CHAPTER 14, 15 and 16

Ch 14 Bond Prices and Yields

Ch 15 The Term Structure of Interest Rates
Ch 16 Managing the Bond Portfolios
Comparative Performance of Stocks and Bonds
(1997-2008)
 3

Bond Prices and Yields

CHAPTER 14
 4

Bond Characteristics

• Bonds are debt – “IOU” securities. Issuers

are borrowers and holders are creditors.

– The indenture is the contract between the

issuer and the bondholder.
– The indenture gives the coupon rate, maturity
date, and par value.
 5

Bond Characteristics

• Face or par value is typically $1000; this is the

principal repaid at maturity.

• The coupon rate determines the interest

payment.
– Interest is usually paid semiannually.
– The coupon rate can be zero.
– Interest payments are called “coupon
payments”.
 6

U.S. Treasury Bonds

• Bonds and notes may be purchased
directly from the Treasury.
• Maturities vary.
– Note maturity is 1-10 years
– Bond maturity is 10-30 years
• Denomination can be as small as $100,
but $1,000 is more common.
• Bid price of 100:08 means 100 8/32 or
$1002.50
7
 8

Corporate Bonds
• Callable bonds can be repurchased before
the maturity date.

• Convertible bonds can be exchanged for

shares of the firm’s common stock.

• Puttable bonds give the bondholder the

option to retire or extend the bond.

• Floating rate bonds have an adjustable

coupon rate
 9

List of Corporate Bonds

 10

Callable Bonds
• Thus far, we have calculated bond prices
assuming that the actual bond maturity is the
original stated maturity.

• However, most bonds are callable bonds.

• A callable bond gives the issuer the option to buy

back the bond at a specified call price anytime
after an initial call protection period.

• Therefore, for callable bonds, YTM may not be

useful.
 11

YTM and YTC

• Suppose a 20-year bond has a coupon of 8 percent, a
price of 98.851, and is callable in 10years. The call
prices 105. What are its yield to maturity and yield to
call?
 
$80  1   $1,000
$988.51  1 
YTM  220 
   
220
 1  YTM  1  YTM
2 2

• YTM = 8.12 percent

 
$80  1  $1,050
$988.51  1  
YTC  210 
   
210
 1  YTC  1  YTC
2 2
• YTC = 8.50 percent
 12
Inflation-Indexed Treasury
Securities
• Recently, the U.S. Treasury has issued securities called Treasury
Inflation Protected Securities (TIPS) that guarantee a fixed rate of
return in excess of realized inflation rates .

• That is, they are indexed to inflation in order to protect investors

from the negative effects of inflation.

• TIPS can be purchased directly from the government through the

TreasuryDirect system in $100 increments with a minimum
investment of $100 and are available with 5-, 10-, and 20-year
maturities.

• You can hold a TIPS until it matures or sell it in the secondary

market before it matures.
 13

Example: TIPS
• Their par value rises with inflation and falls with deflation, as measured
by the CPI.
– TIPS pay interest twice a year, at a fixed coupon rate on their
current principal
– But, principal are adjusted semiannually according to the most
recent inflation rate.
– So, like the principal, interest payments rise with inflation and fall
with deflation.
– When a TIP matures, you are paid the adjusted principal or original
principal, whichever is greater.

• Suppose an inflation-indexed note is issued with a coupon rate of 3.5%

and an initial principal of $1,000.
– Six months later, the note will pay a coupon of $1,000 × (3.5%/2) =
$17.50.
– Assuming 2 percent inflation over the six months since issuance,
the note’s principal is then increased to $1,000 × 102% = $1,020.
– Six months later, the note pays $1,020 × (3.5%/2) = $17.85
– Its principal is again adjusted to compensate for recent inflation.
 14
Principal and Interest Payments for a
Treasury Inflation Protected Security
 15

Bond Pricing
PB = Price of the bond
Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual
yield to maturity

PB  
T
C 
ParValue
t 1 (1 r ) (1 r )
t T
 16

Bond Pricing

Price of a 30 year, 8% coupon bond

with semi-annual coupon payments.
Market rate of interest is 10%.
60
$40 $1000
Price   
t 1 1.05 1.05
t 60

Price  $810.71
 17

Bond Prices and Yields

• Prices and yields (required rates of return) have
an inverse relationship
• The bond price curve is convex.
– For a given absolute change in a bond’s YTM, the
magnitude of the price increase caused by a decrease in
yield is greater than the price decrease caused by an
increase in yield.
• The longer the maturity, the more sensitive the
bond’s price to changes in market interest rates.
• The lower the coupon rate, the more sensitive
the bond’s price to changes in market interest
rates.
 18
The Inverse Relationship Between Bond
Prices and Yields
 19
Bond Prices at
Different Interest Rates
 20

Yield to Maturity

• Interest rate that makes the present value

of the bond’s payments equal to its price is
the YTM.
Solve the bond formula for r

PB  
T
C 
ParValue
t 1 (1 r ) (1 r )
t T
 21

Yield to Maturity Example

Suppose an 8% coupon paid semiannually,

30 year bond is selling for $1276.76. What is
its average rate of return?

