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LOS 43.a: Calculate and interpret the sources of return from investing in a
fixed-rate bond.
Let us focus on the second source. This is important because the YTM assumes that
the coupons on a bond can be re-invested at this yield throughout the life of the
bond. This is a big assumption because interest rates are likely to change over a
period of time especially for long-term bonds. That is one of the reasons why we can
say that longer maturity bonds have reinvestment risk.
So, the YTM is only a good measure of return if we can assume two things:
● That the coupons can be reinvested at the YTM rate throughout the life of the
bond
● That the capital gains will also be the same as the YTM only if the YTM has
not changed since the purchase of the bond
● If the YTM increases, then a bondholder who holds the bond till maturity will
earn a higher rate of return than the YTM at purchase
● If the YTM increases, then a bondholder can re-invest coupons at a higher
rate as they earn the coupon and will earn a higher rate of return than the
YTM at purchase if the bond is held for a short period of time
● If the YTM decreases, then a bondholder who holds the bond till maturity will
earn a lower rate of return than the YTM at purchase
● If the YTM decreases, then a bondholder can re-invest coupons at a lower
rate as they earn the coupon and will earn a lower rate of return than the YTM
at purchase if the bond is held for a long period of time
We will now see a few examples to illustrate how the holding period rate of return
of the bond changes with changes in YTM.
Suppose there is a 4-year annual pay 5% bond that is trading at a YTM of 6.5%. The
price of this bond is 94.86 per 100 of par value.
Assuming that the coupons can be reinvested at the YTM, the following table shows
the growth of each coupon payment until maturity.
Time 1 2 3 4
Coupon 5 5 5 5
Investment Value in 5 x (1 + 5 x (1 + 5 x (1 +
Year 4 6.50%)3 6.50%)2 6.50%)1 5 x (1 + 6.50%)0
What we have seen here is that the coupon in Year 1 will be invested for 3 years, the
coupon in Year 2 will be invested for 2 years and so on.
This can also be done on the financial calculator with the following inputs:
Details Amount
N 4
I/Y 6.50%
PV 0
PMT 5
Now think about this number this way: we received 4 coupon payments of Rs. 5
each. The total amount received over 4 years is Rs. 20. This Rs. 20 is now worth Rs.
22.04 because we have re-invested some part of it every year. So, the investment
amount that we have earned only from reinvesting coupons is 22.04 - 20 = 2.04.
Now consider the total re-invested coupon of 22.04 again. This is the value at the
end of 4 years. At the end of 4 years, we also get the face value of the bond i.e. 100.
So, at maturity, our cash flow from reinvested coupons plus the face value of the
bond is 22.04 + 100 = 122.04.
Remember that we had purchased the bond for 94.86. Therefore, the annualised
rate of return is (122.04/94.86)¼ - 1 = 6.50% (we take the power ¼ because this
return has been obtained over a period of 4 years and we want the annualised
return). This entire calculation demonstrates and confirms that only if the coupons
are reinvested at the YTM, then the annualised rate of return equals the YTM
when the bond is held till maturity.
Another key assumption is that the issuer will not default. This calculation only
works when the coupon and principal is paid in full and on time.
We can say that the investor’s investment horizon is the time between purchase
and sale. So if a 10-year bond is sold in 7 years then the investment horizon is 7
years.
Remember that the price of a bond converges to its face value as it reaches
maturity. The carrying value of the bond is the bond’s price assuming that the bond
follows this path towards the face value.
Suppose the 10-year bond was purchased at a YTM of 8% and it pays an annual
coupon of 6%. The bond is sold in 7 years for a price of 98.92. We can calculate the
capital gain/loss with the following logic.
Now we must price the bond using this yield but for a 3-year investment horizon.
This is because we want to see the price of the bond 7 years from the original date
so that we can compare it to the selling price.
Details Amount
N 3
I/Y 8%
FV 100
PMT 5
This tells us that the 10-year bond in 7 years should be priced at 92.2687. This is the
carrying value.
Instead, the bond is sold for a price of 98.92. So the capital gain is 98.92 - 92.27 =
6.65 per 100 of face value.
These bonds have no capital gain or loss since they are not sold.
What about bonds that are sold before maturity but the YTM hasn’t changed?
