semi govt. and non-govt. bonds
reveal credit spreads)
- Credit spreads: extra yield on non-govt. bonds over the yield on treasury
bonds
Treasury bonds issued:
Parcels of Treasury bonds are issued via a tender process:


Treasury bonds:
- there is not one type of treasury bond
- Fixed-rate treasury bond: 10 or more bond series distinguished by
different maturity dates, each series has a fixed coupon rate, a series is
identified by its coupon rate and maturity date
Trading treasury bonds:
- It is a wholesale OTC market where dealers operate as market makers
under AFMA trading protocols
- They are actively traded, dealers quote bid offer yields, $10m is standard
parcel size, each treasury bond has a face value of $1000, settlement is
through Austraclear
State govt. issue bonds:
- They are called semi-governmental or semis
- Issued by state borrowing authorities or state agencies
- Medium long term bonds w fixed or floating coupon rates
- Yields are higher than treasury bonds
- Issued through dealer panels, often as a closed auction these dealers
make the secondary market
Major non-govt. bond issuers:
- Mostly major banks
- Kangaroo bonds
- MBS
- Corporate bonds
MBSs: Mortgage backed securities
- Fund residential properties
- Issued in tranches where each tranche has different terms
- Most are floating-rate bonds with a nominal maturity of 25yr
- Make regular payments that include both interest and principal
- Interest is paid quarterly based on BBSW at the start of each quarter

- Who are the other major issuers:
- Kangaroo bonds (non residents)
- Non-financial companies (issue long term bonds for large amounts
How is settlement price of bonds calculated:
- Bonds settlement price is the present value as at T+3 of its remaining
payments using the agreed yield at which it was traded
- Coupons are paid at 6 montly on the 15
th
day of the coupon month
- On the 8
th
day of a coupon month the coupon is assigned to the then
holder
- Price of a bond on a coupon date does not include the coupon paid on the
coupon date

Bond prices very inversely with yields:
- In the formula for bond prices the purchase yield is in the denominator
and the rules of maths explain their inverse relationship with P
Calculate bond investment yields:
- returns from a bond investment are:
- Coupons received
- Interest earned on the reinvestment of the coupons
- The bonds face value (or selling price if sold before maturity)
- Elements that comprise the investment return are shown on the time line
for a three year bond


Reinvestment of the coupons:
- in the example it was assumed they were invested by buying more of this
bond at 5%, hence they earned 5% not 5.6%
- Had the coupons been reinvested at more than the purchase yield the
investment would have earned more than 5.6% pa
- The risk of reinvesting the coupons at a lower yield than the purchase
yield is called Reinvestment risk
- Its severity increase with the length f the investment
Bonds are sold before their maturity:
- This is the holding-period investment strategy used by active investment
managers
- The plan is to enhance the earning from the coupons received over the
holding period with a capital gain when selling the bonds
- A capital gain is achieved if the bonds selling yield is lower than the
purchase yield
- But the strategy eposes the bond investor to price risk (the risk of selling
at a loss due to an increase in the money market yield
- Price risk diminishes as bonds approach their maturity date
- Holding a bond to maturity avoids the risk of capital loss


Bonds as an investment:
- treasury bonds are expected to be defaultrisk free- yield is likely to be low
relative to other investments
- When the bonds are held to maturity their yield will be similar to the
yield at which they were purchased
- Dont earn high return but less risk
- But they face risk that yields in the bond market increase, which reduces
the value of the bonds
Long term rates change:
- The 10 year bond yield is the reference long term bench mark rate
- The influence upon demand for bonds and bond yields is the expected
inflation rate over the bonds term
- An increase erodes the expected purchasing power of a bonds fixed
payments
- So reduces demand and hence the price for the bond causing its market
yield to increase
- Other influence inclue liquidity premiums
- Liquidity causes higher yields
- Flight to quality that occurred during the GFC
- Treasury bond yields fell relative to non-govt. bond yields

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