Bonds are a type of investment that is used by many people to generate income and build their wealth. They are essentially loans that are issued by companies, governments, or other organizations to raise capital for various purposes. The bond market refers to the place where these bonds are bought and sold. In this article, we will explore the history of bonds and the bond market, and how they have evolved over time.
The history of bonds dates back to the 16th century, when the Medici Bank of Florence issued bonds to raise capital for various projects. However, it was not until the 17th century that bonds became widely used as a source of financing. During this time, governments began issuing bonds to raise capital for their various wars and other expenses. The first recorded bond issue by a government was by the Dutch East India Company in 1602, when it issued bonds to finance its voyages to the Far East.
Over the next few centuries, bonds continued to be used as a source of financing for governments, companies, and other organizations. In the 19th century, bonds became increasingly popular in the United States as a way for companies to raise capital. This was due, in part, to the growing size and complexity of the American economy, which required more capital to fuel its growth.
In the 20th century, bonds became even more popular as a source of financing. During World War I, governments around the world issued bonds to raise capital to finance the war effort. This led to a huge expansion of the bond market, and bonds became an important part of the financial landscape. After the war, bonds continued to be used as a source of financing for governments, companies, and other organizations.
In recent years, the bond market has evolved to include a wider range of bonds, including government bonds, corporate bonds, and municipal bonds. Today, the bond market is a global marketplace that is used by investors to buy and sell bonds from around the world. The bond market has become an important part of the financial system, providing a source of financing for governments, companies, and other organizations.
In conclusion, bonds and the bond market have come a long way since their inception in the 16th century. Today, they are an important part of the financial landscape and provide a source of financing for governments, companies, and other organizations. The bond market continues to evolve and expand, offering investors a wider range of investment opportunities. Whether you are a seasoned investor or just starting out, bonds can be an excellent way to generate income and build your wealth.
Public Questions about Bonds:
Question: Let’s take example of ETF X which invest in 20 year investment-grade corporate bonds. Suppose during it’s first year, it bought 20 year duration bond worth 1 Million. In consecutive years, average duration of holding will decrease to 19, 18, 17, and so on. How it will maintain 20 year average duration now?
Answer: To maintain an average duration of 20 years for the bond ETF, the ETF manager will need to continually buy new bonds to replace the bonds that are maturing or being sold from the ETF.
In this scenario, if the ETF X bought a 20-year duration bond worth 1 million dollars in the first year, and the average duration of holding decreased to 19, 18, 17, and so on in consecutive years, the ETF manager would need to buy new bonds with longer maturities to maintain the 20-year average duration.
For example, in the second year, when the average duration of holding decreased to 19 years, the ETF manager could buy a new bond with a 21-year maturity to maintain the average duration of 20 years. In the third year, the manager would need to buy a bond with a 22-year maturity, and so on.
The ETF manager can also use other strategies, such as swaps or options, to adjust the average duration of the bond ETF as necessary. The primary goal is to maintain the desired level of interest rate risk exposure for the investors in the ETF.
Question: How do they calculate average bond duration? Suppose I have 1 Million worth 19 Year bond and 100K worth 21 year bond, 200K worth 22 year bond. What is the average duration of it?
Also curious about cases when there is cashflow/liquidity problems. Suppose there is not enough new cash inflow ever year and corporate bonds are quite illiquid, so you can’t really sell them either.
What they will do now? Will they buy swaps now or something else? They won’t get yield with swaps so it sounds bad deal?
Answer: The average bond duration is calculated as the weighted average of the time until the bonds’ cash flows are received, where the weights are the present values of the cash flows. The formula for average duration is:
Average Duration = [ (Duration1 x PV1) + (Duration2 x PV2) + … + (Durationn x PVn) ] / Total Present Value
Where Duration is the time until each cash flow is received, and PV is the present value of each cash flow.
Using your example of a 19-year bond worth 1 million, a 21-year bond worth 100k, and a 22-year bond worth 200k, the calculation for the average duration is:
Average Duration = [(19 x 1,000,000) + (21 x 100,000) + (22 x 200,000)] / (1,000,000 + 100,000 + 200,000) = 19.54 years
So, the average duration of this bond portfolio is 19.54 years.
In the case of cash flow or liquidity problems, the ETF manager may face challenges in maintaining the desired average duration of the bond ETF. If the ETF is unable to purchase new bonds to replace maturing bonds, the average duration will gradually decrease as the portfolio’s maturity shortens.