If the YTM does not change then the price after 3 years can be found with the
following inputs:
Details Amount
N 1
I/Y 7%
FV 100
PMT 5
The coupon interest and reinvestment for 3 years can be found with the following
inputs:
Details Amount
N 3
I/Y 7
PV 0
PMT 5
The future value of these coupons reinvested at the YTM is therefore 16.0745.
The total cash flow of the bond at the end of 3 years is now the carrying value plus
the total of the reinvested coupons = 98.1308 + 16.0745 = 114.2053.
The annualised return given the purchase price is (114.2053/93.2256)1/3 - 1 = 7% =
YTM hence proving that there is no real capital gain.
Following the same logic as before, notice that the only difference will be that the
coupons are reinvested at a higher rate than the YTM. When the coupons are
reinvested at a higher rate than the YTM, then there will be a capital gain.
The total of the reinvested coupons will be higher than the total if the YTM had not
increased at all.
When the coupons are reinvested at a lower rate than the YTM, then there will be a
capital loss.
The total of the reinvested coupons will be lower than the total if the YTM had not
decreased at all.
Note that these results are true only when there is enough time to reinvest
coupons. Let us take the same example from before but change the investment
horizon and the YTM after the bond is purchased.
Suppose there is a 4-year annual pay 5% bond trading at a YTM of 5%. This gives a
par price of 100.
The YTM increases to 8% after the first coupon but the bond is sold in one year. The
carrying value at that point in time is:
Details Amount
N 3
I/Y 8
FV 100
PMT 5
The carrying value is 92.2687.
The investor receives the first coupon of 5 and so the total cash flow received is
92.2687 + 5 = 97.2687.
Notice that the coupon was not allowed to grow at the increased YTM. So, the total
return on the bond in one year is (97.2687/100) -1 = -2.7313% this is much less than
the YTM of the bond.
The YTM decreases to 4% after the first coupon but the bond is sold in one year.
The carrying value at that point in time is:
Details Amount
N 3
I/Y 4
FV 100
PMT 5
The investor receives 5 as a coupon so the total cash flow is 107.7751. The total
return in one year is (107.7751/100) - 1 = 7.7751%. This is greater than the YTM of
the bond.
For a long-term investment horizon, the reinvestment risk is greater than the
market price risk. One of the reasons is because there is more emphasis on the
value derived from reinvesting coupons rather than the carrying value of the bond.
LOS 43.b: Define, calculate, and interpret Macaulay, modified, and effective
durations.
We will combine the explanation of LOS 43.b with LOS 43.g, LOS 43.h, and LOS
43.i because it flows better in terms of explanation. We will see the effective duration
and effective convexity at the end of the entire explanation of duration and convexity.
We will see how to calculate and interpret the Macaulay duration and the modified
duration in the following example.
Coupon 5%
Frequency* 1
YTM 7.39%
Maturity 7 years
*frequency indicates the number of times a coupon is paid during one year. A
frequency of 1 means the bond is annual-pay, 2 is semi-annual, etc.
1 5 7.39% 4.66
2 5 7.39% 4.34
3 5 7.39% 4.04
4 5 7.39% 3.76
5 5 7.39% 3.50
6 5 7.39% 3.26
Now we know that the bond’s price is the sum of all present values which is 87.31.
The Macaulay duration takes the weightage of the present value of each cash
flow, given the price of the bond.
Weightage
Present
Period Value (as % of Bond Price)
1 4.66 5.33%
2 4.34 4.97%
3 4.04 4.62%
4 3.76 4.31%
5 3.50 4.01%
6 3.26 3.73%
7 63.76 73.03%
You can see that the earlier cash flows have a higher weightage because they are
discounted at lower discount factors. You can also see that the final payment at
maturity will have the highest weightage because it is the principal plus coupon
payment.
The next step is to multiply the weight by the amount of time taken to receive
these cash flows. For instance, the weight multiplied by the time in period 6 will be
3.73% x 6 = 0.22.
1 5.33% 0.053329
2 4.97% 0.099322
3 4.62% 0.138735
4 4.31% 0.172255
5 4.01% 0.200507
6 3.73% 0.224057
7 73.03% 5.111796
But we need the modified duration in order to assess the interest rate risk.
Now we can assess the interest rate sensitivity. The ModDur tells us that for a 1%
change in interest rates, the price of a bond will move by 1% x -ModDur. Why
the minus sign? Because bond prices are inversely related to interest rates.
