Hello Hello!!
I may have two very dumb questions, to which I won't know the answer until I ask them.
1) Isn't it possible to exploit pull to par in order to lock in the difference between the bond price and par value?
Like imagine I short a bond trading at 105 (premium of 5) and then just before maturity its price will be close to 100 at which I unwind and get that 5 of free money.
I could do the same for bonds trading at a discount, I buy a 95 bond then sell it before maturity when it reaches 100.
I've seen this strategy in some economic research from Gavekal and thought it seemed too good to be true.
2)To be honest bonds are products which I have quite an issue with, I feel like they don't have much value as buy and hold strategy: I mean they are priced so that you don't win money by holding them, aren't they? (price of a bond being the sum of discounted future cash flows).
So, from my own incomplete understanding, the only way to create $$$ through bonds is through capital gains, no?
I may be completely wrong, so could any of you provide me with their insights on the subject?
Thank you.
If a bond is trading at 105 and you short it, you will have to pay the owner the coupon and pay to borrow the bond. That will offset the pull to par.
Fixed income generally offers less risk (senior in the capital structure, so you get paid before equity does) and less reward (your upside is capped at par + coupons). However, fixed income runs the gamut from risk-free government bonds (there are trillions of dollars of government bonds globally that trade with negative yields) to highly-distressed bonds that offer a high risk of being worthless, offset by the potential to make multiples on your investment.
Thank you, but then how about exploiting discounted bonds? Also, what about the pricing of bonds? Bonds are priced so that they are worth their discounted future cash-flows, meaning that coupons you receive are already paid by you when you get the bond. So is there really a way to make money from bonds just by doing buy and hold?
when you buy and hold a bond to maturity (without leverage), you earn the yield....thats it there is no arbitrage to be had there in most cases. Bonds with higher yields genrerally reflect credit quality (% chance the entity defaults and you get nothing or pennies on the dollar). For entities that cannot default, like the US Govt, the risk is your $$ tied up in the bond is worth lessin the future if inflation goes up in the future, more than is expected by the market at the time you bought the bond.
the present value/future value formula must take into account expected inflation....but actual realized inflation in the future (your opportunity cost to use the vcash to buy a better performing asset) most likely will not = expected inflation when you bought the bond...inflation is not constant..it fluctuates based on the global macro economy
most professional investors/traders buy and sell their bonds just like stocks. but that is different from your question.
Hi, yes I get the credit quality, inflation points etc... my question wasn't actually about how bonds are priced or how X or Y factor affect them (even tho I understand your point about taking into account opportunity costs of investing into something better). Imagine you have a 3y govie trading at a discount, at t0 it's worth 98, then at t2.99 it's worth 99.9. If you buy at 98 and sell at 99.99, you make a 1.99 profit right? And this happens whatever is the state of interest rates, inflation, etc... If i'm not wrong whether they are trading at a premium or at a discount all bonds mechanically converge to par (maybe only a default could change this?).
Actually my question about buy and hold is not related to the previous subject (convergence to par), it's more about the no arbitrage pricing logic, which is the same for all assets, that is to say: an asset is only worth as much as how much money it can bring home. For a bond, it's priced by discounting future cash flows, meaning the bond price is the sum of discounted coupons and principal, so when you buy a bond you have already paid for each and every coupon ==> therefore receiving coupons shouldn't contribute to increasing your wealth, no? (it's like paying $1 to receive $1) It's the same principle for options, when you price them for example with binomial pricing, it makes it so that the option price is the expected value of discounted future cash flows (what probability that underlying will go up or down multiplied by the corresponding payoff). This reasoning is used to price almost everything, futures, swaps, stocks etc... The thing I don't get is how could buy-and-hold be viable for bondholders, in the sense of never selling the bond and just keeping it to maturity. In my mind it makes no sense at all first because he already paid for all future coupons when he bought the bond, so receiving coupons will not increase his wealth; and second as you said if we take into account inflation which is not priced-in in the bond then the poor bondholder is even losing purchasing power by choosing this strategy.
All this rambling is just the result of what I've remembered from my fixed income class, so please bear with me if I have said anything stupid.
No
take 2 bonds from same issuer, same maturity, same place in the capital struture
A - imagine a 20yr bond was issued 10 years ago, and has 10 years remaining to maturity, issued when interest rate was 6%
B - now imagine a second bond issued today, also with 10 years remaining to maturity, but 10yr interest rate is 3%
The 6% 20yr bond will have a price above par....because current interest rates are 3%, but that bond has a 6% coupon...which is now more valuable than it was at issuance (because you can only get a 3% coupon from a newly issued bond with same relevant details). In order for that 20yr bond, with 10 years left to maturity to also yield 3%, the price to purchase the bond will rise, such that the total return will be equal to the currently issued 10yr note....that yields 3%
So, when you combine the principal pull to par effect (whichever direction it may be), plus the coupon payments, the net return will be the same for both bonds, that have the same yield to maturity.
Your bond with a price below par will have smaller coupons that the bond with a higher price.
In this example, if you had bought the 20yr bond at issuance (when interest rates were 6%) and held that bond for 10 years...and now that same security has a 3% yield....the assumptions at issuance are no longer valid...either inflation expectations have changed..or credit quality has changed...such that the prevailing level of interwst rates (yields) have changed. But bonds with fixed coupons don't change...so the stream of cashflows (the coupons) are worth more now then they were at issuance...so their price changes.
Understood thanks!
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