Bond Spreads and Government Policy

This assignment analyzes the relationship between bond spreads and government policy. It examines data on Australian Federal Government bonds and NSW Treasury bonds for various maturity periods (3-year, 5-year, and 10-year) from 2007 to 2008. The analysis focuses on identifying trends in the spread between these bonds and exploring potential reasons for differences in yields due to distinct monetary policies implemented by the federal and state governments.

Business Finance

Question 1
Expected return on each security using CAPM is as follows:
E(r) = Rf + ß (Rm - Rf )
Share A E (r) = 3% + 1.5 (8% - 3%)
= 10.5%
Share B E (r) = 3% + 0.6 (8% - 3%)
= 6%
Share C E (r) = 3% + 1.2 (8% - 3%)
= 9%
Share D E (r) = 3% + 1.8 (8% - 3%)
= 12%
a)
Security Expected return
using CAPM
Expected return of
investor
Share pricing
A 10.5% 14% Overvalued
B 6% 8% Overvalued
C 9% 9% Correctly priced
D 12% 10% Undervalued
b) Beta measures the volatility of a stock in comparison to the stock market. A beta of 1
means the stock has same volatility as the market, a beta more than 1 means the stock
has higher volatility than the market and a beta of less than 1 means the stock has a
lower volatility than the market. Stock portfolios build with low volatility stocks tend
to outperform the high beta growth stocks. This is because these stocks have low
volatility resulting in gradually increasing dividend income and due to low volatility
the price also remains more or less stable (Jim 2011)

In the present case also, share A and B have low beta as compared to share D. Even though
share D is undervalued and both shares A and B are overvalued, however a portfolio of low
beta stocks will tend to outperform share D as they have low volatility.
c) The NPV of the three projects is presented below:
Year Cash Flows PV Present value of cash flows
Project A Project B Project C Project A Project B Project C
-20,000 -40,000 -70,000 1 -20,000 -40,000 -70,000
1 18,000 5,000 30,000 0.893 16,071.4 4,464.3 26,785.7
2 18,000 10,000 30,000 0.797 14,349.5 7,971.9 23,915.8
3 18,000 30,000 40,000 0.712 12,812.0 21,353.4 28,471.2
4 80,000 50,000 0.636 - 50,841.4 31,775.9
5 1,00,000 1,80,000 0.567 - 56,742.7 1,02,136.8
NPV 23,233.0 1,01,373.8 1,43,085.5
According to the NPV the ranking of the projects is:
Rank NPV Project
1 1,43,085.5 C
2 1,01,373.8 B
3 23,233.0 A
d) The payback period for the company is as follows:
Year Cash Flows Cumulative cash flows
Project A Project B Project C
Project
A Project B Project C
-
-
20,000
-
40,000
-
70,000
-
20,000
-
40,000
-
70,000
1 18,000 5,000 30,000
-
2,000
-
35,000
-
40,000
2 18,000 10,000 30,000 16,000
-
25,000
-
10,000
3 18,000 30,000 40,000 34,000 5,000 30,000
4 80,000 50,000 85,000 80,000

5 1,00,000 1,80,000 1,85,000 2,60,000
Payback Period
1.11
years 2.83 years 2.25 years
Since the company has a policy of accepting projects with a payback period of less than 2.75
years, hence the company would accept projects A and C. project B has a payback period of
2.8 years which is higher than the acceptable.
e) Profitability index
Project A Project B Project C
PV of future cash flows 43,233.0 1,41,373.8 2,13,085.5
Initial investment 20,000 40,000 70,000
PI 2.2 3.5 3.0
Internal rate of return
Project A Project B Project C
IRR 72% 56% 56%
Question 2
Price of house = $700,000
Down payment = 10% of $700,000 = $70,000
Home loan to be taken (P) = $700,000 - $70,000 = $63,000
Interest rate (r) = 3.5%
a) Annual repayments for Sam for a 20 years loan period and 25 year loan period
Loan instalment = r (P) / (1-(1+r)-n)
Loan instalment for 20 years loan period = (0.035*630000) / (1-(1+0.035)-20)
= $22050 / 0.497
= $44,327.5
Loan instalment for 25 years loan period = (0.035*630000) / (1-(1+0.035)-25)

