Question 1
REGULAR TREASURY BOND WORKING STRUCTURE
The regular treasury bonds are the bonds, which were issued by the government or central bank of the country or any agency that is under government’s oversight can issue these bonds on the behalf of the government. These bonds are not considered to be risk free. The maturities of these bonds are medium to long-term (10 years or more).
The interest payments on these bonds are normally on semi-annual basis. The holders of these bonds also have an option to convert it at annual basis however;this will have an impact upon the interest rate and amount.
The interest payments over these bonds are tax allowable means that the holder of the bond can claim tax savings calculated on the rate given by federal authorities of the company.The minimum amount at which these bonds are traded is $1000.
These bonds are frequently available to the general public. The structure of this transaction is the government contacts with dealers which will directly deal with the public on the behalf of the government. These dealers are limited in numbers and the transaction between the dealers and the general public is an auction based transaction which means that who ever bids for the bond at a level acceptable to the dealers and government gets the bond.If the above statement should be summarized then it shows that the government introduced its bond to the open market indirectly through their dealers.
The introduction into the open market drives the current market prices and the yield. The yield is basically the return earned by holders of the bond as by trading them at higher prices it would mean thatt he market value will be higher than the present value of the bond.After that the holder will likely earn an arbitrage profit from it. These bonds are traded normally at below par value.
The yield to maturity rises which is the market interest rate the price of the bond decrease or vice versa. This increase in the rate creates the interest rate risk for the buyer however,it creates opportunity for the lender to earn higher interest income. This shows that the correlation between the interest rate and bond price is negative.
IMPACT OF INFLATION ON COUPONS AND PRINCIPAL OF T-BONDS
Inflation is generally described as a general rise in the price of goods or commodities. There are generally two kinds of inflation; one has an impact on the price of the goods, which is price inflation, and the other has the impact on the value of the money.
As the value of the money deteriorates and supply of the goods begins to increase this results in an inflationary situation which slows down the economy of the country and for dealing with this problem the company expands the money supply as well. However,with the decreased value it means that the return earned from the bonds will be lower as compared to its value in present terms and similar will be the impact on the bonds coupon and principle as the inflation rises.Furthermore, the interest rates cause the value of principle and coupon to deteriorate in current price terms.
DIFFERENCE OF TIPS WITH REGULAR T-BOND
Treasury Inflation Protected Securities are the securities that are used to hedge inflation risk in a simple and an effective way. These bonds provide a real return rate of return to the investor by the government of the country. These are those bonds in which the coupon and principle are positively correlated with inflation or in other words consumer price index.As the prices index increases, therefore the coupon and principle will also increase in the same proportion and vice versa in the event of deflation.
At the maturity stage of these bonds, the government pays adjusted principal or the original principal amount whichever is greater in between them. The above situation has been clearly shown in the graph given in the case file (Exhibit 3). In this exhibit, the real return on the Tbills is negatively correlated to CPI but perfectly or positively correlated in the case of TIPS.
CONDITIONS IN WHICH TIPS OUTPERFORMS THE REGULAR T BONDS
The condition which makes the TIPS to outperform the regular T BONDS is when the actual rate of inflation increases in such a way that it exceeds the market anticipation, which means that as the rising inflation is positively correlated with the TIPS and negatively correlated with T BONDS. Therefore, the holder of TIPS will earn a greater return than the holder of T BONDS however,in normal circumstances where the inflation remains in equilibrium then T BONDS returns will outperform the TIPS.Nonetheless,due to the volatile nature of T BONDS, which are more sensitive to CPI changes, the TIPS will outperform them in the short term..............................
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