CHAPTER 17

Fixed Income Securities Are Available Worldwide

Slide 1 : BOND YIELDS AND INTEREST RATES

Interest rates measure the price paid by a borrower to a lender for the use of resources over
some time period—that is, interest rates are the price for loanable funds. The price differs
from case to case, based on the demand and supply for these funds, resulting in a wide
variety of interest rates. The spread between the lowest and highest rates at any normal
point in time could be as much 10 to 15 percentage points. In bond parlance, this would be
equivalent to 1,000 to 1,500 basis points, since 1 percentage point of a bond yield consists of
100 basis points

Slide 2 : THE BASIC COMPONENTS OF INTEREST RATES

The basic foundation of market interest rates is the opportunity cost of foregoing
consumption, representing the rate that must be offered to individuals to persuade them to
save rather than consume. This rate is sometimes called the real risk-free rate of interest,
because it is not affected by price changes or risk factors

Slide 3 :

RP represents all risk premiums involved, including time to maturity and credit quality as
well as differences among corporate bonds such as call features, collateral, and sinking fund
provisions
Slide 4 :
THE TERM STRUCTURE OF INTEREST RATES
The term structure of interest rates refers to the relationship between time to maturity and
yields for a specified category of bonds at a particular point in time. Ideally, other factors are
held constant, particularly the risk of default

Slide 5 :
Yield Curves
A graphical depiction of the relationship between yields and time for bonds that are identical
except for maturity
The term structure is usually plotted in the form of a yield curve. The horizontal axis
represents time to maturity, whereas the vertical axis represents yield to maturity

Slide 6 :
Term Structure Theories
A theory of the term structure of interest rates is needed to explain the shape and slope of
the yield curve and why it shifts over time. Theories traditionally advanced are the
expectations theory, the liquidity premium theory, the preferred habitat theory, and the
market segmentation theory.

Slide 7 :

 Expectation Theory
States that the long-term rate of interest is equal to an average of the shortterm rates that
are expected to prevail over the long-term period

 Liquidity Preference Theory

States that interest rates reflect the sum of current and expected short rates, as in the
expectations theory, plus liquidity (risk) premiums

Slide 8 :

 Preferred Habitat Theory

The preferred habitat theory is a term structure theory suggesting that different bond investors
prefer one maturity length over another and are only willing to buy bonds outside of their maturity
preference if a risk premium for the maturity range is available
 Market Segmentation Theory

The market segmentation theory states that the yield curve is determined by supply and demand
for debt instruments of different maturities. The level of demand and supply is influenced by the
current interest rates and expected future interest rates. The movement in supply and demand
for bonds of various maturities causes a change in bond prices

Slide 9:

Forward rates

In effect, the term structure consists of a set of forward rates and a current known rate. Forward
rates are rates that are expected to prevail in the future; that is, they are unobservable but
anticipated future rates.

The rate for the three-year bond referred to above must be a geometric average of the current
one-year rate ðtR1Þ and the expected forward rates for the subsequent two years. Therefore, in
equation form

Slide 10 :
 Slide 11:

RISK PREMIUMS (YIELD SPREADS)

Risk premiums, or yield spreads, refer to the issue characteristics of the bonds
involved. They are a result of the following factors:

1. Differences in quality, or risk of default. Clearly, all other things being equal, a bond rated
BAA will offer a higher yield than a similar bond rated AAA because of the difference in
default risk.

2. Differences in time to maturity. The longer the time period involved, the greater the
uncertainty.

3. Differences in call features. Bonds that are callable have higher ytms than otherwise
identical noncallable bonds. If the bond is called, bondholders must give it up, and they could
replace it only with a bond carrying a lower ytm. Therefore, investors expect to be
compensated for this risk.

4. Differences in coupon rates. Bonds with low coupons have a larger part of their ytm in the
form of capital gains.

5. Differences in marketability. Some bonds are more marketable than others, meaning that
their liquidity is better. They can be sold either more quickly or with less of a price
concession, or both. The less marketable a bond, the higher the ytm.

6. Differences in tax treatments.

7. Differences between countries.

Notes : diPPT gausah pake penjelasan

Slide 12 :

OTHER FACTORS AFFECTING YIELD SPREADS

Investors expect to be compensated for the risk of a particular issue, and this compensation
is reflected in the risk premium. However, investors are not the only determining factor in yield
spreads. The actions of borrowers also affect them

Slide 13 :

YIELD SPREADS OVER TIME

Yield spreads among alternative bonds may be positive or negative at any time. Furthermore,
the size of the yield spread changes over time. Whenever the differences in yield become smaller,
the yield spread is said to “narrow”; as the differences increase, it “widens.”

