You are on page 1of 55

Copyright 2000 by Harcourt, Inc.

All rights reserved


Version 1.2
Copyright 2000 by Harcourt, Inc.
All rights reserved. Requests for permission to make
copies of any part of the work should be mailed to:
Permissions Department
Harcourt, Inc.
6277 Sea Harbor Drive
Orlando, Florida 32887-6777
Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 16
Copyright 2000 by Harcourt, Inc. All rights reserved
Chapter 16 - The Analysis
and Valuation of Bonds
Questions to be answered:
How do you determine the value of a
bond based on the present value
formula?
What are the alternative bond yields that
are important to investors?
Copyright 2000 by Harcourt, Inc. All rights reserved
Chapter 16 - The Analysis
and Valuation of Bonds
How do you compute the following major
yields on bonds: current yield, yield to
maturity, yield to call, and compound
realized (horizon) yield?
What are spot rates and forward rates
and how do you calculate these rates
from a yield to maturity curve?
What is the spot rate yield curve and
forward rate curve?
Copyright 2000 by Harcourt, Inc. All rights reserved
Chapter 16 - The Analysis
and Valuation of Bonds
How and why do you use the spot rate
curve to determine the value of a bond?
What are the alternative theories that
attempt to explain the shape of the term
structure of interest rates?
What factors affect the level of bond
yields at a point in time?
What economic forces cause changes in
bond yields over time?
Copyright 2000 by Harcourt, Inc. All rights reserved
Chapter 16 - The Analysis
and Valuation of Bonds
When yields change, what characteristics
of a bond cause differential price changes
for individual bonds?
What is meant by the duration of a bond,
how do you compute it, and what factors
affect it?
What is modified duration and what is
the relationship between a bonds
modified duration and its volatility?
Copyright 2000 by Harcourt, Inc. All rights reserved
Chapter 16 - The Analysis
and Valuation of Bonds
What is effective duration and when is it
useful?
What is the convexity for a bond, how do
you compute it, and what factors affect
it?
Under what conditions is it necessary to
consider both modified duration and
convexity when estimating a bonds price
volatility?
Copyright 2000 by Harcourt, Inc. All rights reserved
Chapter 16 - The Analysis
and Valuation of Bonds
What happens to the duration and
convexity of bonds that have embedded
call options?
Copyright 2000 by Harcourt, Inc. All rights reserved
The Fundamentals of Bond Valuation
The present-value model

n
t
n
p
t
t
m
i
P
i
C
P
2
1
2
) 2 1 ( ) 2 1 (
2
Where:
P
m
=the current market price of the bond
n = the number of years to maturity
C
i
= the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
P
p
=the par value of the bond
Copyright 2000 by Harcourt, Inc. All rights reserved
The Yield Model
The expected yield on the bond may be
computed from the market price
Where:
i = the discount rate that will discount the cash flows to
equal the current market price of the bond

n
t
n
p
t
i
m
i
P
i
C
P
2
1
2
) 2 1 ( ) 2 1 (
2
Copyright 2000 by Harcourt, Inc. All rights reserved
Computing Bond Yields
Yield Measure Purpose
Nominal Yield
Measures the coupon rate
Current yield Measures current income rate
Promised yield to maturity Measures expected rate of return for bond held
to maturity
Promised yield to call Measures expected rate of return for bond held
to first call date
Realized (horizon) yield
Measures expected rate of return for a bond
likely to be sold prior to maturity. It considers
specified reinvestment assumptions and an
estimated sales price. It can also measure the
actual rate of return on a bond during some past
period of time.
Copyright 2000 by Harcourt, Inc. All rights reserved
Nominal Yield
Measures the coupon rate that a bond investor
receives as a percent of the bonds par value
Copyright 2000 by Harcourt, Inc. All rights reserved
Current Yield
Similar to dividend yield for stocks
Important to income oriented investors
CY = C
i
/P
m

where:
CY = the current yield on a bond
C
i
= the annual coupon payment of bond i
P
m
= the current market price of the bond
Copyright 2000 by Harcourt, Inc. All rights reserved
Promised Yield to Maturity
Widely used bond yield figure
Assumes
Investor holds bond to maturity
All the bonds cash flow is reinvested at the
computed yield to maturity
Solve for i that will
equate the current price
to all cash flows from
the bond to maturity,
similar to IRR

