Actuarial Investments

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Actuarial Investments

• Shane Whelan
• L527

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Description of Key Markets

• - THE BOND MARKET
• II of II

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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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Yield Curves

• Yield curve a graph of the (best-fit) GRY on
  gilts against unexpired term.
• Often separate one drawn for high, medium, and
  low coupon bonds FTSE Actuaries Government
  Securities (UK) yield indices.
• Other methods to overcome problem of different
  coupon levels are generally too elaborate, e.g.,
  the yield surface.
• Strip curve (or zero coupon curve or spot curve)
  yield curve when all gilts are zero coupon.
• Also known as the term structure of interest
  rates
• This is key for theoretical considerations

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Yield Curve Sovereign Sterling Debt Gross
Redemption Yield, 25th July 2004
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Yield Curve Sovereign Euro Debt Gross Redemption
Yield, January 2004
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Yield Curves

• Par yield curve the coupon that would be
  required by the market for a gilt issued at par
  for the given term. The axes are coupon value
  (y-axis) against term to redemption (x-axis).
• Used by issuer (in Ireland the NTMA but elsewhere
  generally central banks)
• Important to understand when issuance is at
  significant levels.

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Theories of Shape of the Yield Curve

• Expectations Theory yield curve gives the
  markets expectations for the future course of
  short-term interest rates.
• A (crude) application of the REH
• Implies that if yield curve changes then this
  must mean that investors views of future
  interest rates have changed
• In particular, their expectations of inflation
  affect both interest rate level and trends hence
  yield curve level and shape

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Theories of Shape of the Yield Curve

• Liquidity Preference Theory investors as a
  class prefer liquid assets to illiquid ones.
  Longer dated stocks are less liquid than shorter
  dated stocks hence yields should be higher on
  higher dated stocks.
• A fair point made, but overdone.

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Theories of Shape of the Yield Curve

• Market Segmentation or preferred habitat theory
  yields at each term to redemption are determined
  by supply and demand from investors with
  (nominal) liabilities of that term.
• Different investors have different needs
• Banks at short end
• Life offices and pensions at long end
• Is there a natural hump in UK gilt curve?
• Price is a function of supply demand in each
  segment.

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Combining the theories

• Majority of investors want positive real return
  hence demand
• Overall level of curve depends on inflation
  outlook (expectations theory)
• Want compensation for uncertainty with an
  inflation risk premium which is upward sloping
  with term (by liquidity preference theory)
• Within this overall shape, near independent
  movements in the different maturity ranges
  reflecting supply and demand conditions in the
  different habitats (Market Segmentation)

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The Real Yield Curve

• Make a wild guess on its definition!
• What theories would you propose for the shape of
  the real yield curve?

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Relationship between Real Nominal Yields

• Nominal Yield Real Yield Expected
  future inflation inflation risk premium
• Hence difference between nominal and real yield
  curve gives markets expectation for inflation
  plus the inflation risk premium.
• Inflation risk premium can be positive or
  negative.

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Switching between conventional IL

• Conventional bonds will outperform
  index-linkers if expectations of future
  inflation fall and vice versa. Hence your
  portfolio split between these categories depends
  on how your inflation expectations differ from
  the markets.
• So we can indirectly trade inflation
  expectations.
• IN TRADING THE GAME IS THAT ONE
• Must anticipate the markets anticipation of the
  event

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Key Historical Statistics Irish Gilt Returns
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Principal Economic Influences on Money Bond
Markets
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The Obvious Point

• General price level in market set by supply
  demand
• Shift in supply or demand higher/lowers level of
  market (yield, ex ante return expectations)
• Demand for capital assets is very price elastic
  as many close substitutes
• In general think of supply and demand factors
  when justifying current levels and anticipating
  future price changes.
• Note that demand in the market can generally
  change faster than supply.

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Factors Affecting Short-Term Interest Rates

• Generally set by central banks (through repo rate
  and signalling)
• To control inflation hence high i and strong
  exchange rate
• To maximise economic growth hence low i and
  weak exchange rate
• To maintain independence hence needs to remain
  esteemed
• Over long term we note the close relationship
  between inflation and short-term interest rates
  hence level of inflation a key driver.
• Rates naturally correlated with business cycle as
  demand for credit increases (relative to supply)
  in up periods and is weak in down periods.

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Factors Affecting Long-Term Interest Rates

• Inflation
• as bond investor wants compensation for its
  expected level.
• Inflation risk premium
• As bond investor wants compensation for
  uncertainty in inflation outlook.
• The level of short-term interest rates
  especially for short bonds
• but are they too low to keep check of inflation
  or too high so recession imminent?
• The exchange rate as demand can come from
  overseas investors
• And other yield curvesespecially the long
  treasury

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Factors Affecting Long-Term Interest Rates

• Governments fiscal position and its funding
  policy (supply).
• Institutional cashflow on demand side
• Regulation changes
• Retail trends
• Investment policy alternative investments
• Any economic news in its affect on
• inflation, exchange rate, short-term interest
  rates,
• or any other factor that affects long-term
  interest rates.

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The Credit Yield Spread

• To judge corporate yields one needs to consider
  all the factors affecting the underlying yield
  curve plus anything that affects the probability
  of default, the marketability, and taxation
  differences if any
• Hence economic/business cycle in general.
• Corporate and sector profitability in particular.

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Completes Overview of Bond Markets

• Shane Whelan
• L527

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Actuarial Investments

• Shane Whelan
• L527