In this scenario, the ETF manager may consider using derivatives such as swaps or options to adjust the ETF’s duration exposure. However, swaps do not generate yield, so they may not be an ideal solution for maintaining the ETF’s income generation. Additionally, derivative instruments can carry risks and may require regulatory approvals, so the ETF manager will need to carefully evaluate these options before implementing them.
Question: So I learned about the Zero Bond Discount Factor in relation with the present value of future payments. I saw that you could use the Zero Bond Discount Factor not only for Zero Bonds, but also for future payments with normal bonds. I was wondering if anyone knows a formula for the zero bond discount factor because the formula i used always results in a wrong answer to my tasks. Also I didn’t quite understand how the Zero Bond Discount Rate is calculated over a timespan with different interest rates. Let’s say I have buy a bond (face value 100000) with a maturity of 3 years and we know the interest rates in the next year’s are gonna be 4%, 5% and 6%. How would I calculate this with the Zero Bond Discount Rate?
Answer: The formula for the Zero Bond Discount Factor is:
Zero Bond Discount Factor = 1 / (1 + r)^n
where “r” is the yield to maturity (YTM) of the bond and “n” is the number of years until maturity.
To calculate the Zero Bond Discount Rate over a timespan with different interest rates, you would need to calculate the discount factors for each year using the appropriate interest rate for that year. Here is an example calculation for your scenario:
Year 1: Discount Factor = 1 / (1 + 0.04)^1 = 0.9615 Year 2: Discount Factor = 1 / (1 + 0.05)^2 = 0.9070 Year 3: Discount Factor = 1 / (1 + 0.06)^3 = 0.8403
To find the Zero Bond Discount Rate for the entire three-year period, you would multiply the discount factors for each year:
Zero Bond Discount Rate = 0.9615 * 0.9070 * 0.8403 = 0.6992
This means that the present value of the future payments from this bond is 69.92% of its face value, which is the same as saying that the YTM is approximately 10.08%.
Question: Thanks, I understand that part now. I didn’t quite get how I would discount the payments while using the zero bond discount factor tho (I’m obliged to use it due to my class). If not for that restriction the correct way to discount it would be, If I understood correct: Present Value = future payment * (1/ interest rate)time period) However this would only be possible if the interest rates stay same for the whole time period. I didn’t quite understand how I would calculate it if the interest rates changed between f.g. year 1 and year 2 from 4% – 6%.
Answer: You’re correct that the formula for calculating the present value of a future payment assuming a constant interest rate is:
Present Value = Future Payment / (1 + Interest Rate)^Time Period
If the interest rate changes over time, you can still use this formula, but you would need to calculate the present value for each year using the appropriate interest rate for that year. Then you would add up all the present values to get the total present value of the future payments.
For example, let’s say you have a bond with a face value of $100,000, a coupon rate of 5%, and a maturity of 3 years. The coupon payments are made annually. The interest rates for each year are as follows:
Year 1: 4% Year 2: 5% Year 3: 6%
To calculate the present value of the coupon payments using the zero bond discount factor, you would need to first calculate the zero bond discount factors for each year based on the respective interest rates. The formula for the zero bond discount factor is:
Zero Bond Discount Factor = 1 / (1 + Interest Rate)^Time Period
Using this formula, we can calculate the zero bond discount factors for each year as follows:
Year 1: Zero Bond Discount Factor = 1 / (1 + 0.04)^1 = 0.9615 Year 2: Zero Bond Discount Factor = 1 / (1 + 0.05)^2 = 0.9070 Year 3: Zero Bond Discount Factor = 1 / (1 + 0.06)^3 = 0.8396
Now that we have the zero bond discount factors for each year, we can calculate the present value of the coupon payments for each year using the following formula:
Present Value = Coupon Payment * Zero Bond Discount Factor
For example, the coupon payment for Year 1 would be 5% of $100,000 = $5,000. The present value of that payment would be:
Present Value = $5,000 * 0.9615 = $4,807.50
Similarly, the present value of the coupon payment for Year 2 would be:
Present Value = $5,000 * 0.9070 = $4,535.00
And the present value of the coupon payment for Year 3 would be:
Present Value = $5,000 * 0.8396 = $4,198.00
Finally, we can add up all the present values to get the total present value of the coupon payments:
Total Present Value = $4,807.50 + $4,535.00 + $4,198.00 = $13,540.50
So the total present value of the coupon payments is $13,540.50. Note that this assumes you plan to hold the bond to maturity and receive the face value payment at the end of Year 3.
Pingback: Asset Classes 101: An Introduction to different classes