It seems reasonable to assume that yield spreads widen during recessions, when investors become
more risk-averse, and narrow during times of economic prosperity
Slide 14 :

MEASURING BOND YIELDS

 Current Yield

A bond’s annual coupon divided by the current market price

 Yield To Maturity

Yield to Maturity (YTM) The promised compounded rate of return on a bond purchased at the
current market price and held to maturity
 Slide 15 :

YTM

Slide 16 :

Example 17-5

Consider a 10 percent coupon bond with three years to maturity. The annual coupon is $100, which
is paid $50 every six months, and the total number of semiannual periods is six. Assume that the
bond is selling at a premium with a current market price of $1,052.42. Because of the inverse relation
between bond prices and market yields, it is clear that yields have declined since the bond was
originally issued, because the price is greater than $1,000. Using Equation 17-4, we can illustrate
conceptually what is happening when we solve for ytm, although to actually solve for ytm we would
use a calculator or computer.

Bond-Equivalent Yield Yield on an annual basis, derived by doubling the semiannual compound yield
Slide 17 :

YIELD TO FIRST CALL

Yield to First Call The promised return on a bond from the present to the date that the bond is likely
to be called

Slide 18 :

Example 17-7

Slide 19 :

REALIZED COMPOUND YIELD

Realized Compound Yield (RCY) Yield earned on a bond based on actual reinvestment rates during
the life of the bond

The realized compound yield can be calculated using the following formula:

For our purposes, we define Total Dollar Return for a coupon bond held to maturity as the sum of the
maturity value ($1,000), the coupons, and the interest earned by reinvesting the coupons.
Slide 20 :

Example 17-10

Slide 21 :

Horizon Return

Horizon (Total) Return Bond returns to be earned based on assumptions about reinvestment rates

Slide 22 :

Reinvestment Risk

Interest-on-interest is the income earned on the reinvestment of the intermediate cash flows, which
for a bond are the coupon (interest) payments made semiannually.

Reinvestment Rate Risk

That part of interest rate risk resulting from uncertainty about the rate at which future interest
coupons can be reinvested

Slide 23 :

Bond Prices

Slide 24 :

THE VALUATION PRINCIPLE

A security’s estimated value determines the price that investors place on it in the open market.

A security’s intrinsic value, or estimated value, is the present value of the expected cash flows from
that asset. Any security purchased is expected to provide one or more cash flows some time in the
future. These cash flows could be periodic, such as interest or dividends, or simply a terminal price or
redemption value, or a combination of these. Since these cash flows occur in the future, they must
be discounted at an appropriate rate to determine their present value

Slide 24 :

Rumus

Slide 25 :

BOND VALUATION

The price of a bond should equal the present value of its expected cash flows
Slide 26 :

Example 17-11

Slide 27 :

Bond Price Changes

Slide 28 :

BOND PRICE CHANGES OVER TIME

(Penjelasan gausah di tulis di PPT)

Figure 17-4 illustrates bond price movements over time assuming constant yields. Bond 2 in Figure
17-4 illustrates a 10 percent coupon, 30-year bond assuming that yields remain constant at 10
percent. The price of this bond does not change, beginning at $1,000 and ending at $1,000. Bond 1,
on the other hand, illustrates an 8 percent coupon, 30-year bond assuming that required yields start,
and remain constant, at 10 percent. The price starts below $1,000 because bond 1 is selling at a
discount as a result of its coupon of 8 percent being less than the required yield of 10 percent. Bond
3 illustrates a 12 percent coupon, 30-year bond assuming that required yields start, and remain
constant, at 10 percent. The price of bond 3 begins above $1,000, because it is selling at a premium
(its coupon of 12 percent is greater than the required yield of 10 percent). If all other factors are held
constant, the price of all three bonds must converge to $1,000 on the maturity date. Before the
maturity date, however, interest rates and bond prices are continually changing. An important issue
is, how much do they change, and why. The sensitivity of the price change is a function of certain
variables, especially coupon and maturity. We now examine these variables.

Slide 29 :

BOND PRICE CHANGES AS A RESULT OF INTEREST RATE CHANGES

Bond prices change because interest rates and required yields change. Understanding how bond
prices change given a change in interest rates is critical to successful bond management. The basics
of bond price movements as a result of interest rate changes have been known for many years

Slide 30 :

Bond Prices Move Inversely to Interest Rates

Investors must always keep in mind the fundamental fact about the relationship between bond
prices and bond yields: Bond prices move inversely to market yields. When the level of required
yields demanded by investors on new issues changes, the required yields on all bonds already
outstanding will also change. For these yields to change, the prices of these bonds must change. This
inverse relationship is the basis for understanding, valuing, and managing bonds.

