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Invest in Bonds

Essay by   •  March 16, 2017  •  Essay  •  917 Words (4 Pages)  •  973 Views

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While investors are going to invest in the bond market, they may firstly consider the macroeconomic condition to decide on their investment strategies. In this essay, it is generally expected that the U.S. Federal Reserve will continue to raise interest rate in the foreseeable future and the price of bond is likely to decline because it is the present value of the coupon payments and maturity value.

Under this expected condition, there are still many ways people can make profit in the bond markets. Here are some strategies for investing and profiting.

Strategy 1: Buy a Floating-Rate Bond.

To the extent that interest rates reflect the expected inflation rate, floating-rate bonds have a lower level of inflation risk. Here we choose Morgan Stanly Float 02/14/20 corporate bond as an example:

Bond Description

[pic 1]

We can see from the bond description that it’s coupon rate is reset quarterly based on the reference rate (3-month U.S. LIBOR) plus the quoted margin (80 basis points). Here we suppose the interest rate increases by 0bp, 50bp, 100bp, 150bp and 200bp respectively in two years from now, the expected coupon rate is calculated as below:

Expected Coupon Rate

[pic 2]

With these numbers, then we get the coupon payments:

Coupon Payments

[pic 3]

Then we assume all the coupons can be reinvested on interest rates equal to the floated coupon rates, then we get their value on 2019/2/15 when we decide to sell this bond:

FV of Reinvestment

[pic 4]

Finally, summing up the future value of coupon reinvestment and the bond price on 2019/2/15, we get the bonds’ total future value and the correlated HPR:

[pic 5]

Through this investment strategy, people are able to avoid inflation risks as well as interest-rate risk. Because of increased interest rates, people also do not need to worry about the influence of reinvestment risk. Based on the credit rating, we only suffer little credit risk that the corporation may default. As this bond is traded in U.S. dollar and Hong Kong dollar has a fixed exchange rate with U.S. dollar, exchange-rate is unimportant and we do not need to care about it. However, we are exposed to liquidity risk as we do not want to hold it to maturity. Based on the existed data, the spread between the bid price and the ask price quoted is not much wider, so we may suffer loss if we cannot successfully sell this bond at a proper time.

As this is a callable bond, it’s price equals price of option-free bond minus price of embedded option. If volatility risk increases while remain all other factors unchanged, the option price will increase and bond price further decrease. Under this situation, we may not face call risk because corporate is more likely to retire the issue when it’s market price increases, so this may not happen under our assumption.

Strategy 2: Buy a high yield bond

As the interest rate increases, we are likely to suffer a loss because the bond price decreases. Under this condition, buy a high yield bond can be a better chose for us investors. Here we choose Republic of Indonesia 03/04/19 corporate bond as an example:

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