Bond Actual and Expected Returns.

[N_Exam]

Hi Everyone,

Having done some exam questions, I'm a bit confused about a bonds expected and actual returns. Please could some people and tutors help.

Question1) Confusion on Expected return and Actual return.
Exam 2014 April paper 1 asks
A pension scheme invests in two investment portfolios:
A Long term conventional bonds
B A combination of domestic and foreign equities
iii) Explain how portfolio A could provide higher returns over the next twelve months.

The answer states that the expected return on Portfolio A will be higher if its Liquidity, Marketability and Credit risk is higher. However, is this not the “Required Return” equation which states its risk premium is comprised of Inflation, Liquidity/marketability, Credit risk? The expected return equation doesn't talk about these risks specifically.

The answer also says the actual returns on Portfolio A would be higher if "A fall in bond yields would increase the price of bonds which would increase the return on the bond portfolio." Does this mean actual returns are the price of the bond?

Question2) Why do investors want to maximise expected return.
Several questions (eg Apr 2013 paper 1 Q7) ask about "how an individual can maximise their expected returns on bonds". The answers talk about increasing the risk of the bond, eg default risk.
I understand that when the bond yield goes up (i.e. risk goes up), its price goes down. So, why do individuals want to maximise their expected returns on bonds (i.e. increase their yield) if this means the value of their bond reduces? As its a bond it gets fixed coupon payments so I don't think an increase in yield gives an increase in coupon payments?
Please can someone explain?

Question3) Equity Risk Premium.
I understand the Required Return equation for a bond, eg its risk premium is comprised of Inflation, Liquidity/marketability, Credit risk.
So, is the equity risk premium comprised of Inflation, Liquidity/marketability, Credit risk, uncertain dividend risk? Or something else?

Question4) Index Linked.
In the exam, should I take the index on an "Index Linked" bond to be the inflation index?


Thank you to all who answer!!!!!!!!!!

 

[Richie Holway]

Hi there, taking your questions in turn:

Question 1

Yes, the risk premium is part of the ‘required return’ equation as you state: the higher the risk from investing in an asset, the higher the return we would require in order to be prepared to invest in it. However, risk is also relevant to ‘expected return’ – because you would expect an asset with higher risk to generate a higher return (over a reasonable period of time). For example, we would expect to receive a higher return from equities than we would from cash – hence the first answer point that you refer to here. In terms of the second point, actual returns comprise both income and capital gains, where capital gains means the change in price – hence a price increase generates a higher return.

Question 2

It is important to distinguish between those investors considering purchasing a bond and those investors who already hold bonds, because a change in prices & yields mean very different things for each. If an investor is considering purchasing a bond, an increase in yields (ie a decrease in price) is a good thing, because they can then buy the bond at a cheaper price. If an investor already holds a bond, an increase in yields (ie a decrease in price) is a bad thing, because the value of their portfolio (the value of the bonds) will be lower. The questions you refer to are talking about the situation where someone is considering purchasing a bond.

Question 3

For equity, the risk premium reflects the risks of low liquidity, low marketability, uncertain dividends and volatile share prices. It doesn't reflect the risk of higher or lower inflation than expected, since company profits and so equity values tend to rise in line with inflation anyway. There might be some reflection of the risk that equity prices don't perfectly move in line with inflation.

Question 4

Yes, the payments of index-linked bonds depend on the value of an inflation index.

I hope this helps,
Richie

 

[N_Exam]

That clears things up! Thank you Richie