In our case, suppose interest rates increase by 2%. Then we can say that the bond
price will change by 2% x -5.59 = -11.18%.
If rates decrease by 2% then we can say that the bond price will change by -2% x -
5.59 = 11.18%.
We can also say that the modified duration is the slope of the line of the price of a
bond plotted against its YTM. Think about it this way: the slope measures (y2 - y1)/(x2
- x1). In this case, the y-axis is the bond price and the x-axis is the YTM. So any
change in the x-axis will have a corresponding change in the y-axis.
We can use the following notation for modified duration = (V- - V+)/∆YTM
Here, V- is the price of the bond when YTM falls (hence the minus sign under V) and
V+ is the price of the bond when the YTM increases. The denominator (i.e. the x-
axis) is the change in YTM.
INSERT R43_LOSb_1
Notice that this line is not a straight line and so the slope will be different for different
points. So we must use the approximate duration.
Then
This accounts for the percentage change in the bond price more accurately.
INSERT R43_LOSb_2
The tangent line represents the slope of the curve at any given point and the
approximate duration is an approximation of the change in price given a change in
yield.
Another tool that can be used is convexity. Convexity accounts for the curvature of
a price-yield curve. It is a more accurate measure of interest rate sensitivity.
INSERT R43_LOSh_1
We can see that if we use the duration as a measure of interest rate sensitivity, there
is some component that is not being accounted for. Duration does not show the
exact price, it shows an estimate.
That is why we must add a convexity measure to understand the full effect on the
price given a change in yields.
INSERT R43_LOSh_2
This gives a more accurate estimate of the change in bond price when combined
with the duration.
LOS 43.i: Estimate the percentage price change of a bond for a specified
change in yield, given the bond’s approximate duration and convexity.
The total change in the bond price is a function of the duration measure plus the
convexity factor. Therefore,
We will now discuss the duration and convexity for bonds with embedded options.
Recall that bonds with embedded options can be exercised at any point, given a
certain move and level of interest rates. All along the duration and convexity
calculations, we have assumed a change in the YTM of the bond. We have also
assumed that the cash flows are predictable.
Now consider the following explanation. Suppose a company has issued callable
bonds. If interest rates reduce in general then the benchmark yield curve’s rates
will also reduce. This means that the issuer can call back the bonds and issue new
debt at a lower rate. So, the calculation of the effective duration must start with the
change in benchmark yields rather than the change in the YTM of the bond.
INSERT R43_LOSi_1
We can see that the difference here is that the effective measures will specifically
look at the change in the benchmark curve, not the change in YTM of the bond.
Following from the example of the call option, we also have the following situation:
INSERT R43_LOSi_2
This graph shows us that callable bonds have negative convexity after a certain
level of reduction in benchmark rates. This illustrates that there is a cap on the price
of a callable bond. This is because after a certain point, the bonds will be called back
and the value cannot increase any further. Bondholders will receive the value of the
call price and nothing more. These bonds will have a lower convexity than option-
free bonds.
Putable bonds will have a floor on their prices. This is the minimum price at which
the bond will be sold back to the isser given an increase in rates. These bonds will
have a higher convexity than option-free bonds.
INSERT R43_LOSi_3
Key Differences
Remember that the YTM can change due to company-specific reasons even if the
benchmark rate does not change. The effective duration and convexity calculation
assumes that we are changing the rates of the benchmark yield curve.
Another important difference is that the modified duration and convexity measures
do not give importance to why the yields have changed. Effective duration implicitly
calculates the change in bond price specifically for the change in the benchmark
curve. The changes due to credit spreads are called the credit duration.
Note that the effective measures do not necessarily provide more accurate
measures for convexity and duration for bonds with embedded options. These too
are estimates and it will all depend on the predictability of interest rate changes.
LOS 43.g: Calculate and interpret the money duration of a bond and price
value of a basis point (PVBP).
Money Duration
The money duration is expressed in currency units so it will consider the amount
invested in the bond, given the current price of the bond.
Money Duration = Annual Modified Duration × Full Amount of Bond Position’s Value
This is helpful for fixed income portfolio management because we can assess the
interest rate risk of the entire portfolio of bonds, given that an approximation can be
made for the annual modified duration of the total portfolio.
Since modified duration is used to measure the percentage change in bond value,
money duration is used to measure the absolute change in bond value.
