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Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 6 - The Domestic and International Bonds Market

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter six.

Chapter introduction

When lending funds the lender will want the principal to be returned (that is the original sum of money lent) and to receive interest, at a rate that is usually expressed as a percentage per annum of the principal loaned. Interest rates charged on loans reflect many factors, such as the length of the loan, the perceived risk attached to the borrower of funds, fundamental economic forces, the liquidity of the loan contact and expected inflation during the period of the loan. In this chapter we examine the fundamental forces that determine the price of bonds issued by governments, which in turn provides the benchmark for the cost of funds for corporations and other borrowers.

Government bonds are very important financial securities. They have a high degree of liquidity and transaction costs are much lower than for equities. In addition, settlement takes place the day after the transaction. Bonds are held by a variety of financial institutions including pension funds, insurance companies, banks and savings societies. Some financial institutions tend to invest in bonds for the whole life of the bond, especially pension funds and insurance companies, while others such as banks tend to on-sell much of their bond holdings prior to maturity in order to meet short-run liquidity demands. Government bonds are sometimes accorded special tax treatment to encourage investors to hold them.

Learning Objectives

In this chapter you will learn about:

A Bulleted List

  • ​The pricing of Treasury bonds and their relationship with long-term interest rates
  • The meaning of yield to maturity
  • Bond price volatility and the meaning of duration
  • The economic significance of the yield curve
  • The role of credit rating agencies
  • The difference between domestic, foreign and Eurobonds

Further Reading

Brown, P. (2006) An Introduction to the Bond Markets, Wiley.

Choudhry, M. (2006) An Introduction to the Bond Market, 3rd edn, Wiley.

Fabozzi, F. (2009) Bond Markets, Analysis and Strategies, Pearson.

Revision Questions

  1. Explain the difference between a domestic bond, foreign bond and a Eurobond giving examples of each.
  2. A Treasury bond with ?100 maturity value has a ?7 annual coupon and 10 years left to maturity.
    (i) What price will the bond sell for assuming that the 10 year yield to maturity in the market is 4%, 7% and 10% respectively? (Show your calculations.)
    (ii) What would be your answer to part (i) if the bond only had 8 years to maturity?
    (iii) What would be your answer to part (i) if the bond had only 4 years to maturity?
    (iv) What does your answer to parts (i) to (iii) tell you about the relationship of bond prices, term to maturity and changes in bond yields?
  3. Currently the yields to maturity on 10 year bonds are as follows:
    Bond type Yield to maturity
    Treasury 5.00%
    AAA corporates 6.00%
    BBB corporates 8.00%

    You are a bond manager and currently have 33% of your portfolio in Treasuries, 33% in AAA corporates and 34% in BBB corporates. Your analysis of ‘normal’ yield spreads suggest that AAA bonds should offer about 150 basis points above Treasuries and BBB bonds should offer about 250 basis points over Treasuries.

    How will you adjust your portfolio and what does this involve you in doing?
    Suggest a new indicative weighting for your bond portfolio between the three classes of bonds.
  4. (i) Calculate the Macaulay duration for an ?8 annual coupon bond with a face value of ?100 and 5 years left to maturity if the bond’s yield to maturity is 10%.
    (ii) What is the modified duration of the bond?
    (iii) If the 5-year yield to maturity were to suddenly increase from 10% to 10.30% and the bond in problem (i) was selling for ?92.42 at 10% yield, what would you expect the bond price to be after the yield increases to 10.30%?
  5. You currently have a ?100 million bond portfolio invested 30% in 5 year bonds with a modified duration of 4.05 years, 25% invested in 10 year bonds with a modified duration of 6.88 years and 45% in 20 year bonds with a modified duration of 10.09 years. The yield curve is currently flat at 8% across all maturities (5 year, 10 year and 20 year).

    (i) Calculate the modified duration for your entire bond portfolio.
    (ii) What will be the approximate value of your portfolio if the entire yield curve suddenly shifts down to yield 7.5% across all maturities?
    (iii) What might you wish to do with the length of the duration of your portfolio in the light of a projected fall in bond yields from 8% to 7.5%?
    Suggest a new weighting for your portfolio to achieve this and what it would involve you doing.
  6. Consider the following bond data:


    (i) Is the duration of bond 4 shorter or longer than bond 3 or can we not say? Explain your reasoning.
    (ii) You expect bond yields to fall across all maturities by 1%. What strategy will you employ in respect of bonds 1 and 5?
    (iii) If you expect a recession and fall in yields generally combined with a widening of the corporate bond spread, which of bonds 2 and 6 would you choose to buy? Explain your reasoning.
    (iv) Consider bond 5. If the yield to maturity on this bond were to move downward because of a credit rating upgrade to 12% what would be the expected percentage price change in this bond?
  7. Briefly explain what is meant by a warrant attached to a bond and the advantages/disadvantages to a firm of issuing a bond with a warrant attached.
  8. A Treasury bond with ?100 maturity value has a ?6 annual coupon and 4 years left to maturity.
    (i) What price will the bond sell for, assuming that the 4-year yield to maturity in the market is 7%? (Show your calculations.)
    (ii) What would be your answer to part (i) if the 4-year yield to maturity in the market is 9%? (Show your calculations.)
    (iii) What does your answer to parts (i) and (ii) tell you about the relationship of bond prices, term to maturity and changes in bond yields?

Multiple Choice Questions

Click here to launch multiple choice questions for chapter 6.