Financial Institutions and Markets 7th

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Chapter 8: The bond market

TRUE/FALSE

1. Most bonds pay a series of coupon payments and are redeemed on their maturity date by the payment
of their face value.

ANS: T
There are many types of bonds but these are the features of a standard bond.

PTS: 1 DIF: Easy REF: Introduction

2. A convertible bond is a medium term security where the coupon rate is based on the reference rate at
the start of each coupon period.

ANS: F
A convertible bond can be converted into the issuer’s shares under specified conditions.

PTS: 1 DIF: Moderate REF: Introduction

3. Australia’s principal bond market is the wholesale, OTC, primary market for Commonwealth
government, state governments and non-government issuers.

ANS: F
It is the secondary market for these bonds.

PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market

4. The amount of Treasury and semi-government bonds outstanding has increased in recent years
because of the impact of the GFC.

ANS: T
The crisis caused government revenues to fall and expenditures to rise resulting in budget deficits
that have been financed through bond issues.

PTS: 1 DIF: Easy REF: 8.1 The OTC bond market

5. Non-government bonds only make up a small proportion of the total amount of bonds issued in the
Australian market.

ANS: F
They are the largest category of bond issuer, with outstanding issues approximately equal to the
Commonwealth and state government issues combined.

PTS: 1 DIF: Easy REF: 8.1 The OTC bond market

 6. Bonds are a high-risk, high-return asset class compared with shares.

ANS: F
Bonds are riskier than money-market securities as an asset class but less risky than shares.

PTS: 1 DIF: Moderate REF: 8.1.1 Contribution to the flow of funds

7. Investors in the bond market face the issuer’s credit risk and the securities’ market risk.

ANS: T
Most bonds in the Australian OTC market are highly rated and so pose low credit risk. Market risk
stems from interest rate movements which cause bond prices to change.

PTS: 1 DIF: Moderate REF: 8.1.1 Contribution to the flow of funds

8. Trading in Treasury bonds reveals the interest rate that applies on long-term loans.

ANS: F
The Treasury bond yield is regarded as default-free. Hence credit risk premiums need to be added to
Treasury bond yields to determine the interest rates that should apply on other long-term loans.

PTS: 1 DIF: Moderate REF: 8.1.2 Contributions to price discovery

9. Credit spreads are measured by the difference between the market yields for risky bonds less the
yield on Treasury bonds with the same term.

ANS: T
They represent the price of risk because they show the risk premium borrowers have to pay
depending upon their credit rating.

PTS: 1 DIF: Moderate REF: 8.1.2 Contributions to price discovery

10. Credit spreads change over time, reflecting changes in investors’ attitudes to risk.

ANS: T
For example, the GFC caused credit spreads to widen considerably.

PTS: 1 DIF: Moderate REF: 8.1.2 Contributions to price discovery

11. Australia has a large low-grade (or speculative-grade) bond market.

ANS: F
This is true of the US bond market. In Australia, the majority of bonds are highly-rated (AAA or
AA).

PTS: 1 DIF: Easy REF: 8.1.2 Contributions to price discovery

12. Australia’s bond market is conducted by the ASX.

ANS: F
Whilst some bonds are traded on the ASX, this is a very small market compared to the wholesale
OTC market.

PTS: 1 DIF: Easy REF: 8.1.3 Trading and settlement

13. Bonds are traded over-the-counter by dealers who provide bid-offer prices.

ANS: F
Dealers quote bid-offer yields. The yield agreed to is used to calculate the settlement price.

PTS: 1 DIF: Moderate REF: 8.1.3 Trading and settlement

14. A bond trade is settled after three business days.

ANS: T
Treasury bonds are settled T + 3 and this is arranged by Austraclear, the market’s clearinghouse, on
an RTGS basis.

PTS: 1 DIF: Easy REF: 8.1.3 Trading and settlement

15. The turnover in Treasury bonds dominates the secondary bond market.

ANS: T
Non-government issues exceed the amount of Treasury bonds (see figure 8.1) however many
non-government (and semi-government) bonds are not actively traded, while Treasury bonds are
very liquid.

PTS: 1 DIF: Moderate REF: 8.2 Market segments

16. Treasury bonds are long-term securities issued by state governments or their borrowing authorities.

ANS: F
Treasury bonds are long-term bonds issued by the Australian Commonwealth government.

PTS: 1 DIF: Easy REF: 8.2.1 Treasury bonds

17. The bonds issued by a particular borrower are referred to as a bond series.

ANS: F
Treasury bonds are divided into series according to their maturity date and coupon rate.

PTS: 1 DIF: Moderate REF: 8.2.1(a) The issuing process

18. A Treasury bond’s coupon rate is based on the market yield at the time it is first issued.

ANS: T
New Treasury bond series are issued at par (or close to).

PTS: 1 DIF: Moderate REF: 8.2.1(a) The issuing process

19. Treasury bonds are issued through a competitive tender process where dealers submit bids as interest
rates and bonds are allocated to the highest bidders.

ANS: F
Bonds are allocated to the lowest bidders, given the inverse relationship between interest rates and
prices.

PTS: 1 DIF: Difficult REF: 8.2.1(a) The issuing process

20. Treasury bonds tenders can be for extra bonds of an existing bond series or they can be the first
bonds issued in a new series.

ANS: T
As at September 2013 there were 18 bond series, providing investors with a wide range of maturities.

PTS: 1 DIF: Moderate REF: 8.2.1(a) The issuing process

21. Bonds issued by state governments are referred to as semi-government bonds.

ANS: T
‘Semis’ are issued by the borrowing authorities of state governments and by government agencies.

PTS: 1 DIF: Easy REF: 8.2.2 Semi-government bonds

22. The market for fixed-interest TCorp bonds would be just as effective as the Treasury bond market in
performing the price discovery function for long-term interest rates.

ANS: F
TCorp bonds are less liquid and have fewer series (and thus provide fewer observations). Moreover,
the NSW government is less creditworthy than the Australian Treasury and so its yields include a
small risk premium that could vary independently from the default-free rate.