= $22050 / 0.576
= $38,224.6
b) Total interest paid on both loans
Interest paid on 20 year loan = $630000*3.5% * 20
= $441,000
Interest paid on 25 year loan = $630000*3.5% * 25
= $551,250
c) With an increase in the loan term, the annual payment reduces and vice versa. This
means loan term and annual payment have an inverse relationship .And with an
increase in the loan term; the total interest paid also increases. This means loan term
and total interest paid have a direct relationship.
d) Annual loan repayment for 20 year loan from August 2021 = (0.06*630000) / (1-
(1+0.06)-17)
= $60,130.2
Annual loan repayment for 25 years loan from August 2021 = (0.06*630000) / (1-(1+0.06)-22)
= $52,318.7
Question 3
a) The yield curve for November 2007, May 2008 and November 2008 is presented
below:

0 1 2 3 4 5 6 7 8 9 10
2.00
3.00
4.00
5.00
6.00
7.00
8.00
Yield Curve
Nov-07 Nov-08 May-08
b) The shape of a yield curve under normal circumstances is an upward sloping curve. Yield
curve plots the yields on bonds of different maturities ranging from short term to medium
term to long term. Long term bond will generally have higher yield as compare to short term
bonds. This means with an increase in maturity, the yield on the bonds increase. Thus, the
shape of a normal yield curve is upward sloping.
c) The yield curve of November 2007 is almost flat with the yield reducing very slightly with
the increasing years to maturity. The yield has remained between the levels of 6-6.75%.
There is not much of variation. The yield curve of May 2008 is downward sloping. This may
also be called a negative or inverted yield curve. This is because the short term yields are
higher than the long term yields. The yield curve of November 2008 is upwards sloping from
1 year to maturity. This shows a normal yield curve.
The slope of the yield curve tells us about the future inflation and the economic activity of an
economy. An upward sloping yield curve denotes a rising economy as the interest rates move
up and vice versa. For the Australian economy, we see that from November 2007 to
November 2008, the yield curve has fallen. The yield was in the range of 6-7% in Nov. 2007,

it increased to the range of 7 in May, 2008, however in November 2008, and the yield has
come down between 3-4%. This shows the economy had slowed down between 2007 to
2008. However, in Nov, 2008, the yield curve has an upward sloping curve denoting a rising
economy. So it can be said that the Australian economy is expected to grow in the future with
increasing yields on bonds.
d) The yield on the 2 year bond in January 2007 is 6.18%.
according to the expectations theory, the rate investors would expect for a 1 year bond next
year (Jan 2008) is calculated as follows:
Step 1
Add 1 to the January 2007 interest rate = 1.0618
Square the figure = 1.127
Step 2
Divide the above by 1 year interest rate plus 1 = 1.127 / 1.0626 = 1.061
Rate expected for a 1 year bond in January 2008 = 1.061 – 1
= 6.1%
The expected rates on 1- year bonds for all the months of 2008 is calculated below:
Month
(2007)
YTM for
2 years
bond
(2007)
Step 1
YTM for 1
year bond
(2007)
Step 2
Expected
rate on 1-
year bond
(2008)
January 0.0618 1.127 0.063 1.061 6.10%
February 0.0608 1.125 0.062 1.059 5.93%
March 0.0612 1.126 0.065 1.058 5.79%
April 0.0625 1.129 0.063 1.062 6.20%
May 0.0619 1.128 0.064 1.060 6.03%
June 0.064 1.132 0.065 1.063 6.30%
July 0.0638 1.132 0.066 1.062 6.19%
August 0.0629 1.130 0.065 1.061 6.06%
September 0.0632 1.130 0.066 1.061 6.09%
October 0.0658 1.136 0.069 1.063 6.30%

November 0.0667 1.138 0.068 1.065 6.51%
December 0.0672 1.139 0.069 1.066 6.58%
e) Comparison of actual interest rates with expected interest rates in 2008:
Month
Expected
interest rates
(2008 1 year
bond)
Actual interest rates
(2008 1 year bond)
January 6.10% 6.83%
February 5.93% 7.12%
March 5.79% 7.03%
April 6.20% 7.21%
May 6.03% 7.35%
June 6.30% 7.26%
July 6.19% 6.87%
August 6.06% 6.34%
September 6.09% 5.63%
October 6.30% 4.33%
November 6.51% 3.09%
December 6.58% 2.67%
From the above table we see that the expectation theory does not hold true for the 1 year
bonds in 2008. The expected and actual interest rates are different. The theory has
underestimated the interest rates from January to August and understated the rates from
September to December.
Possible reasons why expectation theory may not hold true include:
i) Change in inflation (Tease 1986)
ii) Change in economic growth pattern
f) The average spread between the Australian Government bonds and the NSW Treasury
for 3, 5, 10 year bonds is calculated below:

