Longer-dated bonds

Maturity Generally default spreads are larger for longer date bonds and narrow for short-term bonds. 

Generally, the theoretical default spread is almost exactly proportional to the default probability, assuming a constant default probability. Generally, however, the default probability is not constant over time, nor do we expect it to be. In Figure 8.3, we show the theoretical default spread for triple-B-rated bonds of various maturities, where the default probability rises from 0.2% to 1 % over time. The longer dated bonds, therefore, have a higher aimual default risk and so their theoretical default spread is higher. Note that after around 20 years the expected default probability is constant at 1%, so the required yield premium is also fairly constant. 

Probably the most popular euro-denominated contracts available on European bonds are those offered by Eurex Deutschland and, in particular, those on longer-dated bonds issued by the German Federal Government the Buxl, Bnnd, and Bobl. Also popular but at the shorter end of the maturity spectrum are short-term notes issued by either the Federal Government or the Treuhandanstalt the Euro-Schatz notes. 

Due to the youth of the Euro credit market, an accurate comparison with the sterling market is difficult to make, but we can still observe an increased issuance of longer-dated bonds. 

Extend duration brfore a market rally, shorten duration before a market correction This is the most basic approach, and in its crudest form amounts to punting the market. The fond manager basically decides when he or she expects the market to rally and buys longer-dated bonds ahead of the anticipated move upward, which benefit from such a move more than shorter-dated bonds. Unfortunately, very few fond managers consistently get such a call right, and this approach is not often adopted, at least not explicitly anyway. 

From Figure 7.3, we see fliat to price a very Iraig-dated bond off the yield of the 30-year government bond would lead to errors. The unbiased expectations hypothesis suggests that 100-year bond yields are essentially identical to 30-year yields however, this is in fact incorrect. The theoretical 100-year yield in fact will be approximately 20-25 basis points lower. This reflects the convexity bias in longer dated yields. In our illustration, we used a hypothetical scenario where only three possible interest-rate states were permitted. Dybvig and Marshall showed that in a more realistic environment, with forward rates calculated using a Monte Carlo simulation, similar observations would result. Therefore, the observations have a practical relevance. 

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. 

The medinm term, 4.5-5.5 years, is the domain of the Enro-Bobl contract, while the 1.75-2.25 year matnrity segment is covered by the Euro-Schatz contract. Both of these fntnres contracts have basically the same specification as the longer-dated contracts described above. All contracts reqnire the delivery of an acceptable German government bond at settlement. 

The above examples have focused on the use of the Euro-Bund future as a vehicle for achieving a particular bond portfolio exposure. As indicated earlier, there are several other futures contracts available in the European arena and these could be used in the same way as described above. The futures contracts could also be used to alter the maturity characteristics of the portfolio by using, for example, futures contracts constructed around shorter or longer dated instruments than those currently held in the portfolio. The fact that the contracts can be bought or sold on margin, that the major contracts are liquid and span the European markets, and their flexibility of use make them essential financial market instruments. 

Exhibits 25.1 and 25.2 show how the iBoxx indices have evolved during 2002. Notice the rebalancing spikes at the turn of each month, caused by bonds falling under a year to maturity, the addition of new, longer-dated issues and the removal of cash. 

The segmented markets hypothesis, first described in Culbertson (1957), seeks to explain the shape of the yield curve. It states that different types of market participants, with different requirements, invest in different parts of the term structure. For instance, the banking sector needs short-dated bonds, while pension funds require longer-term ones. Regulatory reasons may also affect preferences for particular maturity investments. 

The yields quoted on T-bills often differ from their true yields. This is because their yield calculations often assume simple rather than compound interest. Nevertheless, true yield is important for its application to longer-dated coupon bonds. 

The zinc-methyl bond (1.914(4) A) is the shortest zinc-carbon bond reported to date, while the zinc-nitrogen bonds (2.040(2) A) are slightly longer than those in neutral, three-coordinate zinc diketiminato complexes (Figure 48). 

---