PTS: 1 DIF: Difficult REF: 8.2.2 Semi-government bonds

23. The secondary market for semis is not as liquid as the market for Treasury bonds.

ANS: T
The Treasury bond market is the most liquid bond market in Australia. The liquidity of semis is
enhanced through the establishment of dealer panels, limited bond series and central borrowing
authorities.

PTS: 1 DIF: Easy REF: 8.2.2 Semi-government bonds

24. Prior to the mid-1990s, the issue of non-government bonds was very low in Australia.

ANS: T
Non-government bonds have since become the largest category of issuer.

PTS: 1 DIF: Easy REF: 8.2.2 Semi-government bonds

25. The major banks mostly issue long-term fixed-rate bonds in the bond market.

ANS: F
They mainly issue medium-term floating-rate notes.

PTS: 1 DIF: Moderate REF: 8.2.3(a) Financials

26. ‘Kangaroo bonds’ are issues by Australian borrowers in offshore bond markets.

ANS: F
These are issues of AUD bonds by non-residents in Australia’s bond market.

PTS: 1 DIF: Easy REF: 8.2.3(b) Non-resident bonds

27. Mortgage-backed securities are mainly 25-year fixed-rate bonds.

ANS: F
The securities are usually floating-rate, reflecting the interest rate basis on the underlying assets.
Their indicative term is often 25 years, but they may be repaid early depending on the payments on
the underlying loans.

PTS: 1 DIF: Moderate REF: 8.2.3(c) Mortgage-backed securities

28. MBSs issued by Australian institutions proved to be reliable unlike MBSs issued by US institutions.

ANS: T
However the crisis caused investors to abandon MBSs in general.

PTS: 1 DIF: Moderate REF: 8.2.3(c) Mortgage-backed securities

29. ‘Credit wrapping’ is a credit enhancement practice that allows lower-rated borrowers to issue bonds
at a lower yield.

ANS: T
For example, a financial institution may guarantee the bond’s payments.

PTS: 1 DIF: Moderate REF: 8.2.3(d) Bonds issued by non-financial

companies

30. Bonds issued by non-financial companies only make-up a small proportion of the market because
each borrower just issues a small amount of bonds.

ANS: F
Bond issues involve substantial costs so are only economical when relatively large amounts are
raised.

PTS: 1 DIF: Difficult REF: 8.2.3(d) Bonds issued by non-financial

companies

31. Bonds are rated when issued and this rating is kept under review (and may be modified) up until
when the bonds are redeemed.

ANS: T
This is necessary given that bonds are long-term securities.

PTS: 1 DIF: Easy REF: 8.2.4 Ratings agencies

32. The cost of credit ratings is borne by investors who want access to the ratings information.

ANS: F
The cost is paid by the bond issuer. It is necessary because investors are generally unwilling to
purchase unrated bonds.

PTS: 1 DIF: Moderate REF: 8.2.4 Ratings agencies

33. Fixed-rate Treasury bonds pay coupons six-monthly on the first day of the coupon month.

ANS: F
Treasury bonds pay interest six-monthly on the 15th or the 21st of the coupon month, whichever
corresponds to the maturity day.

PTS: 1 DIF: Moderate REF: 8.3 Calculating bond investment yields

34. The 4.5 per cent 15 April 2020 Treasury bond will pay coupons of $2.25 (per $100 of face value) on
15 April and 15 October each year up to and including maturity.

ANS: T
Treasury bonds pay interest six-monthly on the 15th or the 21st of the coupon month, whichever
corresponds to the maturity day.

PTS: 1 DIF: Easy REF: 8.3 Calculating bond investment yields

35. The ex-interest period is one week before the coupon payment date.

ANS: T
Bond trades for settlement during the ex-interest period do not transfer ownership of the next
coupon.

PTS: 1 DIF: Moderate REF: 8.3 Calculating bond investment yields

36. The coupon component of a bond can be valued as a perpetuity.

ANS: F
The coupon component of a bond can be valued as an annuity.

PTS: 1 DIF: Moderate REF: 8.3.1 Calculating a bond’s price on a coupon

date

37. If bond yields rise above the coupon rate, the bond will trade at a discount to its face value.

ANS: T
Prices and yields are inversely related – if bond investors now require a higher return that can only be
achieved by them paying a lower price, since the bond’s coupons and face value are fixed.

PTS: 1 DIF: Easy REF: 8.3.2 Bond prices and movements in yields

38. A discount bond represents a better value investment than a premium bond.

ANS: F
Bonds trade at a discount when the coupon rate is less than the market yield, and at a premium when
the coupon rate exceeds the market yield. One is not a better investment than the other as the best
estimate of return to maturity is the market yield.

PTS: 1 DIF: Moderate REF: 8.3.2 Bond prices and movements in yields

39. Long-term bonds have greater potential for capital gains than short-term bonds.

ANS: T
Price risk is positively related to the term to maturity.

PTS: 1 DIF: Difficult REF: 8.3.2 Bond prices and movements in yields
40. Bond portfolio managers typically reinvest the coupons received in money market securities.

ANS: F
They reinvest coupons by purchasing more bonds.

PTS: 1 DIF: Moderate REF: 8.3.3 Bond investments

41. Given a two-year investment in 10-year bonds, the selling price is calculated for an eight-year bond
and the investment yield is calculated over two years.

ANS: T
The value of ‘n’ in the settlement price formula is 20 when the bond is acquired, it is 16 when the
bond is sold and four when used to calculate the accumulated value of the coupons and the
investment’s yield.

PTS: 1 DIF: Moderate REF: 8.3.3 Bond investments

42. All managers of bond portfolios will buy and sell with the aim of achieving higher returns than the
market.

ANS: F
Whilst this is true of active managers, passive managers will pursue a buy and hold strategy with the
aim of matching market returns.

PTS: 1 DIF: Moderate REF: 8.3.3 Bond investments

43. An investment strategy to buy bonds which are then held until their maturity poses price risk.

ANS: F
Price risk arises when a bond is sold before maturity. A buy-and-hold strategy does pose
reinvestment risk.

