Explain why the yield curve for lower quality bonds

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Reference no: EM1382133

Q1: Case Study

On the advice of some of its wealthiest alumni, Clare College has borrowed £15m on a 40-year inflation- linked loan. One year, as any beleaguered banker will tell you, is a long time in the markets. Banks crash, governments bail out and the landscape of the City shifts forever. But in the cloistered colleges of Cambridge University it's a mere blip in financial history and the brightest academics in the land are banking on the good times rolling round once again.

Clare College, Cambridge is attempting to cash in on the current economic crisis by borrowing money for the first time in its 700- year history to take advantage of cheaper shares. On the advice of some of its wealthiest alumni, it has borrowed £15m on a 40 year inflation- linked loan, which, it hopes, will one day in the distant future reap a profit of £36m.

Only Oxbridge with its bulging endowment coffers could afford to squirrel away £15m over such a long period of time, as Donald Hearn, Clare's bursar freely admits. "Because we have a very, very long term perspective - we've been around for 700 years and plan to be around for at least 700 more- we have the advantage of not worrying about short term thresholds," he said. "We are putting the £15m away for 40 years and will not touch it for all that time."

The college has borrowed the money at a real rate of interest of 1.09% to invest it in rock-bottom stocks and shares. The length and type of loan makes it the first of its kind for any British or American college, according to HSBC, who did all the work on the deal. Rather than a conventional loan paying back the same amount of money in 40 years plus interest, the inflation-linked loan means the college will have to pay back an estimated £70m in 2052 but with a projected profit of £36m.

"Because real interest rates adjusted for inflation are so unusually low it happened to be one of those occasions where we could borrow at 1.09% and it's almost inconceivable that real returns on equities will average less than 1.09% over the next 40 years," Hearn said.

Because UK institutions have been forced to match their long-term liabilities very closely, long-term inflation-linked yields in the UK are very low. The real yield on the 2052 I/L gilt is 0.8 per cent per year. The real yields on comparable I/L government bonds in the US and France are 3.1 per cent and 2.6 per cent respectively. Clare is borrowing at 1.09 per cent (including a cap on its nominal liability at 7 per cent inflation). One Independent City expert told the Financial Times: "They are almost bound to make money, when you allow for rises in equity prices and dividends over the next 40 years." This belief is reinforced by Clare's view that stock markets are now at or near their bottom.

Required:

(a) Critically assess the theoretical and empirical evidence for the belief that ‘it's almost inconceivable that real returns on equities will average less than 1.09% over the next 40 years'.

(b) Critically assess the theoretical and empirical evidence for the belief that the strategy outlined in the case is less risky over the long run than it would be over a short period of time.

(c) It is suggested in the case study that ‘stock markets are now at or near their bottom' and ‘they are almost bound to make money'. In relation to these statements, with relevant data and evidence, discuss to what extent market timing is feasible using:

(i) Reverse yield gap
(ii) Tobin's q
(iii) PE ratios
(iv) Charts, including moving averages

(d) Discuss the theoretical and empirical arguments for Clare College including commodities as an additional long-term asset class.

Where appropriate, your answer should include recent and seminal academic literature, fully referenced, that relate to the specifics of the question.

Section B

(a) Calculate both Macaulay and modified durations of the 8-year, 8.5% coupon bond given a flat yield curve at 10%.

(b) Explain why zero coupon bonds have a higher Macaulay Duration than coupon paying bonds of the same return.

(d) Define the following international bonds and markets:

a. Eurobond Market
b. Foreign Bond
c. Internal Market or National Market
d. External Market or Offshore Market
e. Interbank Foreign Exchange Market

1. Generate the price-yield curve for a zero-coupon bond with a face value of £100 and 260 actual days to maturity using the following annual yields: 4%, 4.25%, 4.5%, 4.75%, 5%, 5.25%, 5.5%, 5.75%, 6%, 6.25%, 6.5%, 6.75%, 7%, 7.25, 7.5%, 7.75%, and 8%. Use actual/actual day count convention.

2. Given a 10-year, 8% coupon bond with a face value of £100 and semi-annual coupon payments:
a. Generate the bond's price-yield curve using annual yields ranging from 5% to 10% and differing by .5%.
b. What is the price change when the yield increases from 8% to 8.5%?
c. What is the price change when the yield decreases from 8% to 7.5%?
d. Comment on the capital gain and capital loss you observe in b and c.
e. Comment on the features of the price-yield curve.

3. Explain why the yield curve for lower quality bonds could be negatively sloped when the yield curves for other bonds are not.

Reference no: EM1382133

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