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3 General Market Concepts

Talking specifically about bond markets today, big topic is the yield curve

What makes a bond a bond?

Pimco? It's the only truly famous and highly respected financial firm in Los Angeles. It's rly in newport beach, it was founded by Bill Gross, who was a professional Blackjack player. What he learned in BJ helped him. He's known as "the bond king". He always has something surprising to say, and he's often right. He ended outed of pimco because of bad relationships.

The ROI from purchasing a bond can be divided into two parts: 1. interest income (coupon payments) 2. Capital gain or loss - difference between purchase and sale price (or par if held till maturity)

Which is more risky for an investor? a long term bond or a short term bond?

if we ignore US treasuries for a moment there's a risk of defaulting on the bond. But more importantly, price sensitivity to interest rates. the sensitivity is directly correlated to the duration of the bond, hence, longer term bonds are more sensitive.

Duration:

  • weighted average of time until payment is made.

Compounding, EAR vs APR

  • \(EAR = (1 + r/n)^n - 1\)
  • \(\lim_{n \to \infty} EAR = e^r - 1\)

IRR (Internal Rate of Return)

the rate that you apply to make the net present value of all cash flows equal to zero.

YTM (Yield to Maturity)

- calculated as the IRR of the bond when held to maturity.

Bonds and Yields

Schwab is a broker. Ones you might experience, fidelity, Schwab, Vanguard, Robinhood etc.

CDs are a very illiquid purchase, might be consistent with the market, and is probably a little worse than the market, can't really sell them, and you probably don't get a good value on it.

Yield rates for longer term bonds, etc.

highest risk, highest returns, so some of the (A) Corporate bonds, there is 7.124% at 30 years

the lowest risk would be treasury bonds at 3 months, but why are agencies, and corporates lower?

Here's the reason: Schwab is the broker, their job is to connect the customer, they buy low and sell high, that's how they make their money. If they want to buy cheap, etc.

These are yields at which retail bond dealers are willing to sell bonds

some bonds are thin "illiquid" and will have lower rates even despite being more risky.

All securities have a CUSIP number.

floating rate bonds: tied to some benchmark, etc, where the rate can change with the interest rate on the market, etc.

there is always a bid and an offer (ask). Bid, means someone is willing to pay that much to buy something. Ask is what someone wants you to pay to buy it from them. if you want to buy something you have to buy the ask, and if you want to sell something, you have to hit the bid, where you lose some of that value in the difference btwn the two.

Where Bid = 98.906 and ask = 98.910

first dealer will buy at 98.91

Short Selling: Can you sell something you don't even own?

Yes! Financial people refer to this as shorting something

For example - you borrow your parent's car - put it in public with "for sale" sign and you sell it - you owe your parents a car - to cover the short, you need to buy a similar car and give it to your parents. - If this takes too long, and the cost of vehicles goes up, we can short them separately.

Markets

Short selling in financial markets - short selling is a structured process regulated by financial markets - short sellers must remain collateral margin as a percentage of the shorted asset's value. - If the assets price rises, brokers demand more collateral - if short sellers cannot meet the margin call, they must buy back the asset at a higher price. - if short sellers cannot meet the margin call, they must buy back the asset at a higher value. - when many short sellers are forced to buy back at once, the price rises even more, called a short squeeze.

why would schwab want to sell shares you don't even own.

if attests proceses value, etc. How much can you lose? A theoretical infinite loss.

Long: you own the asset and hope its price increases Short: you borrow and sell, (at which point you "owe" the asset to someone else) and hope the price decrease.

Bonds: converting from yield to price

by convention, whenever we talk about compounding that you're going to use. there's some quarterly, here's some annual, etc,

given the bonds yield

\(P = \sum_{t=1}^{n} C/(1 + r)^t + 100/(1 + r)^n\)

the price of a bond is the present value of its cash flows

Example: converting from yield to price. How frequent are the coupon payments for this bond. Semi annual.

what is the nominal coupon rate? if 3.50 then the nominal rate is 7 per year, which makes sense. #=: 3.50 * 2

what happens when yield goes up? Price goes down.

can you solve for \(y\) in terms of \(p\)?

ans: not easily (usually requires numerical methods)

Bond: Recap of major points

  • the bond value can be specified either by its price or its yield (YTM)
  • prices and yields move in opposite direction
  • "the bond market is rallying" = interest rates are going down
  • market professionals
  • interest rates with bond yields
  • the bond market is, in essence, a real-time market for loans.

