R55 Understanding Fixed Income Risk and Return PDF

CFA® Level I – Fixed Income
Understanding Fixed-Income Risk and Return
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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
1
Contents and Introduction
1. Introduction
2. Sources of Return
3. Interest Rate Risk on Fixed-Rate Bonds
4. Interest Rate Risk and the Investment Horizon
5. Credit and Liquidity Risk
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2. Sources of Return
The total return is the future value of reinvested coupon interest payments and the sale price (or
redemption of principal if the bond is held to maturity). The horizon yield (or holding period rate of
return) is the internal rate of return between the total return and purchase price of the bond.
Sources or return
• Receipt of the promised coupon and principal payments on the scheduled dates
• Reinvestment of coupon payments
• Potential capital gains or losses on the sale of the bond prior to maturity
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Example 1
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Example 2
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Constant Yield Price Trajectory
10-year, 8% annual payment bond purchased at a price of 85.503075 per 100 of par value
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Example 3
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Example 4
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Example 5
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Example 6
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Example 7
3. Interest Rate Risk on Fixed-Rate Bonds
1. Macaulay, Modified and Approximate Duration
2. Effective Duration
3. Properties of Bond Duration
4. Duration of a Bond Portfolio
5. Money Duration of a Bond and the Price Value of a Basis Point
6. Bond Convexity
3.1 Macaulay, Modified, and Approximate Duration
The duration of a bond measures the sensitivity of the bond’s full price (including
accrued interest) to changes in interest rates.
• Yield Duration
 Macaulay duration
 Modified duration
 Money duration
 PVBP
• Curve Duration
 Effective duration
Macaulay Duration
Macaulay duration is a weighted average of the time to receipt of the bond’s promised
payments, where the weights are the shares of the full price that correspond to each
of the bond’s promised future payments.
The Macaulay duration of the 10-year, 8%

annual payment bond is calculated by
plugging r = 0.1040, c = 0.0800, N = 10, and
t/T = 0 into the above equation.
Modified Duration
Modified duration provides an estimate of the

percentage price change for a bond given a change in its
yield-to-maturity.
%ΔPVFull ≈ −AnnModDur × Δyield
Modified duration provides a linear estimate of the

percentage price change.
Approximate Modified Duration
Example 8
3.2 Effective Duration
• Bond’s with embedded options and mortgage back securities do not have a well
defined YTM. Hence yield duration statistics do not apply.
• The effective duration of a bond is the sensitivity of the bond’s price to a change in
a benchmark yield curve.
Example 9
3.3 Properties of Bond Duration
The Macaulay and modified yield duration statistics for a traditional fixed-rate bond are functions of
the input variables: the coupon rate or payment per period, the yield- to-maturity per period, the
number of periods to maturity (as of the beginning of the period), and the fraction of the period that
has gone by.
Exhibit 7 – Properties of Macaulay Yield Duration
Example 10
Exhibit 8 – Interest Rate Characteristic of a Callable Bond
Exhibit 8 – Interest Rate Characteristic of a Putable Bond
3.4 Duration of a Bond Portfolio
Weighted average of time to receipt of Weighted average of the individual bond
the aggregate cash flows durations that comprise the portfolio
• Theoretically correct but difficult to use in • Commonly used in practice
practice • Easy to use a measure of interest rate risk
• Cash flow yield not commonly used • More accurate as differences in YTMs of
• Amount and timing of cash flows might not be bonds in portfolio become smaller
known • Assumes parallel shift in the yield curve
• Interest rate risk is usually expressed as a
change in benchmark interest rates, not as a
change in the cash flow yield
• Change in the cash flow yield is not
necessarily the same amount as the change in
the yields-to-maturity on the individual bonds
Example 11
3.5 Money Duration of a Bond and the Price Value of a
Basis Point
The money duration of a bond is a measure of the price change in units of the currency in which the
bond is denominated.
MoneyDur = AnnModDur × PVFull
ΔPVFull ≈−MoneyDur×ΔYield
The PVBP is an estimate of the change in the full price given a 1 bp change in the yield-to-maturity
Example 12
3.6 Bond Convexity
Example 13
Convexity is Good
Convexity impacted by:
1. Time to maturity
2. Coupon rate
3. Yield to maturity
4. Dispersion of cash flows
Example 14
Effective Convexity
The effective convexity of a bond is a curve convexity statistic that measures the secondary effect of a
change in a benchmark yield curve. It is used for bonds with embedded options.
Callable bonds have negative convexity
4. Interest Rate Risk and the Investment Horizon
• Short-term investors are concerned with the impact on the flat price given a
sudden change in yield to maturity
• Long term investors are also concerned with the reinvestment of coupon interest
4.1 Yield Volatility
• Yield volatility refers to the volatility of a bond’s YTM
• Typically short term bonds have greater yield volatility than long term bonds
• Bond price changes depend on