PTS: 1 DIF: Easy REF: 8.3.3(a) Reinvestment risk

44. Bond investors face reinvestment risk because they are assumed to reinvest the coupons they are
paid.

ANS: T
The investors do not know in advance the yields they will earn on the reinvested coupons.

PTS: 1 DIF: Moderate REF: 8.3.3(a) Reinvestment risk

45. At least to some extent, the effects of price risk and reinvestment risk on bonds offset one another
(for investors who plan to sell before maturity).

ANS: T
When yields fall prices rise, however coupons are now only able to be reinvested at a lower yield.
When yields rise prices fall, however coupons are now able to be reinvested at a higher yield.

PTS: 1 DIF: Difficult REF: 8.3.3 Bond investments

46. An investor in bonds who intends to sell them before they mature is exposed to price risk.

ANS: T
The investor will not know (when the investment is made) the yield at which the bonds will be sold,
and thus faces the risk of a capital loss.

PTS: 1 DIF: Easy REF: 8.3.3(b) Price risk

47. The degree of price risk faced by bond investors increases in proportion to the period for which they
hold the bonds.

ANS: F
Price risk diminishes over time since the price sensitivity of bonds declines as the period to maturity
diminishes.

PTS: 1 DIF: Difficult REF: 8.3.3(b) Price risk

48. Say an active bond manager believed that bond market yields were going to fall in the near future. In
order to achieve higher returns the manager would sell short-term bonds and buy long-term bonds
now.

ANS: T
Whilst a fall in market yields would cause the value of all bonds to rise, long-term bond prices will
rise by more.

PTS: 1 DIF: Difficult REF: 8.3.3(b) Price risk

49. If movements in yields cause bond prices to change, it follows that bond prices will not change
provided yields remain the same.

ANS: F
Bond prices gradually rise during coupon periods (holding yields constant) and fall on their
ex-interest date. They will also trend towards their face value.

PTS: 1 DIF: Moderate REF: 8.4 The impact of coupon payments on a bond’s
price
50. Bond prices fall a week before coupon payments.

ANS: T
This is when the next coupon is assigned (the bond goes ex-interest) causing the price to fall since a
buyer would now receive one fewer coupons.

PTS: 1 DIF: Moderate REF: 8.4 The impact of coupon payments on a bond’s
price

51. The majority of trades in Treasury bonds are on a cum-interest basis.

ANS: T
Bonds only trade ex-interest for the seven days prior to a coupon payment (14 days a year). The rest
of the time bonds trade cum-interest.

PTS: 1 DIF: Moderate REF: 8.4.1 Price on cum-interest dates

52. The main factor that influences demand for bonds is the cash rate.

ANS: F
The greatest influence on the demand for bonds is the expected inflation rate over the bond’s term.

PTS: 1 DIF: Easy REF: 8.5 Determinants of movements in long-term

yields

53. Bond yields equal the real interest rate plus the current inflation rate.

ANS: F
Bond yields equal the real interest rate plus the expected inflation rate over the bond’s term.

PTS: 1 DIF: Moderate REF: 8.5 Determinants of movements in long-term

yields

54. An upward movement in the 10-year bond yield from say, 6 to 7 per cent could indicate an increase
in inflation expectations over the long term.

ANS: T
Bond yields can be expected to include an inflation component and so an increase in bond yields
could be due to an increase in this component.

PTS: 1 DIF: Moderate REF: 8.5 Determinants of movements in long-term

yields

55. The correlation between bond yields and the expected inflation rate is known as the Fisher effect.

ANS: T
This is because the real rate is assumed to be constant.

PTS: 1 DIF: Moderate REF: 8.5.1 The Fisher effect

56. In the Fisher equation, risk premiums are embedded in the expected inflation rate.

ANS: F
In the Fisher equation, risk premiums are embedded in the assumed real interest rate.

PTS: 1 DIF: Difficult REF: 8.5.1 The Fisher effect

MULTIPLE CHOICE

1. Of the following, which is NOT a standard bond feature?

A. Floating-interest rate coupons.
B. Half-yearly coupons.
C. Redeemed by the payment of face value.
D. Face value payable at the maturity date.
E. All of these are standard bond features.
ANS: A PTS: 1 DIF: Easy REF: Introduction

2. Which of the following is NOT one of the major categories of issuer within the bond market?
A. Commonwealth Treasury
B. State government
C. Local government
D. Non-government issuers
E. None of these.
ANS: C PTS: 1 DIF: Moderate REF: Introduction

3. A bond that is secured and issued to retail investors is a:

A. Treasury bond
B. semi-government bond
C. convertible bond
D. debenture
E. floating-rate note.
ANS: D PTS: 1 DIF: Difficult REF: Introduction

4. In terms of the amount of bonds outstanding, which is the largest bond category by issuer?
A. Treasury bonds
B. Semi-government bonds
C. Foreign issuer bonds
D. Non-government bonds
E. Local-government bonds
ANS: D PTS: 1 DIF: Easy REF: 8.1 The OTC bond market

5. Which of the following are NOT major investors in the Australian bond market?
A. Non-Australian residents
B. Foreign central banks
C. Banks
D. Fund managers
E. Retail investors
ANS: E PTS: 1 DIF: Difficult REF: 8.1 The OTC bond market
 6. Which of the following is NOT a role of the bond market?
A. Being a source of long-term capital for wholesale borrowers.
B. Providing wholesale investors with access to a long-term, defensive investment.
C. Performing the price discovery process for long-term interest rates.
D. Providing a mechanism for the RBA to implement its monetary policy.
E. All of these are bond market functions.
ANS: D PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market

7. Treasury bond investors are exposed to:

A. credit risk
B. price risk
C. reinvestment risk
D. price risk and reinvestment risk
E. credit risk, price risk and reinvestment risk.
ANS: D PTS: 1 DIF: Difficult REF: 8.1 The OTC bond market

8. Wide credit spreads:

A. represent a low price for risk
B. show that investors are concerned about the risks posed by bonds
C. occur when investors are very confident in the ability of borrowers to repay debt
D. tend to narrow during times of crisis, like the GFC
E. increase the profitability of trading for bond dealers.
ANS: B PTS: 1 DIF: Difficult REF: 8.1.2 Contributions to
price discovery