Date 3 year bond Spread 5 year bond Spread 10 year bond Spread

Australian
Federal
Gov.
NSW
Treasury
Australian
Federal Gov.
NSW
Treasury
Australian
Federal Gov.
NSW
Treasury
Jan-2007 6.11 6.33 0.23 6.05 6.28 0.23 5.88 6.17 0.30
Feb-2007 6.02 6.24 0.22 5.97 6.19 0.23 5.81 6.09 0.28
Mar-2007 6.04 6.27 0.23 5.95 6.19 0.24 5.74 6.03 0.30
Apr-2007 6.19 6.42 0.23 6.11 6.35 0.24 5.91 6.19 0.28
May-2007 6.15 6.38 0.23 6.07 6.32 0.25 5.92 6.21 0.29
Jun-2007 6.39 6.66 0.26 6.34 6.66 0.32 6.20 6.56 0.35
Jul-2007 6.38 6.68 0.31 6.30 6.71 0.41 6.15 6.62 0.47
Aug-2007 6.24 6.64 0.41 6.13 6.62 0.48 5.93 6.46 0.54
Sep-2007 6.29 6.73 0.44 6.21 6.70 0.49 5.99 6.52 0.52
Oct-2007 6.56 6.93 0.38 6.45 6.87 0.42 6.17 6.66 0.49
Nov-2007 6.57 7.15 0.58 6.36 7.01 0.65 6.03 6.66 0.63
Dec-2007 6.66 7.18 0.53 6.46 7.09 0.63 6.21 6.76 0.55
Jan-2008 6.58 6.99 0.41 6.34 6.92 0.57 6.08 6.58 0.50
Feb-2008 6.75 7.33 0.59 6.50 7.26 0.76 6.29 6.96 0.67
Mar-2008 6.21 6.94 0.74 6.10 6.90 0.80 6.09 6.82 0.73
Apr-2008 6.25 6.89 0.64 6.19 6.84 0.65 6.17 6.78 0.61
May-2008 6.47 7.02 0.54 6.33 6.91 0.58 6.36 6.89 0.54
Jun-2008 6.84 7.36 0.52 6.69 7.23 0.54 6.59 7.10 0.51
Jul-2008 6.49 7.14 0.65 6.40 7.05 0.65 6.37 7.01 0.64
Aug-2008 5.74 6.35 0.62 5.77 6.38 0.61 5.86 6.49 0.63
Sep-2008 5.48 6.21 0.73 5.54 6.24 0.70 5.65 6.33 0.69
Oct-2008 4.59 5.27 0.68 4.83 5.48 0.65 5.22 5.85 0.63
Nov-2008 3.96 4.75 0.79 4.28 5.14 0.87 4.94 5.69 0.75
Dec-2008 3.43 4.54 1.10 3.72 4.87 1.15 4.22 5.12 0.90
Average
spread 0.50
Average
spread 0.55
Average
spread 0.53
The average spread is the highest for 5 year bonds. Australian Federal Government bond is a
bond issued by the federal government whereas NSW treasury bond is a state government
bond. There is likely to be a difference in the yields of the bond because of the monetary
policies initiatives of both the federal and state government.
g) The graph showing the spread between the Australian government bonds and NSW
Treasury is presented below:

Jan-2007
Mar-2007
May-2007
Jul-2007
Sep-2007
Nov-2007
Jan-2008
Mar-2008
May-2008
Jul-2008
Sep-2008
Nov-2008
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
10 year
5 year
3 year
For all three maturity periods, the bonds follow the same pattern from 2007 to 2008. The
spread is the highest for 10 year bond followed by 5 year and then 3 year bonds. This means
when there is an increase in the Australian government bonds, there is also an increase in the
NSW bonds at all the levels of bonds.
Bibliography
Jim, F 2011, 'The Greatest Anomaly in Finance: Low-Beta Stocks Outperform', InvestingDaily, 22
September 2011.