$1276.76  
60
$40 1000

t 1 (1 r ) (1 r )
t 60

r = 3% per half year

Bond equivalent yield = 6%
EAR = (1.03)2 - 1 = 6.09%
 22

YTM vs. Current Yield

YTM Current Yield

• The YTM is the bond’s • The current yield is the
internal rate of return. bond’s annual coupon
• YTM is the interest rate payment divided by the
that makes the present bond price.
value of a bond’s
payments equal to its • For bonds selling at a
price. premium, coupon rate >
• YTM assumes that all current yield>YTM.
bond coupons can be • For discount bonds,
reinvested at the YTM relationships are
rate. reversed.
 23

Yield to Call

• If interest rates fall, price of straight bond

can rise considerably.

• The price of the callable bond is flat over a

range of low interest rates because the
risk of repurchase or call is high.

• When interest rates are high, the risk of

call is negligible and the values of the
straight and the callable bond converge.
 24
Bond Prices:
Callable and Straight Debt
 25
Realized (Horizon) Yield vs.
Promised YTM
• YTM is a promised yield, which may not equal the realized yield.

• Two assumptions with YTM

– YTM assumes the investor’s holding bond until maturity.
– YTM assumes that coupons are reinvested at YTM.

• That is, YTM will equal the realized return only if all coupons are
reinvested at YTM and investors hold the bond until maturity..

• Two questions on the Promised YTM.

– What if the investor does not hold the bond until maturity?
– What if the investor is unable to reinvest coupons at the promised YTM?

• Horizon Yield or Holding Period Return (HPR) measure the

expected rate of return of a bond that you expect to sell prior to its
maturity with varying reinvestment rates.
 26

YTM vs. HPR

YTM HPR
• YTM is the average • HPR is the rate of
return if the bond is held return over a particular
to maturity. investment period.
• YTM depends on coupon • HPR depends on the
rate, maturity, and par bond’s price at the end
value. of the holding period,
• All of these are readily an unknown future
observable. value.
• HPR can only be
forecasted.
 27

Growth of Invested Funds

 28

Example
• Suppose we bought a par bond with 14%, 20-year
bond.
– This means that YTM is 14%.
• Assume the holding period is 2 years.
• Assumes that the market interest rate is expected
to decline to 10 percent.
• Expected price at the end of year 2
– N = 36, I = 10 (2P), PMT = 70, FV = 1000
– Price at the end of year 2 = $1,330.94
• Horizon Yield
– N = 4, PV = -1000, PMT = 70, FV = 1330.94,
– I = 27.50%
 29
Prices over Time of 30-Year Maturity,
6.5% Coupon Bonds
 30
The Price of a 30-Year Zero-Coupon
Bond over Time
 31

Default Risk and Bond Pricing

• Rating companies:
– Moody’s Investor Service, Standard & Poor’s,
Fitch
• Rating Categories
– Highest rating is AAA or Aaa
– Investment grade bonds are rated BBB or Baa
and above
– Speculative grade/junk bonds have ratings
below BBB or Baa.
 32

Factors Used by Rating Companies

• Coverage ratios
• Leverage ratios
• Liquidity ratios
• Profitability ratios
• Cash flow to debt
 33
Financial Ratios and Default Risk by
Rating Class, Long-Term Debt
 34

Protection Against Default

• Sinking funds – a way to call bonds early

• Subordination of future debt– restrict
additional borrowing
• Dividend restrictions– force firm to retain
assets rather than paying them out to
shareholders
• Collateral – a particular asset bondholders
receive if the firm defaults
 35

Default Risk and Yield

• The risk structure of interest rates refers to

the pattern of default premiums.
• There is a difference between the yield based
on expected cash flows and yield based on
promised cash flows.
• The difference between the expected YTM
and the promised YTM is the default risk
premium.
 36

Yield Spreads
 37

Credit Default Swaps

• A credit default swap (CDS) acts like an insurance
policy on the default risk of a corporate bond or loan.
• CDS buyer pays annual premiums.
• CDS issuer agrees to buy the bond in a default or pay
the difference between par and market values to the
CDS buyer.
• Institutional bondholders, e.g. banks, used CDS to
enhance creditworthiness of their loan portfolios, to
manufacture AAA debt.
• CDS can also be used to speculate that bond prices
will fall.
• This means there can be more CDS outstanding than
there are bonds to insure!
 38