Slide 31 :

The Effects of Maturity

The effect of a change in yields on bond prices depends on the maturity of the bond. An important
principle is that for a given change in market yields, changes in bond prices are directly related to
time to maturity.

 As interest rates change, the prices of longer term bonds will change more than the prices of
shorter term bonds, everything else being equal.

The Effects of Coupon

In addition to the maturity effect, the change in the price of a bond as a result of a change in interest
rates depends on the coupon rate of the bond.

 Bond price fluctuations (volatility) and bond coupon rates are inversely related.
Slide 32
CHAPTER 18
MANAGING BOND PORTFOLIOS: SOME ISSUES AFFECT ALL INVESTORS

Slide 33
BUYING FOREIGN BONDS
Why do U.S. investors consider foreign bonds for possible inclusion in their portfolios?
1. Foreign bonds may offer higher returns at a given point in time than alternative
domestic bonds. Investors can sometimes make a good case for buying foreign bonds
on the basis of potentially attractive returns.
2. 2. Foreign bonds can expand diversification possibilities. Diversification is extremely
important, both in a stock portfolio and a bond portfolio.

Slide 34:
What About Currency Risk?
Investors in foreign bonds (or any other security) face exchange rate risk, which can be
favorable or unfavorable. The euro strengthened against the dollar for several years of the
new decade, providing a currency gain to U.S. investors. Of course, the opposite can happen.
If the euro weakens instead of strengthens, a U.S. investor’s dollar-denominated return
suffers. Investors buying mutual funds can choose world-bond funds that hedge their
currency exposure. When a fund does this, a U.S. investor earns a return close to what local
investors would earn on bonds. On the other hand, investors seeking currency exposure in
the bond area can choose unhedged funds

Slide 35
IMPORTANT CONSIDERATIONS IN MANAGING A BOND PORTFOLIO

Slide 36
UNDERSTANDING THE BOND MARKET
The first consideration for any investor is to understand the relationship between the bond
market and the economy as a whole. It has been commonplace to talk about the bond
market benefiting from a weak economy. If the economy is growing slowly, interest rates
may decline, and bond prices rise. In effect, a decline in economic growth may lead to fewer
investment opportunities, inducing savers to increase their demand for bonds, which pushes
bond price sup and bond yields down. Talk of a rapidly growing economy is thought to
frighten bond investors, because strong economic activity is likely to push interest rates up,
and bond prices down

Slide 37
BOND STRATEGIES AND TECHNIQUES
Bond investing has become increasingly popular, no doubt as a result of record low interest
rates in recent years. Unfortunately, bond portfolio management has not received the same
amount of attention as common stocks. A majority of investors are simply more interested in
owning stocks than in owning bonds. Stocks are more “glamorous,” and more attention has
been devoted to them
Despite the lesser emphasis on bond portfolio management, investors must manage their
bond portfolios and make investment decisions. Different bond investors have adopted
different strategies, depending on their risk preferences, knowledge of the bond market, and
investment objectives. Two broad strategies that any investor can follow with any type of
portfolio are the passive and active strategies.

Slide 38
PASSIVE MANAGEMENT STRATEGIES
Passive bond strategies are based on the proposition that bond prices are determined
rationally, leaving risk as the portfolio variable to control. These strategies have a lower cost
than do active strategies

Slide 39
BUY AND HOLD
The buy-and-hold investor must have knowledge of the yield advantages of various bonds
(for example, agency securities over U.S. Treasuries), the default risk, call risk, the
marketability of a bond, any current income requirements, and taxes. One alternative for the
buy-and-hold investor is to try to duplicate the overall bond market by purchasing a broad
cross-section of bonds. Another is to selectively build a portfolio of bonds based on
characteristics that match those that the investor is seeking, whether a high level of safety,
an intermediate maturity, large coupons, and so forth.
Slide 40
ACTIVE MANAGEMENT STRATEGIES
Although bonds are often purchased to be held to maturity, frequently they are not. Many
bond investors use active management strategies. These strategies have traditionally sought
to profit from active management of bonds by activities such as8
1. Forecasting changes in interest rates, because we know that bond prices will change as
well
2. Identifying abnormal yield spreads between bond sectors and acting to take advantage of
these discrepancies
3. Identifying relative mispricing between various fixed-income securities

Slide 41
FORECASTING CHANGES IN INTEREST RATES
Reasonable forecasts can sometimes be made about the likely growth rate of the economy
and the prospects for inflation, both of which affect interest rates and, therefore, bond
investors. Assuming that an investor has a forecast of interest rates, he or she should
lengthen (shorten) the maturity of a bond portfolio when interest rates are expected to
decline (rise).
It is important to be aware of the tradeoffs in strategies involving maturity.
1. Short maturities sacrifice price appreciation opportunities and usually offer lower coupons
(income), but serve to protect the investor when rates are expected to rise.
2. Longer maturities have greater price fluctuations; therefore, the chance for bigger gains
(and bigger losses) is magnified. However, longer maturities may be less liquid than Treasury
bills.