9. The price discovery role of the Treasury bond market:

A. reveals default-free rates for terms up to 15 years
B. reveals the three-year and 10-year benchmark rates
C. is enhanced by a liquid market
D. allows the credit spread at which riskier bonds trade to be calculated.
E. All of these.
ANS: E PTS: 1 DIF: Moderate REF: 8.1.2 Contributions to
price discovery

10. A Treasury bond trade requires the buyer and seller agree on:
A. the bond series, the quantity and the yield
B. the bond series, the quantity and the price
C. the quantity, the clearinghouse and the yield
D. the quantity, the clearinghouse and the price
E. the bond series, the coupon rate and the yield.
ANS: A PTS: 1 DIF: Moderate REF: 8.1.3 Trading and
settlement
11. Say you are a dealer who needs to sell some of your long-term bonds. You receive a bid-offer quote
of 6.25–6.22% from dealer X and of 6.24–6.21% from dealer Y. What quote is the most attractive?
A. 6.25%
B. 6.22%
C. 6.24%
D. 6.21%
E. Dealers don’t sell to other dealers.
ANS: C PTS: 1 DIF: Difficult REF: 8.1.3 Trading and
settlement

12. In the wholesale bond market, trading is settled on what basis?

A. T + 0
B. T + 1
C. T + 2
D. T + 3
E. T + 4
ANS: D PTS: 1 DIF: Easy REF: 8.1.3 Trading and
settlement

13. Treasury bonds:

A. have a number of series
B. have a range of terms (i.e. maturities)
C. are (approximately) par bonds when a new bond series is first issued
D. have a range of coupon rates
E. All of these.
ANS: E PTS: 1 DIF: Easy REF: 8.2.1 Treasury bonds

14. Dealers in the bond market:

A. trade in both wholesale and retail amounts
B. can bid for Treasury bonds in a competitive tender
C. must trade in accordance with the rules of the exchange
D. trade in ‘same day’ funds
E. earn a commission when a trade is completed.
ANS: B PTS: 1 DIF: Moderate REF: 8.1.3 Trading and
settlement

15. The advantages of central borrowing authorities established by state governments do NOT include
which of the following?
A. A better credit rating than some state agencies would achieve in their own name.
B. The ability to source funds from retail investors.
C. Preventing state agencies from competing with each other for funds.
D. Larger issues which makes securities more liquid.
E. All of these are advantages.
ANS: B PTS: 1 DIF: Moderate REF: 8.2.2 Semi-government
bonds
16. Semi-government bonds:
A. are always floating rate bonds
B. are more liquid than Treasury bonds
C. trade at higher yields than Treasury bonds
D. are issued by the AOFM on behalf of the issuer
E. are listed on the ASX.
ANS: C PTS: 1 DIF: Moderate REF: 8.2.2 Semi-government
bonds

17. Non-government bond issuer categories do NOT include:

A. financials
B. non-residents
C. infrastructure funds
D. asset-backed securities
E. non-financial corporates.
ANS: C PTS: 1 DIF: Moderate REF: 8.2.3 Non-government
bonds

18. The major banks raise funds from the Australian bond market mainly through the issue of:
A. mortgage-backed securities
B. fixed-rate bonds
C. floating-rate medium term notes
D. debentures
E. convertible bonds.
ANS: C PTS: 1 DIF: Moderate REF: 8.2.3(a) Financials

19. The GFC has greatly reduced the amount of MBSs issued in the Australian bond market because:
A. it became apparent that Australian MBSs did not deserve their high rating
B. of high levels of non-performing loans
C. of the weakness of the Australian economy
D. these securities funded non-performing loans in the US
E. of the loss of investor interest in MBSs resulting from the losses incurred on US MBSs.
ANS: E PTS: 1 DIF: Moderate REF: 8.2.3(c) Mortgage-backed
securities

20. Credit wrapping is generally used by:

A. corporate borrowers with speculative-grade credit ratings
B. financial institutions
C. issuers of mortgage backed securities
D. non-resident issuers
E. corporate borrowers with investment-grade credit ratings.
ANS: A PTS: 1 DIF: Difficult REF: 8.2.3(d) Bonds issued by
non-financial companies
21. The ratings provided by ratings agencies are NOT:
A. a trading recommendation
B. useful to investors in bond securities
C. reflected in the market yield for securities
D. based on a qualitative and quantitative analysis of the issuer
E. reviewed after the securities are first issued.
ANS: A PTS: 1 DIF: Moderate REF: 8.2.4 Ratings agencies

22. According to Standard & Poor’s rating definitions, speculative grade securities are rated:
A. below AAA
B. below AA
C. BBB and above
D. BB and below
E. C and D.
ANS: D PTS: 1 DIF: Difficult REF: 8.2.4 Ratings agencies

23. Treasury bonds:

A. trade ‘ex-interest’ between the 9th and 15th of each month
B. are priced using a semi-annual compound rate
C. pay interest once or twice a year
D. are mostly traded on an ‘ex-interest’ basis.
E. All of these.
ANS: B PTS: 1 DIF: Moderate REF: 8.3 Calculating bond
investment yields

24. Calculate the price (per $100 of face value to 6 dps) of the 4.5 per cent 15 April 2020 Treasury bond
when purchased on 15 April 2015 at 5 per cent.
A. $97.811984
B. $97.835262
C. $100
D. $102.216554
E. None of these.
ANS: A PTS: 1 DIF: Moderate REF: 8.3.1 Calculating a bond’s
price on a coupon date

25. The 4.5 per cent 15 April 2020 bond will:

A. be a premium bond if bond yields are 5 per cent
B. be a par bond if bond yields are 4 per cent
C. earn a capital gain, if yields decrease from when it is purchased to when it is sold
D. have more price risk than a longer term bond
E. More than one of these answers is correct.
ANS: C PTS: 1 DIF: Moderate REF: 8.3.2 Bond prices and
movements in yields
26. Of the following, which is NOT relevant to the calculation of the return earned on a Treasury bond
investment?
A. The coupons received.
B. The interest earned on the reinvestment of these coupons.
C. The price paid for the bond.
D. The price the bond is sold for, or its face value if held to maturity.
E. All of these are relevant.
ANS: E PTS: 1 DIF: Easy REF: 8.3.3 Bond investments