Prices of Credit Default Swaps

 39
Credit Risk and Collateralized Debt
Obligations (CDOs)
• Major mechanism to reallocate credit risk in
the fixed-income markets
– Structured Investment Vehicle (SIV) often
used to create the CDO
– Loans are pooled together and split into
tranches with different levels of default risk.
– Mortgage-backed CDOs were an
investment disaster in 2007
 40

Collateralized Debt Obligations

 41

The Term Structure of Interest Rates

CHAPTER 15
 42

Overview of Term Structure

• The yield curve is a graph that displays the

relationship between yield and maturity.

• Information on expected future short term

rates can be implied from the yield curve.
 43

Money Market
Interest Rates
 44

The Treasury Yield Curve

• Because of its sheer size, the leading world
market for debt securities is the market to
U.S. Treasury securities.

• The Treasury yield curve is a plot of Treasury

yields against maturities.

• It is fundamental to bond market analysis,

because it represents the interest rates for
default-free lending across the maturity
spectrum.
 45
Example: The Treasury Yield Curve
 46

Treasury Yield Curves

 47

The Term Structure of Interest Rates

• The term structure of interest rates is

the relationship between time to maturity
and the interest rates for default-free, pure
discount instruments.

• The term structure is sometimes called the

“zero-coupon yield curve” to distinguish
it from the Treasury yield curve, which is
based on coupon bonds.
 48

Two Types of Yield Curves

On-the-run Yield
Pure Yield Curve Curve
• The pure yield curve • The on-the-run yield
uses stripped or zero curve uses recently
coupon Treasuries. issued coupon bonds
• The pure yield curve selling at or near par.
may differ significantly • The financial press
from the on-the-run typically publishes on-
yield curve. the-run yield curves.
 49

Bond Pricing

• Yields on different maturity bonds are not all

equal.
• We need to consider each bond cash flow
as a stand-alone zero-coupon bond.
• Bond stripping and bond reconstitution
offer opportunities for arbitrage.
• The value of the bond should be the sum
of the values of its parts.
 50
Prices and Yields to Maturities on Zero-
Coupon Bonds ($1,000 Face Value)
 51

Valuing Coupon Bonds

• Value a 3 year, 10% coupon bond using

discount rates from Table 15.1:
$100 $100 $1100
Price   2

1.05 1.06 1.073

• Price = $1082.17 and YTM = 6.88%

• 6.88% is less than the 3-year rate of 7%.
 52

Yield Curve Under Certainty

• Suppose you want to invest for 2 years.

– Buy and hold a 2-year zero
- or
– Rollover a series of 1-year bonds

• Equilibrium requires that both strategies

provide the same return.
 53

Two 2-Year Investment Programs

 54

Yield Curve Under Certainty

• Buy and hold vs. rollover:
(1  y2 )  (1  r1 ) x(1  r2 )
2

1
1  y2   (1  r1 ) x(1  r2 )  2

• Next year’s 1-year rate (r2) is just enough

to make rolling over a series of 1-year
bonds equal to investing in the 2-year
bond.
 55

Spot Rates vs. Short Rates

• Spot rate – the rate that prevails today for

a given maturity
• Short rate – the rate for a given maturity
(e.g. one year) at different points in time.
• A spot rate is the geometric average of its
component short rates.
 56

Short Rates and Yield Curve Slope

• When next year’s • When next year’s

short rate, r2 , is short rate, r2 , is less
greater than this than this year’s short
year’s short rate, r1, rate, r1, the yield
the yield curve slopes curve slopes down.
up. – May indicate rates are
– May indicate rates are expected to fall.
expected to rise.
 57

Short Rates versus Spot Rates

 58

Forward Rates from Observed Rates

(1  yn ) n
(1  f n )  n 1
(1  yn 1 )
fn = one-year forward rate for period n
yn = yield for a security with a maturity of n

n 1
(1  yn )  (1  yn1 ) (1  f n )
n
 59

Forward Rates

• The forward interest rate is a forecast of a

future short rate.
• Rate for 4-year maturity = 8%, rate for 3-
year maturity = 7%.

1 f4 
1  y4 
4

1.084
 1.1106
1  y3 3
1.07 3

f 4  11.06%
 60

Interest Rate Uncertainty

• Suppose that today’s rate is 5% and the

expected short rate for the following year
is E(r2) = 6%. The value of a 2-year zero
is: $1000
 $898.47
1.051.06
• The value of a 1-year zero is:
$1000
 $952.38
1.05
 61

Interest Rate Uncertainty

• The investor wants to invest for 1 year.