Slide 42
YIELD SPREAD ANALYSIS
Yield spread analysis involves analyzing the differences in promised yields between various
segments of the bond market at a point in time, and trying to capitalize on this analysis.
 Yield spread strategies seek to profit from an expected change in the yield spreads
between bond sectors, based on an assumption that there exists some normal yield
spread level between sectors.
Slide 43
IDENTIFYING MISPRICING AMONG BONDS
Managers of bond portfolios attempt to adjust to the constantly changing environment for
bonds. They seek to improve the rate of return on the bond portfolio by identifying
temporary mispricings in the bond market, which do occur. Bond swaps refer to selling one
bond and simultaneously buying a different bond. There are various types of swaps, but all
are designed to improve the investor’s portfolio position. Some swaps are relatively
straightforward, simple transactions, while others are very complex. Various inputs are
required to do the analysis for a swap, including most importantly predictions about future
interest rates. Also, a time horizon is needed as an input, with a typical time horizon in the
range of six months to a year.

Slide 44
MANAGING PRICE VOLATILITY
To properly manage bond price volatility, we need a measure that combines these variables.
Duration is such a measure. It combines the properties of maturity and coupon and allows
investors to estimate the change in a bond’s price for any estimated change in interest rates.

Slide 45
DURATION
Duration A measure of a bond’s economic lifetime that accounts for the entire pattern of
cash flows over the life of the bond; a measure of bond price sensitivity to interest rate
movements
As illustrated by Figure 18-1, while the bond has five years to maturity, interest payments
are received in each of the first four years. Therefore, describing the bond as a five-year
bond is not totally accurate because the average time to receipt of each of the cash flows is
clearly less than five years. Duration describes the weighted average time to each payment.
It is very unusual for a coupon-paying bond to have a duration greater than 10 years,
regardless of its maturity date. This is because cash flows far in the future have small present
values today. Because the only payment from a zero-coupon bond is its maturity value, this
amount has a weight of one.

Slide 46
Understanding Duration
 The final maturity of the bond
 The coupon payments
 The yield to maturity

1. Duration expands with time to maturity but at a decreasing rate (holding the size of
coupon payments and the yield to maturity constant, particularly beyond 15 years time
to maturity). Even between five and 10 years time to maturity, duration is expanding at a
significantly lower rate than in the case of a time to maturity of up to five years, where it
expands rapidly.16 Note once again that for all coupon-paying bonds, duration is always
less than maturity. For a zero-coupon bond, duration is equal to time to maturity.17
2. Yield to maturity is inversely related to duration (holding coupon payments and
maturity constant).
3. Coupon is inversely related to duration (holding maturity and yield to maturity
constant). This is logical because higher coupons lead to quicker recovery of the bond’s
value, resulting in a shorter duration, relative to lower coupons.

Slide 47
Estimating Price Changes Using Duration
The real value of the duration measure to bond investors is that it combines coupon and
maturity, the two key variables that investors must consider in response to expected
changes in interest rates

Slide 48
The term modified duration refers to Macaulay’s duration in Equation 18-2 divided by (1
+ ytm).
Slide 49

Slide 50
Convexity
A measure of the degree to which the relationship between a bond’s price and yield departs
from a straight line

Slide 51
MANAGING PRICE VOLATILITY
to obtain the maximum (minimum) price volatility from a bond, investors should choose
bonds with the longest (shortest) duration. If an investor already owns a portfolio of bonds,
he or she can act to increase the average modified duration of the portfolio if a decline in
interest rates is expected and the investor is attempting to achieve the largest price
appreciation possible.
Slide 52
Immunization
Immunization The strategy of immunizing (protecting) a portfolio against interest rate risk by
canceling out its two components, price risk and reinvestment rate risk
To see how such a strategy works, think of interest rate risk as being composed of two
parts:
1. The price risk, resulting from the inverse relationship between bond prices and required
rates of return.
2. The reinvestment rate risk, resulting from the uncertainty about the rate at which future
coupon income can be reinvested. As discussed in Chapter 17, the YTM calculation assumes
that future coupons from a given bond investment will be reinvested at the calculated yield
to maturity. If interest rates change so that this assumption is no longer operable, the bond’s
realized YTM will differ from the calculated (expected) YTM. Notice that these two
components of interest rate risk move in opposite directions:
=> If interest rates rise, reinvestment rates (and therefore income) rise, whereas the price of
the bond declines.
=> If interest rates decline, reinvestment rates (and therefore income) decline, whereas the
price of the bond rises.