Treasury Bills (maturity < year, zero coupon)

  • 4 wk bill
  • 8 wk bill
  • 13 wk
  • 26
  • 52 wk

Treasury Notes

  • 2yrs
  • 3yrs
  • 5yrs
  • 7yr
  • 10yr

Treasury bonds

  • 20-year
  • 30-Year

t

there are 10 year bonds, called more than their

Bond markets and Liquidity.

Fixed income offerings.

bid, offer (ask) liquidity. Big trades can move the market a lot, a big trade can move round liquidity security.

okay

any questions about that stuff?

  • liquidity can be quantified by tightness of bid-ask spread and market depth
  • note that this chart only shows the ask side.

Bond markets are also referred to as fixed income markets. They can also is

Fixed income instruments with maturity less than 1 year are referred to as money market instruments due to their perceived safety and therefore proximity to holding cash.

we would like fixing from instruments.

Examples of illiquid securities

if you go with the 3 month A rated corporation, it gives you the details of the depth of the market.

is this bond very liquid? probably not.

Bond markets

Global markets exceeded 1 QUADRILLION in 2023

Notes: FX = Foreign Exchange MM = Money Markets

Things have evolved over time, this graph shows how even as late as 1990, us bonds were better than everything else. JGB's are issued, china, and all these other countries.

why are the numbers going up so much?

  • governments are borrowing more
  • corporations are issuing bonds instead of taking out loans from banks

Global fixed income and equity issuance equity is a tiny little fraction, while fixed income on bonds.

what does that mean? let's say there is a fixed income, When you issue a stock it's always there, etc,

Equities never mature. Bonds have finite maturity and must be refinanced in order to complete.

this showing you that basically a mix of different types of bonds are really big. Agencies, are like pseudo government bonds.

trading volumes across asset classes, this is fro23,> it's showing you how massive forex is compared to bonds, commodities, and equities/etfs

I'm sorry this one thing gets used pretty soon.

FX is the largest global market when looking at transaction volume.

this includes spot transactions as well as forwards, futures, swaps and other derivative securities.

10 year treasury rate, going back till 1870 or something. we can see the massive spike in the 1980s which was a major freakout, high inflation, oil crisis. now there is a really good run of downward moving interest rates, etc. the 10-year note has been doing really well in the last 20 years.

for a stock, the way you would model it, and there's a certain probability that you could isulate it. it's gonna go up a small percentage or down a small percentage. Interest rates, because of the way they are tied to other market factors, they are mean returning, meaning the mean value is being pulled toward the actual mean.

To model interest rates, and bonds, etc. so yields exhibit mean reversion, etc. If you were to do that, you would get about 6% over the mean.

Bond markets are modeled by first looking at interest rates then deriving bond prices

yields exhibit mean reversion

the long term advantage for the 10year is

The YIELD CURVE

we will go through it fast right now.

\(PV = C_1/(1+r) + C_2/(1 + r)^2 \ldots\)

the \(r\) is always the same, this is an oversimplification.

if you look at the treasury rates rn, the only way this would work if we have something called the

this is from this morning, it's kinda boring, you should look it up. we could say the year last year has come down for the first time, he loved the milk.

I just want to point out how different currencies have different yield rates.

if you deciding between bonds in different countries, markets believe that france is slightly riskier than germany.

these rates are lower than the US treasury counterparts, because the US is considered the least risky. Why is this a thing? it has something to do from the currency markets.

this is what it would look like this a linear scale, a curve, kinda logistical.

yield curves can be normal, (upward sloping) or inverted, (downward sloping)

upward-sloping

  • long term bonds typically offer higher yields than short term bonds, investors typically ask for a premium to compensate for the risks of holding long-term bonds.
  • rising interest rates, causing bond prices to fall
  • inflation eroding nd purchasing power,

Yield curve.

key drivers: - monetary policy - central banks influence short term (overnight) rates. - central banks sometimes play in the banks and directly influence long term rates (Quantitative Easing) - Expectations of future policy impact long term yields - - Fiscal policy - -