Long-term maturity bonds

There are two characteristics of a bond that affect the degree of reinvestment risk. First, for a given yield to maturity and a given nonzero coupon rate, the longer the maturity the more the bond s total return is dependent on reinvestment income to realize the yield to maturity at the time of purchase. The implication is that the yield to maturity measure for long-term coupon bonds tells us little about the potential return an investor may real-... 

Bond A long-term debt-type of security generally issued by corporations or governments to generate cash. The coupon rate is the interest rate paid to the bondholder. The maturity date is when the face value of the bond will be paid to the bondholder. 

This model incorporates mean reversion, which is not an imrealistic feature. Mean reversion is the process that describes that when the short-rate r is high, it will tend to be pulled back towards the long-term average level when the rate is low, it will have an upward drift towards the average level. In Vasicek s model, the short-rate is pulled to a mean level 6 at a rate of a. The mean reversion is governed by the stochastic term odW which is normally distributed. Using Equation (3.24), Vasicek shows that the price at time t of a zero-coupon bond of maturity T is given by ... 

The different types of bonds in the European market reflect the different types of issuers and their respective requirements. Some bonds are safer investments than others. The advantage of bonds to an investor is that they represent a fixed source of current income, with an assurance of repayment of the loan on maturity. Bonds issued by developed country governments are deemed to be guaranteed investments in that the final repayment is virtually certain. For a corporate bond, in the event of default of the issuing entity, bondholders rank above shareholders for compensation payments. There is lower risk associated with bonds compared to shares as an investment, and therefore almost invariably a lower return in the long term. 

For longer-dated debt instruments investors have the a choice of the very long-term notional 30-year, 6% coupon Euro-Buxl contract which covers cash market bonds with a matnrity of between 20 and 30.5 years, or the notional 10-year, 6% coupon Enro-Bnnd contract which covers the 8.5-10.5 years maturity section of the yield curve. The nominal size for each contract is 100,000 both have a minimum allowable price movement (tick) of 1 basis point, which is valued at 10, and a contract cycle of March, Jnne, September, and December, of which the three nearest-to-delivery, snccessive contracts will be available for trading. 

A constant maturity swap, or CMS, is a basis swap in which one leg is reset periodically not to LIBOR or some other money market rate but to a long-term rate, such as the current 5-year swap rate or 5-year government bond rate. For example, the counterparties to a CMS might exchange 6-month LIBOR for the 10-year Treasury rate in eflFect on the reset date. In the U.S. market, a swap one of whose legs is reset to a government bond is referred to as a constant maturity Treasury, or CMT, swap. The other leg is usually tied to LIBOR, but may be fixed or use a different long-term rate as its reference. 

Corporate bonds, as the name indicates, are issued by corporations. Corporate bond values often track the health of the company that issued them even more than they are affected by movements in interest rates. Investors in corporate bonds often evaluate balance sheets, products, management, competitive environment, and even the company s stock performance. There are four different corporate market sectors industrials (cyclicals), airlines/transportation, public utilities, and banking/finance. Maturities fall into four categories short term (up to 4 years), intermediate term (5-12 years), long term (13-40 years), and "absurd term" (41-100 years). 

Expression (3.40) states that the forward rate ft T,T -l-l) is the expected one-period spot rate at time 77 rate given by plus the liquidity premium, which is a function of the maturity of the bond (or the term of the loan). This premium reflects the conflicting requirements of borrowers and lenders traders and speculators will borrow short and lend long in an effort to earn the premium. 

Zero-coupon bonds don t pose these problems, because their durations are identical to their terms to maturity. This potentially increases their attractiveness as investments. A five-year zero-coupon bond has a duration of five years when purchased after two years, its duration is three years, no matter what interest rates have done. A long-dated zero-coupon bond can thus be safely used to match a long-dated liability. 

Investors in securities accept the risk that the issuer will default on coupon payments or fail to repay the principal in full on the maturity date. Generally, credit risk is greater for securities with a long maturity, as there is a longer period for the issuer to potentially default. For example, if a company issues 10-year bonds, investors cannot be certain that the company will still exist in 10 years time. It may have failed and gone into liquidation some time before that. That said, there is also risk attached to short-dated debt securities indeed, there have been instances of default by issuers of commercial paper, which is a very short-term instrument. 

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