n
t
n
p
t
i
m
i
P
i
C
P
2
1
2
) 2 1 ( ) 2 1 (
2
Copyright 2000 by Harcourt, Inc. All rights reserved
Computing the
Promised Yield to Maturity
Two methods
Approximate promised yield
Easy, less accurate
Present-value model
More involved, more accurate
Copyright 2000 by Harcourt, Inc. All rights reserved
Approximate Promised Yield
Coupon + Annual Straight-Line Amortization of Capital Gain or Loss
Average Investment
2
APY
m p
m p
i
P P
n
P P
C

=
Copyright 2000 by Harcourt, Inc. All rights reserved
Present-Value Model

n
t
n
p
t
i
m
i
P
i
C
P
2
1
2
) 2 1 ( ) 2 1 (
2
Copyright 2000 by Harcourt, Inc. All rights reserved
Promised Yield to Call
Approximation
May be less than yield to maturity
Reflects return to investor if bond is called
and cannot be held to maturity
2
m c
m c
t
P P
nc
P P
C
AYC

Where:
AYC = approximate yield to call (YTC)
P
c
= call price of the bond
P
m
= market price of the bond
C
t
= annual coupon payment
nc = the number of years to first call date
Copyright 2000 by Harcourt, Inc. All rights reserved
Promised Yield to Call
Present-Value Method
Where:
P
m
= market price of the bond
C
i
= annual coupon payment
nc = number of years to first call
P
c
= call price of the bond
nc
c
nc
t
t
i
m
i
P
i
C
P
2
2
1
) 1 ( ) 1 (
2 /

Copyright 2000 by Harcourt, Inc. All rights reserved


Realized Yield Approximation
2
P P
hp
P P
C
ARY
f
f
i

Where:
ARY = approximate realized yield to call (YTC)
P
f
= estimated future selling price of the bond
Ci

= annual coupon payment
hp = the number of years in holding period of the bond
Copyright 2000 by Harcourt, Inc. All rights reserved
Realized Yield
Present-Value Method
hp
f
hp
t
t
t
m
i
P
i
C
P
2
2
1
) 2 1 ( ) 2 1 (
2 /

Copyright 2000 by Harcourt, Inc. All rights reserved


Calculating Future Bond Prices
Where:
P
f
= estimated future price of the bond
C
i
= annual coupon payment
n = number of years to maturity
hp = holding period of the bond in years
i = expected semiannual rate at the end of the holding period
hp n
p
hp n
t
t
i
f
i
P
i
C
P
2 2
2 2
1
) 2 1 ( ) 2 1 (
2 /


Copyright 2000 by Harcourt, Inc. All rights reserved
Yield Adjustments
for Tax-Exempt Bonds
Where:
T = amount and type of tax exemption
T - 1
return annual
ETY
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines Interest Rates
Inverse relationship with bond prices
Forecasting interest rates
Fundamental determinants of interest rates
i = RFR + I + RP
where:
RFR = real risk-free rate of interest
I = expected rate of inflation
RP = risk premium
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines Interest Rates
Effect of economic factors
real growth rate
tightness or ease of capital market
expected inflation
or supply and demand of loanable funds
Impact of bond characteristics
credit quality
term to maturity
indenture provisions
foreign bond risk including exchange rate risk and country
risk
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines Interest Rates
Term structure of interest rates
Expectations hypothesis
Liquidity preference hypothesis
Segmented market hypothesis
Trading implications of the term structure
Copyright 2000 by Harcourt, Inc. All rights reserved
Yield Spreads
Segments: government bonds, agency
bonds, and corporate bonds
Sectors: prime-grade municipal bonds
versus good-grade municipal bonds, AA
utilities versus BBB utilities
Coupons or seasoning within a segment or
sector
Maturities within a given market segment or
sector
Copyright 2000 by Harcourt, Inc. All rights reserved
Yield Spreads
Magnitudes and direction of yield spreads can
change over time
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines the
Price Volatility for Bonds
Bond price change is measured as the
percentage change in the price of the bond
1
BPB
EPB

