VALUATION OF FIXED

INCOME SECURITIES
Bond: A debt instrument with periodic
payments of interest and repayment of
principal at maturity

rM rM rM rM rM rM rM+M
|___|____|____|____|____|...…..|___ |
0 1 2 3 4 5 n-1 n

r: coupon interest rate

M: maturity (par value)
n: term to maturity

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Bond Valuation
V= rM(PVIF)i,1+rM(PVIF)i,2 +………
rM(PVIF)i,n + M(PVIF)i,n

i: market rate of interest

Coupon payments (rM) can be regarded as

an annuity,

V= rM(PVIFA)i,n + M(PVIF)i,n

or

(1+i)n -1 1
V = rM ------------- + M ------------
(1+i)n (1+i)n

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 Bond Valuation example
n=10 years, coupon rate: 8%
M= $1,000 Market rate : 10%

$80 $80 $80 $80 $80 $80 $180

|___|____|____|____|____|...…..|___ |
0 1 2 3 4 5 9 10

V= $80x(PVIFA)10%,10 + $1,000x(PVIF)10%,10
= $877.11

If i>r V<M (discount)

i<r V>M (premium)
i=r V=M (par)

Yield-to-maturity: the rate of return on a bond

In the example, the YTM is 10%.

A bond’s YTM is the market rate of interest for

that risk group and maturity.

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 Valuation Between Interest
Payment Dates

1  n 1
rM M 
V
(1  i) c / g rM   (1  i)t  (1  i) n1 
 t 1 

V: invoice price of the bond

c: days until first payment
g: number of days between two payment periods

P= quoted price = V - accrued interest

Accrued Interest = rM (g-c)/g

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 Valuation Example
Eg. N=5 years,semiannual coupon r=8%,
i=10%, first payment 2 months from today.

1  9
40 1000 
V 2/6 
40    9
(1  0.05)  t 1 (1  0.05)
t
(1  0.05) 

V= Invoice Price = $953.29

Accrued Interest = 40 x (4/6)
= $26.67

Quoted price = $926.62

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Risks Faced by a Bond Investor
Default risk
Interest rate risk (price risk)
Reinvestment risk
Call risk
Inflation risk
Foreign exchange risk
Liquidity risk

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Rating
Category Moody’s S&P
------------------------------------------
High Grade Aaa AAA
Aa AA
-------------------------------------------
Investment A A
Grade Baa BBB
-------------------------------------------
Speculative Ba BB
B B
-------------------------------------------
Default Caa CCC
Ca CC
C C
D

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 Interest Rate Risk
Example: Two bond issues of ABC Co.
N1=1 yr N2= 10 yrs r = 5%

Bond Value
Market Rate of First Issue: Second Issue:
Interest N = 1 yr N = 10 yrs
5% 100.00 100.00
6% 99.06 92.64
7% 98.13 85.95
8% 97.22 79.87

As term to maturity increases, value of the

bond becomes more sensitive to movements
in market interest rate.

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 Bond Value and Coupon Rates
Example:Two issues of ABC Co.
n=20 yrs, r1=10%, r2=6%
Market Bond 1 Percent Bond 2 Percent
Interest Rate R=10% change R=6% change
8% 119.64 80.36
9% 109.13 -8.78% 72.61 -9.64%
10% 100.00 -8.36% 65.95 -9.17%
11% 92.04 -7.96% 60.18 -8.75%
12% 85.06 -7.58% 55.18 -8.31%

Low coupon bonds are more sensitive

to changes in market interest rates

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 Value of a Bond in Time
Example: Market rate stays at 10%, values of
two bonds with coupon rates of 8% and 12%
as the term to maturity approaches:

Maturity Bond 1 Bond 2

R=8% R=12%
5 92.42 107.58
4 93.66 106.34
3 95.03 104.97
2 96.53 103.47
1 98.18 101.82
0 100.00 100.00

Assuming that interest rates remain the same,

bond value approaches to par over time as
term to maturity shortens.

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Term Structure of Interest
Rates
Relationship between yield and time to
maturity.

Example: n=1 i=6%

n=5 i=8%
n=20 i=9%

Yield Curve

Maturity

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Possible Explanations of
the Term Structure
1. Expectations Hypothesis

1 + in =[(1+ i1)(1+ 1i2)…….(1+n-1 in)]1/n

Example: i2=8% i1=6% 1i2=?

1 + 0.08 = [(1+ 0.06)(1+ 1i2)]1/2

1i2 = 0.1004 or 10%

2. Liquidity Preference Hypothesis

Slope of the yield curve is higher than

specified in expectations hypothesis

3. Segmented Markets Hypothesis

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Duration
Volatility in bond price is directly proportional
to term to maturity but inversely proportional
to coupon payments. Duration of a bond is a
measure that incorporates both factors that
affect volatility.

n
(t )Ct
D V
t 1 (1  i )
t

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Duration Example
n=5 yrs, r=8%, i=10%
(1) (2) (3) (4) (5) (6)
Year PMT PVIF (2)x(3) (4)/V (1)x(5)
1 8 0.9091 7.27 0.0787 0.0787

2 8 0.8264 6.61 0.0715 0.1430

3 8 0.7513 6.01 0.0650 0.1950

4 8 0.6830 5.46 0.0591 0.2364

5 108 0.6209 67.06 72.57 3.6284

Total 92.41 4.28

Bond Value = $92.41

Macaulay Duration = 4.28 years

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Hedging Interest Rate Risk
$12 $12 $12 $12 $12 $12 $112
|___|____|____|____|____|...…..|___ |
0 1 2 3 4 5 9 10

V0=$84.94 when i=15%

After i declines to 12%, V = $100

V when term to maturity is 4 years:
V6 = $100

Future value of the first 6 coupon payments

reinvested at 12%:
12 x PVIFA 12%,6 = $97.38
Total savings = $100 + $97.38 = $197.38

$84.94 in 6 years grows to $197.38

Annual growth of 15%.