So, if a bond is quoted as “112 per 100 of par value” then the money duration can be
expressed in these terms too.
These are pretty straightforward calculations and so we can look at the LOS
questions for practice.
A basis point is 1% of 1%. So while modified duration shows the sensitivity of a bond
price per percentage change in yield, the PVBP shows the price change of a bond
given a change of 1 basis point.
Suppose the following information has been provided and we want to calculate the
price value of a basis point.
Coupon 7%
N 10
PMT 7
PV -110.13
FV 100
Now we must see the YTM for one basis point move upwards and one basis point
move downwards.
Now, keeping the inputs the same in the financial calculator, we can solve for the
price given these new YTMs.
Therefore, by changing I/Y to 5.66, we can compute the present value which is
110.02.
We now have the following information, where the yield of 5.65% was our starting
point.
Yield Price
5.64% 110.18
5.65% 110.13
5.66% 110.02
So, we can take the absolute price change of the price with the lower YTM and the
price with the higher YTM.
This is the price change of 2 basis point steps and so the price change for 1 basis
point step is 0.16/2 = 0.08
So,
PVBP per 100 of Par Value = (V- - V+)/ 2
Given that the face value of the bond is Rs. 100,000 we can get the absolute value
for as:
(0.08/100) x 100,000 = 80
This tells us that for every 1 basis point change in YTM, the value of the bond will
change by 80.
We divide 0.08 by 100 because we had taken the PVBP as every 100 of face value.
We want the PVBP per 1 of face value when we take the full face value into account.
So,
PVBP per 1 of Face Value = (PVBP per 100 of Par Value/100) x Total Face Value
Note that we do not use the price of the bond in this formula. It is taken as per face
value.
LOS 43.c: Explain why effective duration is the most appropriate measure of
interest rate risk for bonds with embedded options.
The cash flows of bonds with embedded options are unpredictable as interest rates
are unpredictable. The path that the interest rates take also matters. For example, if
a call option is beneficial to exercise at a YTM of 5% and the bond was originally
issued at a YTM of 8% then we can say that the interest rates followed a downward
path which is why the bond was called. There is an interest rate risk given the level
and the path that interest rates take over a period of time.
We cannot use the usual duration measure to assess the interest rate risk of the
bond because the cash flows of the bond will change once the bond is exercised. So
the effective duration must be used, given that the effective duration accounts for
changes in the yield curve and not the YTM.
LOS 43.d: Define key rate duration and describe the use of key rate durations
in measuring the sensitivity of bonds to changes in the shape of the
benchmark yield curve.
The duration is a good measure of price risk for parallel shifts in the yield curve.
Suppose that the yield for the 5-year maturity changes at a higher rate than the yield
on a 10-year maturity.
A key rate duration or partial duration must be used in this case. This is the
sensitivity of a bond’s price or the value of a bond portfolio given any change in the
spot curve for a specific maturity. It holds all other spot rates constant but will
assess the impact of a change in spot rate only by changing a key maturity rate.
There will therefore be a different key rate duration for each maturity.
When we consider a bond portfolio we are simply adding all the effects of individual
bonds.
LOS 43.e: Explain how a bond’s maturity, coupon, and yield level affect its
interest rate risk.
We will assume that all other factors are held constant when we are assessing the
effect on each individual factor.
Maturity
There will be much more variability in interest rates over a period of 30 years than
there will be in 1 year. So, the interest rate risk will be higher for a 30-year bond than
it will be for a 1-year bond.
Also, from a present value perspective, the cash flows that are received later are
discounted at much higher rates than cash flows received sooner. This also makes
the later cash flows more sensitive to interest rates.
However, this may not be the case for discount bonds. It is possible that the
Macaulay duration of a discount bond increases for a longer maturity and then
decreases over a range of longer maturities.
Coupon Rate
Zero coupon bonds will hold greater interest rate risk than coupon bonds. There is
only one payment at maturity and so the entire value of the bond depends on that
one payment. If the spot rate changes for that maturity then the price will be very
sensitive to that change.
YTM
Notice that at interest rates above the midpoint, the price variation is a lot higher than
the price variation after the midpoint. The steeper slope at lower yields suggests that
there is greater interest rate risk at lower yields.
Recall that a call or put provision puts a cap on the price of a bond.