Where:
EPB = the ending price of the bond
BPB = the beginning price of the bond
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines the
Price Volatility for Bonds
Four Factors
1. Par value
2. Coupon
3. Years to maturity
4. Prevailing market interest rate
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines the
Price Volatility for Bonds
Five observed behaviors
1. Bond prices move inversely to bond yields (interest rates)
2. For a given change in yields, longer maturity bonds post larger
price changes, thus bond price volatility is directly related to
maturity
3. Price volatility increases at a diminishing rate as term to maturity
increases
4. Price movements resulting from equal absolute increases or
decreases in yield are not symmetrical
5. Higher coupon issues show smaller percentage price fluctuation for
a given change in yield, thus bond price volatility is inversely
related to coupon
Copyright 2000 by Harcourt, Inc. All rights reserved
What Determines the
Price Volatility for Bonds
The maturity effect
The coupon effect
The yield level effect
Some trading strategies
Copyright 2000 by Harcourt, Inc. All rights reserved
The Duration Measure
Since price volatility of a bond varies
inversely with its coupon and directly with
its term to maturity, it is necessary to
determine the best combination of these two
variables to achieve your objective
A composite measure considering both
coupon and maturity would be beneficial
Copyright 2000 by Harcourt, Inc. All rights reserved
The Duration Measure
Developed by Frederick R. Macaulay, 1938
Where:
t = time period in which the coupon or principal payment occurs
C
t
= interest or principal payment that occurs in period t
i = yield to maturity on the bond
price
) (
) 1 (
) 1 (
) (
1
1
1

n
t
t
n
t
t
t
n
t
t
t
C PV t
i
C
i
t C
D
Copyright 2000 by Harcourt, Inc. All rights reserved
Characteristics of Duration
Duration of a bond with coupons is always less than its
term to maturity because duration gives weight to these
interim payments
A zero-coupon bonds duration equals its maturity
An inverse relation between duration and coupon
A positive relation between term to maturity and duration,
but duration increases at a decreasing rate with maturity
An inverse relation between YTM and duration
Sinking funds and call provisions can have a dramatic
effect on a bonds duration
Copyright 2000 by Harcourt, Inc. All rights reserved
Duration and Bond Price Volatility
An adjusted measure of duration can be used
to approximate the price volatility of a bond
m
YTM
1
duration Macaulay
duration modified

Where:
m = number of payments a year
YTM = nominal YTM
Copyright 2000 by Harcourt, Inc. All rights reserved
Duration and Bond Price Volatility
Bond price movements will vary proportionally with
modified duration for small changes in yields
An estimate of the percentage change in bond prices equals
the change in yield time modified duration
i D
P
P

mod
100
Where:
P = change in price for the bond
P = beginning price for the bond
D
mod
= the modified duration of the bond
i = yield change in basis points divided by 100
Copyright 2000 by Harcourt, Inc. All rights reserved
Trading Strategies Using Duration
Longest-duration security provides the maximum price
variation
If you expect a decline in interest rates, increase the average
duration of your bond portfolio to experience maximum
price volatility
If you expect an increase in interest rates, reduce the
average duration to minimize your price decline
Note that the duration of your portfolio is the market-value-
weighted average of the duration of the individual bonds in
the portfolio
Copyright 2000 by Harcourt, Inc. All rights reserved
Bond Duration in Years for Bonds Yielding
6 Percent Under Different Terms
COUPON RATES
Years to
Maturity 0.02 0.04 0.06 0.08
1 0.995 0.990 0.985 0.981
5 4.756 4.558 4.393 4.254
10 8.891 8.169 7.662 7.286
20 14.981 12.980 11.904 11.232
50 19.452 17.129 16.273 15.829
100 17.567 17.232 17.120 17.064
8
17.167 17.167 17.167 17.167
Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations:
Returns to Bondholders from Nave and Optimal Strategies," Journal of Business 44, no. 4
(October 1971): 418. Copyright 1971, University of Chicago Press.
Copyright 2000 by Harcourt, Inc. All rights reserved
Bond Convexity
Equation 16.14 is a linear approximation of
bond price change for small changes in
market yields
YTM 100
mod

