Debt Markets

Practise Examination Question

Table 2 below shows information on UK benchmark government bonds.

Table 2: Yields on UK Benchmark government bonds
Maturity
Yield (%)
Yield 1- week ago
1 year
0.31
0.31
2 years
0.41
0.43
5 years
1.05
1.08
10 years
1.61
1.67
15 years
1.98
2.06
30 years
2.34
2.41
Adapted from FT.com – downloaded on 12/1/2015

(a) Explain the following characteristics of bonds:
(i) Maturity date (10% of marks)
The maturity date is the date at which the bond is redeemed. Holders of the bond receive the face value of the bond. This is typically £100 in the UK. From the table above, there are a variety of maturity periods illustrated ranging from 1 year to 30 years.

(ii) Coupon (10% of marks)
A coupon is the periodic fixed interest payment made to holders of bonds. This is fixed at a percentage on the face value (£100). So, a 5% coupon would pay £5. However, coupon payments are normally made twice yearly. Consequently, in the above example, coupon payments would involve two payments of £2.50.

(iii) Par value (10% of marks)
A par value is another term for face value. This is typically £100. It represents the amount which will be repaid when the bond matures. This is very different from the market value which will fluctuate over time.

(iv) Yield (10% of marks)
This is the anticipated return on a bond if it is held until maturity, given the current equilibrium price. It includes the return from the coupon, but also the capital gain / loss at redemption. So, for instance, the yield on the 10 year benchmark bond is 1.98% this week. Yield represents the rate of return offered by the next best alternative.

(b) Explain two different reasons for changes in the yields over the last week (30% of marks).
In general, yields have declined over the past week. This means that the prices of these benchmark bonds have risen over the last week. There are a variety of possible reasons for this.
Firstly, interest rates may have decreased. Excessive monetary growth could have caused a decrease in interest rates. A decrease in interest rates reduces the opportunity cost of holding these bonds. This reduces the discount rates applied to the cash flows from these bonds. A reduction in these will increase the present value of the bonds, leading to a surge in demand. An increase in demand (ceteris paribus) will produce an increase in price, and reduction in yield.
Secondly,