Yields on government bonds of many developed economies currently stand at unprecedentedly low levels. The table below compares the yields on a selection of UKgovernment bonds at the start of March 2014 with long term average yields associated with the corresponding terms to maturity.
UK Government Bond Yields
Maturity (Years) Annual Yields March 2014 Long Term Average Yields
1 0.20% 2.90%
2 0.23% 3.10%
3 0.44% 3.29%
4 0.64% 3.46%
5 0.85% 3.61%
8 1.58% 3.75%
9 1.80% 3.87%
10 2.03% 3.99%
18 3.10% 4.11%
19 3.14% 4.14%
20 3.19% 4.17%
Until recently market analysts have tended to express a broadly neutral stance regarding the prospect of government bond yields ˜reverting to mean’ in the near future. But now, a growing number are suggesting that recent data on economic growth, inflation and central government debt have heightened the prospect of yields rising in the forthcoming period.
With reference to the concept of duration, briefly explain why (given the prospect of yields rising in the forthcoming period) it might be advisable to restructure a portfolio of government bonds away from longer term towards shorter term maturities.
(10 per cent)
Calculate clean prices for the four bonds listed below based on the yields prevailing in early March 2014. Assume that the coupons are paid annually and that the redemption payment for each is Â£100.
Maturity 2 years 5 years 10 years 20 years
Annual Coupon Â£5 Â£5 Â£5 Â£5
(12 per cent)
The simple yield expectations model cited below incorporates a coefficient ?(theta) that represents the strength of the tendency for yields to revert to mean levels.
(See the module notes for model specification).
In the light of the shift of the market consensus towards an expectation of rising yields, assume that theta has risen from 0 to 0.1.
Generate estimates for yields one year and two years from now for the four bonds. (Incorporate the term to maturity changes in your calculations)
Measure the impact of the estimated yield changes on the market prices of the four bonds in one year and in two years from now and calculate the one and two-year holding period returns.
In the light of the results from Task 4, assess whether it would be advisable to shift the balance of a portfolio of UK government bonds towards shorter maturities if the intended investment holding period is limited to two years.
(10 per cent)
Instead of a theta of 0.1, assume a stronger expectation of rising yields reflected in a theta of 0.5. Calculate the relevant holding period returns and assess whether or not the stronger expectation of yield increases would affect the portfolio management decision.