D
P
P
Copyright 2000 by Harcourt, Inc. All rights reserved
Bond Convexity
Modified duration is a linear approximation
of bond price change for small changes in
market yields
Price changes are not linear, but a
curvilinear (convex) function
i D
P
P

mod
100
Copyright 2000 by Harcourt, Inc. All rights reserved
Price-Yield Relationship for Bonds
The graph of prices relative to yields is not a straight line,
but a curvilinear relationship
This can be applied to a single bond, a portfolio of bonds,
or any stream of future cash flows
The convex price-yield relationship will differ among
bonds or other cash flow streams depending on the coupon
and maturity
The convexity of the price-yield relationship declines
slower as the yield increases
Modified duration is the percentage change in price for a
nominal change in yield
Copyright 2000 by Harcourt, Inc. All rights reserved
Modified Duration
For small changes this will give a good
estimate, but this is a linear estimate on the
tangent line
P
di
dP
D
mod
Copyright 2000 by Harcourt, Inc. All rights reserved
Determinants of Convexity
The convexity is the measure of the curvature
and is the second derivative of price with
resect to yield (d
2
P/di
2
)
Convexity is the percentage change in dP/di
for a given change in yield
P
di
P d
2
2
Convexity
Copyright 2000 by Harcourt, Inc. All rights reserved
Determinants of Convexity
Inverse relationship between coupon and convexity
Direct relationship between maturity and convexity
Inverse relationship between yield and convexity
Copyright 2000 by Harcourt, Inc. All rights reserved
Modified Duration-Convexity Effects
Changes in a bonds price resulting from a
change in yield are due to:
Bonds modified duration
Bonds convexity
Relative effect of these two factors depends
on the characteristics of the bond (its
convexity) and the size of the yield change
Convexity is desirable
Copyright 2000 by Harcourt, Inc. All rights reserved
Duration and Convexity
for Callable Bonds
Issuer has option to call bond and pay off with
proceeds from a new issue sold at a lower yield
Embedded option
Difference in duration to maturity and duration to
first call
Combination of a noncallable bond plus a call
option that was sold to the issuer
Any increase in value of the call option reduces
the value of the callable bond
Copyright 2000 by Harcourt, Inc. All rights reserved
Option Adjusted Duration
Based on the probability that the issuing
firm will exercise its call option
Duration of the non-callable bond
Duration of the call option
Copyright 2000 by Harcourt, Inc. All rights reserved
Convexity of Callable Bonds
Noncallable bond has positive convexity
Callable bond has negative convexity
Copyright 2000 by Harcourt, Inc. All rights reserved
Limitations of Macaulay and
Modified Duration
Percentage change estimates using modified
duration only are good for small-yield
changes
Difficult to determine the interest-rate
sensitivity of a portfolio of bonds when
there is a change in interest rates and the
yield curve experiences a nonparallel shift
Callable bonds duration depends on market
conditions
Copyright 2000 by Harcourt, Inc. All rights reserved
Effective Duration
Measure the interest rate sensitivity of an asset
Use a pricing model to estimate the market prices
surrounding a change in interest rates
Effective Duration Effective Convexity

PS
P P
2


2
2
PS
P P P

P- = the estimated price after a downward shift in interest rates
P+ = the estimated price after a upward shift in interest rates
P = the current price
S = the assumed shift in the term structure
Copyright 2000 by Harcourt, Inc. All rights reserved
Effective Duration
Effective duration greater than maturity
Negative effective duration
Copyright 2000 by Harcourt, Inc. All rights reserved
Empirical Duration
Actual percent change for an asset in
response to a change in yield during a
specified time period
Copyright 2000 by Harcourt, Inc. All rights reserved
End of Chapter 16
The Analysis and Valuation of
Bonds
Copyright 2000 by Harcourt, Inc. All rights reserved
Future topics
Chapter 17
Alternative bond portfolio
strategies
Implications of Capital Market
Theory and the EMH on bond
portfolio management
Copyright 2000 by Harcourt, Inc. All rights reserved