Actuarial Investments

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Actuarial Investments

• Shane Whelan
• L527

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Description of Key Markets

• - THE BOND MARKET
• I of II

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Bond

• A bond is a negotiable loan raised by some body,
  with generally fixed interest payments and
  redemption date (fixed interest bonds). There
  are other types see later.
• If Government is issuer then often called
  gilt-edged or simply, gilts.
• The largely known cashflows from a bond makes
  them specially useful to matching liabilities
  either nominal ( with fixed interest) or real
  liabilities (with index-linked).
• Very low dealing costs high average bargain size

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The Simplicity of a (Fixed Interest) Bond
Proceeds of a Bond
Proceeds
Years
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Bond Markets

• Bonds can be sub-divided into
• Conventional bond
• Index-linked bond
• Variable interest rate bonds (e.g., FRNs)
• Or Bond markets can be divided into
• Government bonds (gilts), listed in country of
  origin.
• Markets for corporate bonds, listed in country of
  origin
• Government Corporates listed outside country of
  origin
• Eurobond markets.

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Conventional Government Bonds

• Represents the bulk of bonds in issue
• But shrinking in relative size
• generally held by institutional investors.
• Markets are deep (high marketability) and wide
  (extensive choice for matching).

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Source Burger Warnock (2004) Foreign
Participation in Local Currency Bond Markets.
International Finance Discussion Paper No. 794,
Board of Governors of the Federal Reserve System
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Sterling-denominated Government bonds, by
Calendar Year of Maturity ( Billions Nominal,
including inflation uplift), July 2004
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Outstanding Euro denominated Government bonds, BY
Maturity Year (as at Sept. 2003) billions
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Bond Markets -Terminology

• Terminology
• Coupon
• Term
• Nominal Value
• Redemption
• Ex-dividend
• Cum-dividend
• Accrued Interest
• Clean Price
• Dirty Price
• (Gross) Redemption Yield
• Net redemption yield
• Running yield

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Corporate Bonds

• Same key features as government bonds,
  differences relating to
• Security - lower
• Marketability generally less
• Maybe differences in Tax
• Hence higher yielding spread depending on
• Security marketability
• Differences if any in tax treatment
• Economic conditions/conditions in industry which
  reflect on security

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Corporate Bonds - Security

• Types of security
• Unsecured
• e.g., unsecured loan stock
• Floating charge on assets of company
• e.g., Debenture is secured on assets (generally
  floating) of company
• Fixed charge assignment of specific assets to
  cover debt on default.
• e.g., Mortgage debenture fixed charge on
  specified properties.
• Also senior and subordinated debt a hierarchy
  of security described as always in the trust
  deed.

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Assessing Security of Corporate Debt

• Income Cover no. of times operating profit
  exceeds interest on loan and that on any more
  senior debt. Level of cover demanded depends on
• Profit stability
• Prospects for company
• Term of loan
• Yield spread
• Capital cover

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Assessing Security of Corporate Debt

• Capital cover no. of times that the assets of
  co. (excluding intangibles and after notionally
  paying current liabilities) cover the loan and
  any prior ranking debt. Level demanded depends
  on
• Balance sheet values quality of assets
• Term of loan
• Yield spread
• Income cover

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Assessing Security of Debt

• Credit Rating agencies such as Standard Poor,
  Moodys, IBCA give credit ratings to company
  debt. Use them.
• In SP system the list is AAA, AA, A, BBB, (draw
  a line), BB, B, CCC, CC, C, C1, D.
• From BB down they are speculative
  (non-investment grade)
• Moodys go A1, A2, A3, B, C, D
• Under both systems D means the bond is in default
  (missing a payment)

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Eurobonds

• Eurobonds are underwritten by an international
  syndicate of banks who sell it on to their
  clients. Issued in eurocurrencies (see Lectures
  on Money Market). Issuer can be government,
  company, etc.
• The bonds
• Bearer Bonds
• Annual interest paid gross
• Not secured bond-holders rank with trade
  creditors on a wind-up
• The market
• OTC by banks (but can be listed on national stock
  exchanges)
• Fixed and FRNs
• Yield based on yield curve of denominated
  currency.

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Other Bonds

• Issued by regional authorities, with tax raising
  powers.
• Issued by governments outside of the governments
  own country Yankee bonds, Bulldogs, Samurai
  bond.
• Junk bonds do not satisfy reasonable demands of
  security (income or capital).

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Sundry Points on Bond Markets

• Strips common now in most developed bond
  markets,
• e.g. in UK conventional gilt market, on
  conventional and IL (US) Treasuries. In most
  sovereign bond markets since 1999.
• Repos sell and buy-back agreements to raise
  money on secure terms.
• See Money Market, Lectures 3-4, as well
• Stock-lending.
• Enabling some to short a stock sell what they
  do not own.

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Index-Linked Bonds

• Introduced 1981 in UK, now in many countries (US
  since 1997).
• Payments coupon redemption proceeds escalate
  in line with consumer price inflation, lagged a
  no. of months.
• Typically, smaller issue sizes than conventional
  gilts hence lower marketability.
• Quote real yield
• a fall in real yield leads to an increase in
  real price.

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Real Yield on Gov. Guaranteed Index-linked Bonds,
2002
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Actuarial Investments

• Shane Whelan
• L527