SHOW CHART
If interest rates fall so low that the bond is called then there will be no effect on the
price of the bond beyond that point.
The same goes for put options. If interest rates increase so much that the bond is
sold back to the issuer then there will be no effect on the price of the bond beyond
that point.
LOS 43.f: Calculate the duration of a portfolio and explain the limitations of
portfolio duration.
This method takes the IRR of a bond portfolio. To break this down, remember what
we require for the IRR: all future cash flows and an appropriate discount rate. So,
this approach does not work for a portfolio with bonds with embedded options. The
interest rate path is uncertain and so the discount rate is uncertain for future periods.
The cash flows are uncertain too because the bonds can be called or put at any
time, given the changes in interest rates.
This is the more commonly used method. It takes the duration of each bond in the
portfolio and multiplies it by the weightage of that bond in the portfolio. The sum of all
weighted average durations is the weighted average duration of the portfolio.
We must first calculate the weight of each bond in the portfolio, given the market
price of each bond. The total portfolio value is Rs. 170,000 and so the weights,
duration and weighted duration is as follows:
The total of the weighted duration column is the weighted average duration of the
portfolio which equals 4.423. So even though the portfolio has a high duration bond
(Bond 2), its weight in the portfolio is less which keeps the duration of the total
portfolio on the lower end.
The disadvantage of using this method is that it assumes a parallel shift in the yield
curve. The YTM of each bond must move by the same amount. However, we know
that this is not true because each bond will have different risk characteristics
especially if there are corporate bonds in the portfolio. The greater the changes in
yields, the less accurate the weighted average duration of a portfolio.
So, the weighted average method is a more practical approach than the IRR method
but it still has its drawbacks.
LOS 43.j: Describe how the term structure of yield volatility affects the interest
rate risk of a bond.
The term structure of volatility is the volatility of bond yields plotted against the
respective maturities.
We can break the volatility of a bond into two components: the sensitivity of the
bond price given a change in the yield and the volatility of the bond yield itself.
As discussed before, the duration and convexity assumes a parallel shift in the yield
curve. This is not always the case. Short-term rates may be more affected then long-
term rates if the RBI changes the monetary policy which will impact short-term
liquidity. So, shorter term bonds will be more volatile for some time.
LOS 43.k: Describe the relationships among a bond’s holding period return, its
duration, and the investment horizon.
We saw earlier that the Macaulay duration and the maturity of the bond is not the
same. But an investor can choose a bond such that the investment horizon and
the Macaulay duration is the same.
In this case, a parallel shift in the yield curve before the first coupon is paid will not
change the bondholder’s horizon return. For shorter term bonds, the market price
risk is greater than the reinvestment risk.
● When the bondholder sells their bond at a date that is closer to the duration,
the horizon return is closer to the yield before the first coupon date
● When the bondholder sells their bond at a date that is before the duration, the
horizon return is greater than the yield before the first coupon date
● When the bondholder sells their bond at a date that is after the duration, the
horizon return is less than the yield before the first coupon date
Suppose the investor’s horizon is 7 years but the Macaulay duration is is 9 years.
The duration gap is 2 years and the investor is exposed to market price risk.
A negative duration gap is when the investment horizon is less than the Macaulay
duration. This makes the investment risky towards reinvestment risk from decreasing
interest rates.
Fun Fact: Duration gap is also used by banks to manage their assets and liabilities.
Most of the bank’s assets are loans and have longer maturities (think home loans).
The liabilities, however, have shorter maturities (think customer deposits). Banks
need to manage the interest rate risk on their assets with long maturities. The
difference between the duration on assets and duration on liabilities is the duration
gap of a bank’s net worth. Remember that a positive duration gap exposes the
assets to market price risk. So, the duration gap is a good measure of the change in
net worth given an increase or decrease in interest rates.
LOS 43.l: Explain how changes in credit spread and liquidity affect yield-to-
maturity of a bond and how duration and convexity can be used to estimate
the price effect of the changes.
Recall the building blocks of the yield to maturity. The benchmark yield is composed
of the real interest rate plus inflation. The additional spread for corporate bonds is
composed of credit risk and liquidity risk.
Since these yields are all added up, an increase or decrease in any of the building
blocks will increase or decrease the YTM by that amount.
Details Amount
Inflation 2%
We can then use the same formula that we had introduced before: