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**Investment Analysis and Portfolio Management
**

Seventh Edition by

Frank K. Reilly & Keith C. Brown

Chapter 19

**Chapter 19 - 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?

**Chapter 19 - 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?

**Chapter 19 - 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?

**Chapter 19 - 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 bond’s modified duration and its volatility?

**Chapter 19 - 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 bond’s price volatility?

**Chapter 19 - The Analysis and Valuation of Bonds
**

• What happens to the duration and convexity of bonds that have embedded call options?

**Chapter 19 - The Analysis and Valuation of Bonds
**

• What are effective duration and effective convexity and when are they useful? • What is empirical duration and how is it used with common stocks and other assets? • What are the static yield spread and the option-adjusted spread?

The Fundamentals of Bond Valuation

Pp C 2 P 2n (1 i 2) (1 i 2)

Where: Pm=the current market price of the bond n = the number of years to maturity Ci = the annual coupon payment for bond i i = the prevailing yield to maturity for this bond issue Pp=the par value of the bond

The present-value model 2n t m t t 1

**The Fundamentals of Bond Valuation
**

• If yield < coupon rate, bond will be priced at a premium to its par value • If yield > coupon rate, bond will be priced at a discount to its par value • Price-yield relationship is convex (not a straight line)

**The Yield Model
**

The expected yield on the bond may be computed from the market price

Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2)

2n

Where:

i = the discount rate that will discount the cash flows to equal the current market price of the bond

**Computing Bond Yields
**

Yield Measure

Nominal Yield

Current yield Promised yield to maturity Promised yield to call Realized (horizon) yield

Purpose

Measures the coupon rate Measures current income rate Measures expected rate of return for bond held to maturity Measures expected rate of return for bond held to first call date 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.

Nominal Yield

Measures the coupon rate that a bond investor receives as a percent of the bond’s par value

Current Yield

Similar to dividend yield for stocks Important to income oriented investors CY = Ci/Pm where: CY = the current yield on a bond Ci = the annual coupon payment of bond i Pm = the current market price of the bond

**Promised Yield to Maturity
**

• Widely used bond yield figure • Assumes

– Investor holds bond to maturity – All the bond’s cash flow is reinvested at the computed yield to maturity

Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2)

2n

Solve for i that will equate the current price to all cash flows from the bond to maturity, similar to IRR

**Computing the Promised Yield to Maturity
**

Two methods • Approximate promised yield

– Easy, less accurate

**• Present-value model
**

– More involved, more accurate

**Approximate Promised Yield
**

APY Ci Pp Pm n Pp Pm 2

=

Coupon + Annual Straight-Line Amortization of Capital Gain or Loss Average Investment

Present-Value Model

Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2)

2n

**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

Where:

AYC = approximate yield to call (YTC)

c

Pc Pm Ct P = call price of the bond nc AYC P = market price of the bond Pc Pm C = annual coupon payment nc = the number of years to first call date 2

m

t

Promised Yield to Call Present-Value Method

Where: Pm = market price of the bond Ci = annual coupon payment nc = number of years to first call Pc = call price of the bond

Ci / 2 Pc Pm t 2 nc (1 i ) t 1 (1 i )

2 nc

Realized Yield Approximation

ARY

Where:

Ci

Pf P

hp Pf P 2

ARY = approximate realized yield to call (YTC) Pf = estimated future selling price of the bond Ci = annual coupon payment

hp = the number of years in holding period of the bond

Realized Yield Present-Value Method

Pf Ct / 2 Pm t 2 hp (1 i 2) t 1 (1 i 2)

2 hp

Calculating Future Bond Prices

Pf

2 n 2 hp

t 1

Pp Ci / 2 t 2 n 2 hp (1 i 2) (1 i 2)

Where: Pf = estimated future price of the bond Ci = 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

**Yield Adjustments for Tax-Exempt Bonds
**

annual return ETY 1- T

Where: T = amount and type of tax exemption

**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

**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 credit quality term to maturity indenture provisions foreign bond risk including exchange rate risk and country risk

• Impact of bond characteristics

**What Determines Interest Rates
**

• • • • • Term structure of interest rates Expectations hypothesis Liquidity preference hypothesis Segmented market hypothesis Trading implications of the term structure

Expectations Hypothesis

• Any long-term interest rate simply represents the geometric mean of current and future one-year interest rates expected to prevail over the maturity of the issue

**Liquidity Preference Theory
**

• Long-term securities should provide higher returns than short-term obligations because investors are willing to sacrifice some yields to invest in short-maturity obligations to avoid the higher price volatility of longmaturity bonds