– Buy the 2-year bond today and plan to
sell it at the end of the first year for
$1000/1.06 =$943.40.
– Or,
– Buy the 1-year bond today and hold to
maturity.
 62

Interest Rate Uncertainty

• What if next year’s interest rate is more (or

less) than 6%?

– The actual return on the 2-year bond is

uncertain!
 63

Interest Rate Uncertainty

• Investors require a risk premium to hold a

longer-term bond.

• This liquidity premium compensates short-

term investors for the uncertainty about
future prices.
 64

Theories of Term Structure

• Expectations
• Liquidity Preference
– Upward bias over expectations
 65

Expectations Theory
• Observed long-term rate is a function of today’s
short-term rate and expected future short-term rates.
• The term structure of interest rates reflects financial
market beliefs about future interest rates.
• Long-term and short-term securities are perfect
substitutes.
• Forward rates that are calculated from the yield on
long-term securities are market consensus expected
future short-term rates.

• fn = E(rn) and liquidity premiums are zero.

 66

Liquidity Premium Theory

• Long-term bonds are more risky, and therefore, long-term interest
rates contain a maturity premium necessary to induce lenders
into making longer term loans.
– Long-term bonds are more risky; therefore, fn generally exceeds E(rn)
– The excess of fn over E(rn) is the liquidity premium.

• Investors will demand a premium for the risk associated with

long-term bonds.

• Forward rates contain a liquidity premium and are not equal to

expected future short-term rates.

• The yield curve has an upward bias built into the long-term rates
because of the liquidity premium.
 67

Yield Curves
 68

Interpreting the Term Structure

• The yield curve reflects expectations of future

interest rates.
• The forecasts of future rates are clouded by
other factors, such as liquidity premiums.
• An upward sloping curve could indicate:
– Rates are expected to rise
– And/or
– Investors require large liquidity premiums to
hold long term bonds.
 69

Interpreting the Term Structure

• The yield curve is a good predictor of the

business cycle.
– Long term rates tend to rise in anticipation
of economic expansion.
– Inverted yield curve may indicate that
interest rates are expected to fall and
signal a recession.
 70
Term Spread: Yields on 10-year vs. 90-
day Treasury Securities
 71

Dynamic Yield Curve

• http://stockcharts.com/freecharts/yieldcurv
e.html
 72
Inverted Yield Curve = Prognosis for
Recession?
 73
Inverted Yield Curve = Prognosis for
Recession?
 74

Managing the Bond Portfolios

CHAPTER 16
 75

Bond Pricing Relationships

1. Bond prices and yields are inversely related.

2. An increase in a bond’s yield to maturity

results in a smaller price change than a
decrease of equal magnitude.

3. Long-term bonds tend to be more price

sensitive than short-term bonds.
 76

Bond Pricing Relationships

4. As maturity increases, price sensitivity

increases at a decreasing rate.

5. Interest rate risk is inversely related to the

bond’s coupon rate.

6. Price sensitivity is inversely related to the

yield to maturity at which the bond is selling.
 77
Change in Bond Price as a Function of
Change in Yield to Maturity
 78
Prices of 8% Coupon Bond (Coupons Paid
Semiannually)
 79
Prices of Zero-Coupon Bond
(Semiannually Compounding)
 80

Duration
• Bondholders know that the price of their bonds change when interest
rates change. But,
– How big is this change?
– How is this change in price estimated?

• 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 our objective.

• A composite measure considering both coupon and maturity would

be beneficial.

• Macaulay Duration, or Duration, is the name of concept that helps

bondholders measure the sensitivity of a bond price to changes in
bond yields. That is:

 Two bonds with the same duration, but not necessarily the same
maturity, will have approximately the same price sensitivity to a
(small) change in bond yields.
 81

Macaulay’s Duration or Duration

• Macaulay’s Duration values are stated in years, and are often
described as a bond’s effective maturity.

• The weighted average of the times until each payment is

received, with the weights proportional to the present value of
the payment
– For a zero-coupon bond, duration = maturity.
– For a coupon bond, duration = a weighted average of individual
maturities of all the bond’s separate cash flows

• Duration is shorter than maturity for all bonds except zero

coupon bonds.

