I've been reading into Siddhartha Jha's Interest Rate Markets in preparation for a possible rotation in the rates desk and I realize how lacking my knowledge is about bond markets, especially when it comes to the changing of bond prices as they mature. From what I understand, PnL is based on a roll down as bond prices approach parity as time matures. I understand the owner of the bond makes profits through two different explanations: If bonds are below par and rise to par with maturity, trader profits. The other explanation is that if the yield curve is static and upward sloping, as the bond matures, the bond's yield declines and the bond's price rises, resulting in a capital gain.
What I am confused about is how coupon payments figure into this equation. 1. A bond below par rises to par as it edges closer to maturity but at the same time the closer it is to maturity, the less time the owner has to get coupon payments, yet the value of the bond increases. 2.The fact that one can buy a bond that is below par and in the process of holding the bond to maturity, receive coupon payments AND get a guaranteed capital gain back up par seems too good to be true. Does the time value of money/term premium explain both of these points? Please help clarify or correct any misconceptions that I have. Thanks!
1) You are not considering risk. If bond is closer to maturity, market movements are more unlikely, for better or worse, therefore the bond price comes closer to par.
2) Time value of money. If interest rates go up a lot, the yield you are getting from the bond might be crap. For example, if you buy a bond for 100 and are receiving 2% annually ant interest rates rise to 3% you would be able to find secure investments with 4% or 5% returns so your 2% is not "too good to be true".
And your two ways to profit are not right either. The most important factor is the movement of interest rates. You can make money by predicting changes in interest rates, which will inevitably affect bond prices, because of what I explained in 2.
Read investopedia's beginners tutorial on bonds, it's pretty good and pretty basic, so it will help you understand all this.
You buy a bond that is trading below par and rates go up, resulting in capital losses for you. Rather than book the capital losses, why not just hold the bond the maturity, thus wiping out the loss and getting the YtM as a return? Is it that simple or does leverage mess this up.
How does holding it to maturity simply wipe out the losses? The present value of the cash flows is now less than when you purchased the bond.
that makes sense... my naive, incorrect thought process was if a bond is trading at 96, rates increase and the bond is now at 94, why not hold the bond until maturity to get the FV rather than sell the bond and take the two dollar loss. But this is clearly ignoring the increased discount factor.
Because you can use those 94 to reinvest and get more present value than 100+coupons in say 10 years.
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