27. A Treasury bond was bought and sold for $102.200 and $101.050 respectively. The accumulated
value of all coupons was $18. If the bond was held for exactly four years and the bond paid coupons
semi-annually, then the realised yield-to-maturity on this bond was:
A. 4% p.a
B. 3.85% p.a
C. 3% p.a
D. 2.55% p.a
E. 2% p.a
ANS: B PTS: 1 DIF: Moderate REF: 8.3.3 Bond investments

28. Say you purchased a 5% Treasury bond at par and sold it exactly two years later when yields were
4% per annum. If coupons were reinvested at 5% per annum, your holding period yield would be:
A. less than or equal to 4% p.a.
B. between 4% and 5% p.a.
C. exactly 5% p.a.
D. more than 5% p.a.
E. Cannot be calculated with the information provided.
ANS: D PTS: 1 DIF: Moderate REF: 8.3.3 Bond investments

29. An active bond portfolio manager who forms the expectation that bond yields are going to fall in the
near future would mostly likely:
A. sell discount bonds and buy premium bonds
B. sell premium bonds and buy discount bonds
C. sell shares and buy bonds
D. sell longer-term bonds and buy shorter- term bonds
E. sell shorter- term bonds and buy longer-term bonds.
ANS: E PTS: 1 DIF: Difficult REF: 8.3.3(b) Price risk

30. Assuming constant yields, bond prices will:

A. trend upwards for discount bonds
B. trend downwards for discount bonds
C. follow a ‘saw-tooth’ pattern
D. follow a ‘saw-tooth’ pattern and trend upwards for discount bonds
E. follow a ‘saw-tooth’ pattern and trend downwards for discount bonds.
ANS: D PTS: 1 DIF: Moderate REF: 8.4 The impact of coupon
payments on a bond’s price
31. Treasury bonds trade cum-interest for how many weeks of the year?
A. 52
B. 50
C. 48
D. 4
E. 2
ANS: B PTS: 1 DIF: Moderate REF: 8.4.1 Price on cum-interest
dates

32. What was the price, per $100 of face value, of an 8.7% 15 August 2014 Treasury bond settled on 21
April 2008 at a yield of 5.8% p.a.? (f = 116, d = 181)
A. $114.52
B. $116.71
C. $118.87
D. $115.52
E. None of these.
ANS: B PTS: 1 DIF: Difficult REF: 8.4.1 Price on cum-interest
dates

33. An increase in inflationary expectations for the next few years would, all else the same:
A. increase demand for bonds
B. increase the real interest rate
C. decrease the supply of bonds
D. decrease the real interest rate
E. increase long-term bond yields.
ANS: E PTS: 1 DIF: Moderate REF: 8.5 Determinants of
movements in long-term yields

34. The real rate component of bond market yields:

A. will never change
B. includes an inflation risk premium, liquidity premium and volatility premium
C. includes an allowance for expected inflation
D. is stable over very long-periods.
E. All of these.
ANS: B PTS: 1 DIF: Moderate REF: 8.5 Determinants of
movements in long-term yields

35. The Fisher effect is the finding that:

A. changes in real bond yields are associated with changes in the inflation rate
B. changes in real bond yields are associated with changes in nominal bond yields
C. changes in nominal bond yields are associated with changes in the expected inflation rate
D. changes in nominal bond yields are associated with changes in real bond yields
E. yields and inflation are independent of one another.
ANS: C PTS: 1 DIF: Moderate REF: 8.5.1 The Fisher effect
SHORT ANSWER

1. Describe the standard bond features and provide examples of bonds that are issued with
non-standard features.

ANS:
Bonds are long-term debt securities. Standard bond features are the payment of fixed-interest
coupons each half-year until the bond is redeemed on its maturity date by the payment of its face
value. These are the features of the Commonwealth government’s fixed-interest Treasury bonds.

Bonds can be issued with a variety of features. Some examples are:

• Debentures, which are normally a secured bond issued to retail investors.
• Convertible bonds, which can be converted (under specific conditions) to anther security,
usually into the issuer’s shares.
• Floating-rate notes are medium-term bonds where the coupon payment each period is based
on a reference rate at the start of that period.

PTS: 1 DIF: Easy REF: Introduction

2. Explain the impact of the GFC on bond issues in Australia.

ANS:
For both state and Commonwealth governments, the crisis produced an economic slowdown causing
revenues to fall and expenditures to rise resulting in budget deficits that were financed through bond
issues. As a result the amount of Treasury and semi-government bonds outstanding has risen steadily
from 2008 to 2013 by roughly three or four times (see Figure 8.1).

The total amount of non-government bonds outstanding continued to grow during the GFC, but at a
reduced rate and has since plateaued. Within this category Figure 8.2 shows the amount of MBSs fell
quite significantly as new issues stopped and existing issues matured. The amount of securities
issued by financial institutions initially increased during the crisis (as ADIs had the government
guarantee to support their lending) but has since declined, reflecting their preference for a greater
reliance on deposits.

PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market onwards

3. Explain the importance of the Treasury bond market to Australia’s financial system.

ANS:
The market provides the Commonwealth government with a source of long-term wholesale debt
funds and wholesale investors access to a long-term investment opportunity free of credit risk.

It also performs price discovery. That is, the market discovers the current cost of long-term funds, on
a default-free basis, for a range of maturities and reveals inflationary expectations. The three-year
and 10-year benchmark rates in particular are useful for the pricing of other products and
instruments. When used in conjunction with the yields on riskier bonds, they allow the calculation of
credit spreads.

PTS: 1 DIF: Difficult REF: 8.1 The OTC bond market

4. Briefly explain the contributions made by the bond market to the financial system.

ANS:
The bond market contributes to the flow-of-funds by providing wholesale borrowers with access to
long-term debt funds and by giving wholesale investors the opportunity to make long-term
investments in a defensive asset class.

The market performs the price discovery function for long-term interest rates. The yield at which
Treasury bonds trade reveal default-free rates for periods of up to 15 years, although the three- and
10-year rates are the benchmark rates. These benchmark rates are used in various long-term long and
derivative contracts.

The yield at which other bonds trade reveal the risk premiums that apply to riskier bonds. This is
often expressed as the credit spread (the difference between the yield on a risky bond less the yield
on a Treasury bond of the same term). They reveal the risk premium that borrowers with a
corresponding credit rating can expect to pay.

PTS: 1 DIF: Moderate REF: 8.1.1 Contribution to the flow of funds

5. Briefly describe the main trading and settlement arrangements in the wholesale bond market.

ANS:
The wholesale bond market is an over-the-counter market, meaning that dealers act as market
makers and trade in large amounts (a standard parcel is $10 million). They trade with their wholesale
clients and with other dealers either by telephone or using electronic broking systems. Dealers quote
bid and offer yields on a semi-annual compound basis.

The clearinghouse is Austraclear who calculates the settlement price and arranges payment on a T +
3 basis through RTGS.

PTS: 1 DIF: Moderate REF: 8.1.3 Trading and settlement

6. Describe how Treasury bonds are issued.

ANS:
Treasury bonds are regularly issued by the AOFM. Issues can be of extra bonds in an existing bond
series or for the first bonds issued in a new series.

The process used is a competitive tender where bids are invited from bond dealers. These bids are as
interest rates for bond parcels in multiples of $1 million. Bonds are allocated to the lowest bidders.
Settlement is arranged by Austraclear using RTGS on a T + 3 basis.

PTS: 1 DIF: Moderate REF: 8.2.1(a) The issuing process

 7. Describe the issuing processes for semi-government bonds.

ANS:
Semis are issued to dealer panels either as a closed auction or as a fixed-price deal. Dealers place
new issues with investors and make a market for the semis by continuously quoting bid and offer
prices.

PTS: 1 DIF: Easy REF: 8.2.1(a) The issuing process

8. Provide a brief description of semi-government bonds.

ANS:
Semi-government bonds are medium- and long-term securities issued by the borrowing authorities
of state governments and government agencies. Their principal purpose is to raise funds for capital
expenditure by state governments and their agencies. Semi-government bonds can be either
fixed-rate or floating-rate in nature and issues are concentrated into a limited number of series for
each issuer. These bonds tend to be less liquid than Treasury bonds and trade at higher yields than
Treasury bonds.

PTS: 1 DIF: Moderate REF: 8.2.2 Semi-government bonds

9. Describe the issuers of non-government bonds.

ANS:
The largest issuer is financial institutions, particularly the major banks. They mainly issue floating
rate medium-term (three- to five-year) notes. Non-residents issue AUD bonds known as ‘kangaroo
bonds’ and then typically swap payments into USD. MBSs are issued by mortgage originators and
SPVs. Payments made by housing loan borrowers ‘flow through’ to investors. In Australia MBSs are
highly rated and have not suffered the high level of defaults experienced in the US. Lastly,
non-financial companies also raise debt in the bond market, but given the substantial issuing costs, it
is only economical for firms that need to raise relatively large amounts. Some firms with lower credit
ratings use credit wrapping to lower the yields at which their bonds are issued.

PTS: 1 DIF: Moderate REF: 8.2.3 Non-government bonds

10. What is a ‘tranche’?

ANS:
A tranche refers to a specific segment of an issue of securities. MBSs are issued as different tranches
each having particular features and payment priority, and perhaps different credit ratings. The
‘senior tranches’ are usually AAA rated and receive their payments before investors in lower ranked
tranches. MBSs with the lowest priority would have a lower credit rating.

PTS: 1 DIF: Moderate REF: 8.2.3 (c) Mortgage-backed securities

11. Specify the coupon payment (per $100 of face value), the coupon payment dates and the ex-interest
periods for the following Treasury bonds:
a) 5.25% 15 Mar 19
b) 5.75% 15 Jul 22
c) 2.75% 21 Apr 24

ANS:
Series Coupon payment Coupon payment dates Ex-interest periods*
a) 5.25% 15 Mar 19 $2.625 15 March 8–15 March
15 September 8–15 September
b) 5.75% 15 Jul 22 $2.875 15 July 8–15 July
15 January 8–15 January
c) 2.75% 21 Apr 24 $1.375 21 April 14–21 April
21 October 14–21 October

*assuming the start date is a business day

PTS: 1 DIF: Moderate REF: 8.2.3 (c) Mortgage-backed securities

12. Explain the role of ratings agencies in the bond market and identify the moral hazard that they face.

ANS:
Ratings agencies assign credit ratings to debt securities that provide investors with a concise
indication of the credit risk of the security. The rating will influence investor demand for the issue
and the yield at which the issue trades. Ratings for bonds are especially important since investors
face credit risk until the bonds are redeemed.

The cost of rating a security (and its ongoing monitoring) is borne by the issuer, and issuers have a
strong preference for favourable ratings (because this reduces their cost of funds). The moral hazard
faced by the ratings agency is not to succumb to issuer pressure for favourable ratings but rather to
provide unbiased and reliable ratings.

PTS: 1 DIF: Moderate REF: 8.2.4 Ratings agencies

13. Say the 4.50% 15 April 2020 Treasury bond is traded for settlement on 15 April 2016 at 3.50%.
What is the settlement price?

ANS:
C  1 − (1 + 2r )  4.5  1 − (1 + 0.035
2 )

−2t −2*4
F 100
P=  + =  + = $103.702527
2 r  (1 + r ) 2t
2  0.035  (1 + 0.035 )2*4
 2  2  2  2

PTS: 1 DIF: Easy REF: 8.3.1 Calculating a bond’s price on a coupon

date
14. A fund manager buys a $10 million parcel of 5.75% July 2022 bonds on 15 January 2015 at 6%.
Calculate the price paid for the parcel of bonds.