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 Immunization Example
$1,000 $2,000 $2,500 $2,000 $1650
|_____|______|______|______|______|
0 1 2 3 4 5

Total Premiums = Assets = $6,830.82

Market rate = 10% Flat yield curve

Strategy 1: Invest in 1-yr bills with 10% interest

6830.82 -> 7513.90

(1000.00)
6513.90 --> 7165.29
(2000.00)
5165.29 --> 5681.82
(2500.00)
3181.82 ->3500
(2000)
1500 ->1650
(1650)

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Immunization Example
(Cont’d)
However, if interest rates fall, assets will
be short of liabilities

Strategy 2: Invest in 3-yr zero coupon bonds

yielding 10%

Duration of Liabilities:

1 1000 909.09 0.133 0.133

2 2000 1652.89 0.242 0.484
3 2500 1878.29 0.275 0.825
4 2000 1366.03 0.200 0.800
5 1650 1024.52 0.150 0.750
2.990

Duration = 2.99 years

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Immunization Example
(Cont’d)
Market rate 10%, V = $6,830.82
M = $9,091.82 Duration = 3 years

If interest rates fall from 10% to 8%,

V= $9,091.82 x PVIF 8%,3 = $7,217.38

7217.38 ->7794.77
(1000.00)
6794.77 ->7338.35
(2000.00)
5338.35->5765.42
(2500.00)
3265.42->3526.66
(2000.00)
1526.66->1650
(1650)

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Modified Duration
D
MD = -----------
(1 + i)

In the example above, MD = 4.28/1.10 = 3.89

Approximate Change in V = -MD x Change in

yield

Example:
If the yield decreases from 10% to 8%

% Change in V= -4.28 x (-2) = 8.56%

In fact when i=10% V = $92.41

i=8% V = $100 increase 8.21%

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Convexity
Price-Yield Relationship

Yield

The shape of the curve depends on

the coupon rate and term to maturity

High coupon + Short term -----> Linear

Low coupon + Long term ------> Convex

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Convexity (Cont’d)
Higher convexity means that when interest
rates go up, bond value declines slowly; but
when rates decline, increase in bond price is
large

Therefore high convexity is a desirable

feature.

Factors that increase convexity:

* Low coupon
* Long term to maturity
* Low yield

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 Convexity (Cont’d)
2
dV
Convexity  2 V
di
d 2V 1 n
Ct
2 
 (t 2
 t)
di 2
(1  i) t 1 (1  i) t

(1) (2) (3) (4) (5)

Year Ct PVIF(8%,n) (1) x (2) t2 + t (3) x (4)
1 8 0.9091 7.27 2 14.55
2 8 0.8264 6.61 6 39.67
3 8 0.7513 6.01 12 72.13
4 8 0.6830 5.46 20 109.28
5 108 0.6209 67.06 30 2011.79
92.42 2247.41

Convexity = [1/(1.10)2][2247.41][1/92.42]
= 20.10
Appox. Change in V = -MD x i + K x (i)2

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 Alternative Measures of
Yield
Current Yield = rM / V
Yield-to-maturity
◦ Bond is held until maturity
◦ All coupon and principal repayments are made on time
◦ Bond is not called before maturity
◦ Coupon payments are reinvested at yield-to-maturity

Yield-to-call
Holding period yield

Vt+1 - Vt + rM
HPY = --------------------
Vt

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 Approximate yield-to-
maturity
M V
rM 
i n
V M
2
Example V= $877.11 n=3 yrs r=8% M=$1000

1000  877.11
80 
i 10  0.0983
877.11  1000
2

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Bond Investment Strategies
I. Passive Strategies

Investing $100 in 1925

T-bill
Deposits
Stock Market
AAA Corporate Bonds
Gold
Inflation

Passive Strategies are better when:

Interest rate risk is low, and
Inflation is low and stable

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II. Active Strategies
Strategies based on maturity structure
◦ Maturity matching - duration
◦ Spreading the maturity
◦ Investing only in short term bills and long term bonds

Strategies based on forecasting interest rate movements

◦ Interest rate fluctuations
◦ Buy when rates are high, sell when low
◦ Increase duration if higher rates are forecast, reduce duration otherwise

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- Riding the yield curve
Investing in bonds assuming that the
yield curve will not shift

A
B

Maturity

Eg. 1 year bill i=6% V1 = $943.40 B

2 year zero coupon i=8% V2 = $857.34 A

Buy the 2-year bond at $857.34, sell it next year

at $943.40

HPY = (943.40 - 857.34) / 857.34 = 10.04%

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Strategies based on lack of
market efficiency
Junk bonds
Bond swaps
◦Yield swap : same coupon, rating, maturity
and industry, different yield
◦Exchange swap: same rating, maturity,
industry, yield, different coupon. Exchange
current yield for capital gains
◦Tax swap: Selling a bond to realize a loss,
and replacing it with a similar bond
◦Swapping bonds with different tax status:
eg. AAA corporate bond vs. municipal bond

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Strategies based on lack of market
efficiency (cont’d)
Possible shortcomings of bond swaps:
◦ time to execute the swap
◦ taxes
◦ transaction costs
◦ risk level of bonds

Portfolio rebalancing:
adjusting the bond portfolio
for the changes in market
conditions

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