**Segmented-Market Hypothesis
**

• Different institutional investors have different maturity needs that lead them to confine their security selections to specific maturity segments

**Trading Implications of the Term Structure
**

• Information on maturities can help you formulate yield expectations by simply observing the shape of the yield curve

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

Yield Spreads

Magnitudes and direction of yield spreads can change over time

**What Determines the Price Volatility for Bonds
**

Bond price change is measured as the percentage change in the price of the bond

Where:

EPB 1 BPB

EPB = the ending price of the bond BPB = the beginning price of the bond

**What Determines the Price Volatility for Bonds
**

Four Factors 1. Par value 2. Coupon 3. Years to maturity 4. Prevailing market interest rate

**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

**What Determines the Price Volatility for Bonds
**

• • • • The maturity effect The coupon effect The yield level effect Some trading strategies

**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

**The Duration Measure
**

Ct (t ) (1 i) t t 1 D n Ct (1 i) t t 1

n

t PV (C )

t 1 t

n

price

Developed by Frederick R. Macaulay, 1938 Where: t = time period in which the coupon or principal payment occurs Ct = interest or principal payment that occurs in period t i = yield to maturity on the bond

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 bond’s duration equals its maturity

• There is an inverse relation between duration and coupon • There is a positive relation between term to maturity and duration, but duration increases at a decreasing rate with maturity • There is an inverse relation between YTM and duration • Sinking funds and call provisions can have a dramatic effect on a bond’s duration

**Modified Duration and Bond Price Volatility
**

An adjusted measure of duration can be used to approximate the price volatility of a bond

**Macaulay duration modified duration YTM 1 Where: m
**

m = number of payments a year

YTM = nominal YTM

**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

Where: P = change in price for the bond P = beginning price for the bond Dmod = the modified duration of the bond i = yield change in basis points divided by 100

P 100 Dmod i P

**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-valueweighted average of the duration of the individual bonds in the portfolio

**Bond Duration in Years for Bonds Yielding 6 Percent Under Different Terms
**

COUPON RATES

Years to

Maturity 1 5 10 20 50 100

8

0.02 0.995 4.756 8.891 14.981 19.452 17.567 17.167

0.04 0.990 4.558 8.169 12.980 17.129 17.232 17.167

0.06 0.985 4.393 7.662 11.904 16.273 17.120 17.167

0.08 0.981 4.254 7.286 11.232 15.829 17.064 17.167

Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies," Journal of Business 44, no. 4 (October 1971): 418. Copyright 1971, University of Chicago Press.

Bond Convexity

• Equation 19.6 is a linear approximation of bond price change for small changes in market yields

P 100 Dmod YTM P

Bond Convexity

• Modified duration is a linear approximation of bond price change for small changes in market yields

**P 100 Dmod i P
**

• Price changes are not linear, but a curvilinear (convex) function

**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

Modified Duration

Dmod dP di P

For small changes this will give a good estimate, but this is a linear estimate on the tangent line

Determinants of Convexity

The convexity is the measure of the curvature and is the second derivative of price with resect to yield (d2P/di2) divided by price Convexity is the percentage change in dP/di for a given change in yield

d P 2 di Convexity P

2

Determinants of Convexity

• Inverse relationship between coupon and convexity • Direct relationship between maturity and convexity • Inverse relationship between yield and convexity

**Modified Duration-Convexity Effects
**

• Changes in a bond’s price resulting from a change in yield are due to:

– Bond’s modified duration – Bond’s 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

**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

**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

**Convexity of Callable Bonds
**

• Noncallable bond has positive convexity • Callable bond has negative convexity

**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 • Initial assumption that cash flows from the bond are not affected by yield changes

Effective Duration

• Measure of the interest rate sensitivity of an asset • Use a pricing model to estimate the market prices surrounding a change in interest rates Effective Duration

**P P P P 2P
**

2 PS PS

2

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

Effective Convexity

Effective Duration

• Effective duration greater than maturity • Negative effective duration • Empirical duration

Empirical Duration

• Actual percent change for an asset in response to a change in yield during a specified time period

**Yield Spreads With Embedded Options
**

• Static Yield Spreads

– Consider the total term structure

**• Option-Adjusted Spreads
**

– Consider changes in the term structure and alternative estimates of the volatility of interest rates

**The Internet Investments Online
**

www.bondcalc.com www.bondtrac.com www.moneyline.com www.bondsonline.com

End of Chapter 19

–The Analysis and Valuation of Bonds

**Future topics Chapter 20
**

• Bond Portfolio Management Strategies

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