ANS:
C  1 − (1 + 2r )  5.75  1 − (1 + 0.06
2 )

−2t −2*7.5
F 100
P=  + =  + = $98.507758
2 r  (1 + r ) 2t
2  0.06  (1 + )
0.06 2*7.5
 2  2  2  2

The price for the parcel of bonds is $9 850 775.81.

PTS: 1 DIF: Easy REF: 8.3.1 Calculating a bond’s price on a coupon

date

15. Demonstrate when a bond will trade at a discount, at par and at a premium using an 8% Treasury
bond with five years to maturity.

ANS:
The bond will trade at a discount if the market yield exceeds the coupon rate:
8  1 − (1 + 0.09
2 )

−2*5
100
P=  + = $96.043641
2 0.09
 (1 + 0.09 )2*5
 2  2

The bond will trade at par when the market yield and coupon rate are equal:
8  1 − (1 + 0.08
2 )

−2*5
100
P=  + = $100.000000
2 0.08
 (1 + 0.08 )2*5
 2  2

The bond will trade at a premium if the market yield is less than the coupon rate:
8  1 − (1 + 0.07
2 )

−2*5
100
P=  + = $104.158303
2 0.07
 (1 + 0.07 )2*5
 2  2

PTS: 1 DIF: Easy REF: 8.3.2 Bond prices and movements in yields

16. Specify the sources of the returns for a bond investor.

ANS:
Given the investor has purchased the bond for a specified price, the return they achieve on that
investment depends on:
• the number and size of the coupons received;
• the interest earned when these coupons are reinvested; and
• either the bond’s face value (if held to maturity) or the selling price received (if sold before
maturity).

PTS: 1 DIF: Easy REF: 8.3.3 Bond investments

17. A 10-year bond making half-yearly coupon payments at 6% p.a. is purchased at par and held to
maturity. Calculate the investor’s holding-period yield, given that the coupons are reinvested at 5%
p.a. compounding half-yearly.

ANS:
C  (1 + 2r ) − 1  6  (1 + 0.05
2 ) −1 
n 20

( C / 2 ) FVAF =  =

  = $76.633973
2 r
2 0.05 
 2   2 

 1

 C / 2 ( FVAF ) + F, or P  n

r=   − 1 2
sell
  P 
  
buy

  76.633973 + 100  120 

=   − 1 2
 100 
 
= 5.77%

PTS: 1 DIF: Moderate REF: 8.3.3 Bond investments

18. Demonstrate the relationship between price risk and time to maturity by calculating the change in the
price of a 5% coupon Treasury bond if rates increase from 5% to 6% and the bond has (i) one year to
maturity, (ii) five years to maturity and (iii) 10 years to maturity.

ANS:
Initially the bond is a par bond (P = $100) because the yield and coupon rate are both 5%.

(i) If the bond has one year to maturity:

C  1 − (1 + 2r )  5  1 − (1 + 0.06
2 )

−2t −2*1
F 100
P=  + =  + = $99.043265
2  (1 + r )
 ( 2 )
r 2t
2  0.06  1 + 0.06 2*1
 2  2  2

Approximately a 1% fall in value.

(ii) If the bond has five years until maturity:

5  1 − (1 + 0.06
2 )

−2*5
100
P=  + = $95.734899
2 0.06  (1 + 0.06 )2*5
 2  2

Approximately a 4.3% fall in value.

(iii) If the bond has 10 years to maturity:

5  1 − (1 + 0.06
2 )

−2*10
100
P=  + = $92.561263
2 0.06  (1 + 0.06 )2*10
 2  2

Approximately a 7.4% fall in value.

PTS: 1 DIF: Easy REF: 8.3.3(b) Price risk

19. A bond with exactly five years until maturity paying 6% p.a. coupons semi-annually and with a face
value of $100 was purchased at a yield of 6.5% p.a. The bond was sold exactly two years later for a
yield of 5% p.a. All coupons were reinvested at 6% p.a. Calculate the realised yield-to-maturity on
this bond.

ANS:
C  1 − (1 + 2r )  6  1 − (1 + 0.065
2 )

−2t −2*5
F 100
Pbuy =  + =  + = $97.894401
2 r  (1 + r ) 2t
2  0.065  (1 + 0.065 )2*5
 2  2  2  2

6  1 − (1 + 0.05
2 )

−2*3
100
Psell =  + = $102.754063
2 0.05  (1 + 0.05 )2*3
 2  2

Next, calculate the future value of the coupons received:

C  (1 + 2r ) − 1  6  (1 + 0.06
2 ) −1

n 4

( C / 2 ) FVAF =  =

  = $12.550881
2 r
2 0.06 
 2   2 
The holding-period yield is therefore:

 1
   12.550881 + 102.754063  14 
 C / 2 ( FVAF ) + F, or P  n

r=   − 1 2 =    − 1 2 = 8.35%
sell
  P    97.894401 
    
buy

PTS: 1 DIF: Moderate REF: 8.3.3(b) Price risk

20. Suppose that a parcel of 5.75% 15 July 2022 Treasury bonds was purchased at 5% on 15 July 2015
and then sold on 15 January 2017 at a yield of 6%.
A. Calculate the purchase price, per $100 of face value.
B. Calculate the selling price, per $100 of face value.
C. If the coupons were reinvested at 5.5 per cent per annum, find the investor’s
holding-period yield.

ANS:
C  1 − (1 + 2r )  5.75  1 − (1 + 0.05
2 )

A. −2t −2*7
F 100
Pbuy =  + =  + = $104.384092
2 r  (1 + r )2t 2  0.05  (1 + 0.05 )2*7
 2  2  2  2

5.75  1 − (1 + 0.06
2 )

B. −2*5.5
100
Psell =  + = $98.843422
2  0.06  (1 + 0.06 )2*5.5
 2  2
 C. The investor purchased in July 2015 and sold in January 2017. Hence the investor received three
coupons. The future value of these coupons is:

C  (1 + 2r ) − 1  5.75  (1 + 0.055
2 ) −1

n 3

( C / 2 ) FVAF =  

=   = $8.864362
2 r
2  0.055 
 2   2 
The holding-period yield is therefore:

  n 
1
  8.864362 + 98.843422  13 
C / 2 ( FVAF ) + F, or Psell
r =   − 1 2 =    − 1 2 = 2.10%
  Pbuy    104.384092 
    

PTS: 1 DIF: Difficult REF: 8.3.3(b) Price risk

21. Explain the movement in the price of a fixed-rate bond over a year, assuming that the yield remains
unchanged.

ANS:
Given that the market yield is constant, the movement of a bond price over a 12-month period is
determined mainly by the two coupon payments. On each ex-interest date, the bond’s price will fall.
Then the price will trend upwards until the next ex-coupon date. Consequently, the bond’s price
traces a saw tooth pattern with two peaks a year.

For a par bond the pattern is:

A premium bond would also display a downward trend towards the face value at maturity. A
discount bond would trend upwards towards the face value at maturity.

PTS: 1 DIF: Moderate REF: 8.4 The impact of coupon payments on a bond’s
price
22. Calculate the settlement price (per $100 of face value) of the 5.75% 15 June 2016 Treasury bond on
2 May 2015, given a market yield of 5.40% p.a. (f = 44, d = 182)

ANS:
Step 1: Calculate the price on 15 June 2015 (excluding the coupon):

C  1 − (1 + 2r )  5.75  1 − (1 + 0.054
2 )

−2t −2*1
F 100
P=  + =  + = $100.336319
2 r  (1 + r ) 2t
2  0.054  (1 + 0.054 )2*1
 2  2  2  2

Step 2: The bond is cum-interest so add the June 2015 coupon:

P = 100.336319 + 5.75/2 = $103.211319

Step 3: Discount back to 2 May 2015:

f 44
P = Vstep 2 (1 + 2r ) = $103.211319 (1 + 0.054
2 )
− −
d 182 = $102.548681

PTS: 1 DIF: Difficult REF: 8.4.1 Price on cum-interest dates

23. Calculate the settlement price (per $100 of face value) on 7 September 2015 of the 4.5% 15 April
2020 Treasury bond at a yield of 4% p.a. (f = 38, d = 183).

ANS:
Step 1: Calculate the price on 15 October 2015 (excluding the coupon):

C  1 − (1 + 2r )  4.5  1 − (1 + 0.04
2 )

−2t −2*4.5
F 100
P=  + =  + = $102.040559
2 r  (1 + r ) 2t
2  0.04  (1 + )
0.04 2*4.5
 2  2  2  2

Step 2: The bond is cum-interest so add the June 2015 coupon:

P = 102.040559 + 4.5/2 = $104.290559

Step 3: Discount back to 7 September 2015:

f 38
P = Vstep 2 (1 + 2r ) = $104.290559 (1 + 0.04
2 )
− −
d 183 = $103.862595

PTS: 1 DIF: Difficult REF: 8.4.1 Price on cum-interest dates

24. Calculate the settlement price, per $100 of face value, of the 2.75% 21 April 2024 Treasury bond on
18 April 2016 at 5% p.a. (f = 3, d = 183).

ANS:
Step 1: Price on 21 April 2016 (excluding coupon on that date):

C  1 − (1 + 2r )  2.75  1 − (1 + 0.05
2 )

−2t −2*8
F 100
P=  + =  + = $85.313122
2 r  (1 + r ) 2t
2  0.05  (1 + 0.05 )2*8
 2  2  2  2
 Step 2: Purchased ex-interest so do not add coupon.

Step 3: Discount back to 18 April 2016:

f 3
P = Vstep 2 (1 + 2r ) = 85.313122 (1 + 0.05
2 )
− −
d 183 = $85.278595

PTS: 1 DIF: Difficult REF: 8.4.2 Price on ex-interest dates

25. What do you think is implied by a rise in the 10-year bond yield?

ANS:
The most likely reason for an increase in the 10-year bond yield is that the market’s long-run
inflationary expectations have increased.

PTS: 1 DIF: Easy REF: 8.5 Determinants of movements in long-term

yields

26. Explain the impact of an increase in inflationary expectations upon bond investors and issuers, and
upon the market yield.

ANS:
An increase in expected inflation will reduce investor demand for bonds because of the decline in the
real value of a bond’s cash flows. On the other hand, issuers will be increasingly willing to issue
bonds, because higher inflation means that the real cost of the bond’s fixed payments is expected to
fall. This increase in the supply of bonds and decrease in demand will result in a fall in their price,
which corresponds to an increase in yield. This relationship is encapsulated in the Fisher effect, r 
rreal + pe.

PTS: 1 DIF: Moderate REF: 8.5 Determinants of movements in long-term

yields

27. Explain why the ‘real rate’ may change.

ANS:
There are a number of risk premiums embedded in the real rate. These include premiums for
inflation risk, liquidity risk and volatility (price) risk. Changes in the market’s assessment of these
risks will cause changes in the real rate.

PTS: 1 DIF: Moderate REF: 8.5 Determinants of movements in long-term

yields
ESSAY

1. Discuss the Treasury bond market and explain its contribution to the flow of funds and price
discovery functions.

ANS:
Essay answers will need to be individually marked.

PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market

2. Describe semi-government and non-government bonds within the bond market, and explain their
contributions to the market’s performance of the flow-of-funds and price discovery functions.

ANS:
Essay answers will need to be individually marked.

PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market

3. Discuss the impact of the GFC on new bond issues, credit spreads and bond yields in Australia.

ANS:
Essay answers will need to be individually marked.

PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market

4. Clearly describe the trading arrangements, pricing conventions and settlement provisions in the
Australian bond market.

ANS:
Essay answers will need to be individually marked.

PTS: 1 DIF: Moderate REF: 8.1 The OTC bond market

5. Explain the risks associated with bond investments. In your answer discuss the role of ratings
agencies and where possible demonstrate the risks with numerical examples.

ANS:
Essay answers will need to be individually marked.

PTS: 1 DIF: Moderate REF: 8.2 Market segments

6. Discuss the determinants of movements in long-term yields.

ANS:
Essay answers will need to be individually marked.

PTS: 1 DIF: Moderate REF: 8.5 Determinants of movements in long-term

yields