 PVBP
 Number of basis points
• Parallel and non-parallel shifts
Example 15
4.2 Investment Horizon, Macaulay Duration, and Interest
Rate Risk
• With longer term horizons we are concerned with price risk and reinvestment risk
• Consider a 10-year, 8% annual coupon bond priced at 85.50, YTM = 10.40%
• If investment horizon = 10 years, the major concern is reinvestment risk
• If investment horizon = 4 years, the major concern is price risk
• What if the investment horizon = 7 years
Macaulay Duration
Macaulay duration indicates the investment horizon for which

coupon reinvestment risk and market price risk offset each other.
Assumption: one-time parallel shift in the yield curve.
1. Macaulay duration < Investment horizon  coupon reinvestment risk dominates

2. Investment horizon = Macaulay duration  coupon reinvestment risk offsets market price risk
3. Macaulay duration > Investment horizon  market price risk dominates
Duration Gap = Macaulay Duration – Investment Horizon
Example 16
5. Credit and Liquidity Risk
• Credit risk involves the probability of default and degree of recovery if default
occurs
• Liquidity risk refers to the transaction costs associated with selling a bond
• For a traditional (option-free) fixed-rate bond, the same duration and convexity
statistics apply if a change occurs in the benchmark yield or a change occurs in the
spread
• The change in the spread can result from a change in credit risk or liquidity risk
• In practice, there often is interaction between changes in benchmark yields and in

the spread over the benchmark
Example 17
Summary
• Sources of return
• Macaulay and modified duration
• Effective duration
• Interest rate risk impacted by maturity, coupon rate, embedded options and yield
• Money duration and PVBP
• Approximate convexity and effective convexity
• Yield volatility
• Holding period return and investment horizon
• Credit risk and liquidity risk
Conclusion
• Read the summary
• Review learning objectives
• Examples
• Practice problems
• Practice questions from other sources

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CFA® Level I – Fixed Income

Understanding Fixed-Income Risk and Return

3. Interest Rate Risk on Fixed-Rate Bonds

4. Interest Rate Risk and the Investment Horizon

5. Credit and Liquidity Risk

1. Macaulay, Modified and Approximate Duration

3. Properties of Bond Duration

4. Duration of a Bond Portfolio

5. Money Duration of a Bond and the Price Value of a Basis Point

The Macaulay duration of the 10-year, 8%

Modified duration provides an estimate of the

%ΔPVFull ≈ −AnnModDur × Δyield

Modified duration provides a linear estimate of the

MoneyDur = AnnModDur × PVFull

Convexity impacted by:

Callable bonds have negative convexity

• Bond price changes depend on

• Parallel and non-parallel shifts

• Consider a 10-year, 8% annual coupon bond priced at 85.50, YTM = 10.40%

• If investment horizon = 10 years, the major concern is reinvestment risk

• If investment horizon = 4 years, the major concern is price risk

• What if the investment horizon = 7 years

Macaulay duration indicates the investment horizon for which

1. Macaulay duration < Investment horizon  coupon reinvestment risk dominates

Duration Gap = Macaulay Duration – Investment Horizon

• In practice, there often is interaction between changes in benchmark yields and in

• Review learning objectives

• Practice questions from other sources

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