• Duration is a measure of interest rate sensitivity or elasticity

of a liability or asset.
 82

Macaulay Duration
T
CFt
 (t )
 t T
PV (CF ) T
 t    t  weightt
(1 y )
DMAC  T
t 1 t
CFt
 t 1 price t 1

t 1 (1  y )
t

Where
DMAC = duration
t = number of periods in the future
CFt = cash flow to be delivered in t periods
T= time-to-maturity
y = yield to maturity
PV = present value
 83

Example: Annual Bond

 84

Example: Semi-annual Bond

 85
Duration of 2-year, 8% bond:
Face value = $1,000, YTM = 12%

t years CFt PV(CFt) Weight W × years

(W)
1 0.5 40 37.736 0.041 0.020
2 1.0 40 35.600 0.038 0.038
3 1.5 40 33.585 0.036 0.054
4 2.0 1,040 823.777 0.885 1.770
P = 930.698 1.000 D=1.883
(years)
 86
Durations of Coupon and Zero
coupon Bonds
 87

Duration/Price Relationship
• Price change is proportional to duration and not to maturity

P  (1  y )   y 
 D    D 
P  1  y   1  y 
Change in y
Pct. Change in Bond Price  Duration 
1  y 
 2
• Some analysts prefer to use a variation of Macaulay’s
Duration, D*, known as Modified Duration.
D* = DMAC / (1+y/2)

Macaulay Duration
Modified Duration 
 y
 1  
 2
 88

Modified Duration
• The relationship between percentage changes in bond prices and
changes in bond yields is approximately:

P
  D * y
P
Pct. Change in Bond Price  -Modified Duration  Change in YTM
or
Pct. Change in Bond Pric
 -Modified Duration
Change in YTM

• Duration is a measure of interest rate sensitivity or elasticity of a

liability or asset.
 89

Example 1
• Example: Suppose a bond has a Macaulay Duration of 11 years,
and a current yield to maturity of 8%.

• If the yield to maturity increases to 8.50%, what is the resulting

percentage change in the price of the bond?

Pct. Change in Bond Price  - 11

0.085  0.08 
1 0.08 2
 -5.29%.

• The bond’s price will decline by approximately 5.29% in response to

50 basis point increase in yields.
 90

Example 2
• Consider two bonds that have the same durations
of 1.8852 years.
– One is a 2-year, 8% coupon bond with YTM=10%.
– The other bond is a zero coupon bond with maturity of
1.8852 years.

• Duration of both bonds is 1.8852 x 2 = 3.7704

semiannual periods.
– Alternatively, keep DMAC = 1.8852 years

• Modified D = 3.7704/1.05 = 3.5909 semiannual

periods.
– Alternatively, DMOD = 1.8852 / 1.05=1.7954 years
 91

Example 2, cont’d
• Suppose the semiannual interest rate increases by
0.01% (This means 0.02% annual rate). Bond
prices fall by:

P   D y
*
P
= -3.5909 x 0.01% = -0.03591%

Alternatively, -1.7954 x 0.02% = -0.03591%

• Both bonds with equal duration have the same

interest rate sensitivity.
 92

Example 2, cont’d
Coupon Bond Zero
• The coupon bond, • The zero-coupon
which initially sells at bond initially sells for
$964.540, falls to $1,000/1.05 3.7704 =
$964.1942 when its $831.9704.
yield increases to • At the higher yield, it
5.01% sells for
• percentage decline of $1,000/1.053.7704 =
0.0359%. $831.6717. This price
also falls by 0.0359%.
 93

Example 3

• Suppose DMAC = 8 year, YTM = 0.10. Assume that you

expect the bond’s YTM to decline by 75 basis point .

• DMOD = 8/(1+0.10/2) = 7.62

• Percent change in bond price = - DMOD * Change in YTM

• %∆P = -7.62*(-.0075) = 0.0572 or 5.72%

• The bond price should increase approximately 5.72

percent.
 94

Example 4
• The 6-year Eurobond with an 8% coupon and 8% yield,
had a duration of DMAC = 4.99 years. If yields rose 1
basis point, then:

• Since C= YTM, it’s a par bond priced at $1,000.

• DMOD = 4.99 / (1+ 8%) = 4.6204, assuming that it is an
annual bond.
• dP/P = -(4.6204) (.0001) = -.000462 or -0.0462%

• To calculate the dollar change in value, rewrite the

equation,
• dP = -DMOD * P *dR = (-4.6204)($1,000)(.0001)= -$0.462
• The bond price falls to $999.538 after a one basis point
increase in yields.
 95

Examples 5
 96

Calculating Macaulay’s Duration

• In general, for a bond paying constant semiannual

coupons, the formula for Macaulay’s Duration is:

1  YTM 1  YTM  MC  YTM 

Duration  2 2
YTM  
YTM  C 1 

YTM
2

2M
 1


• In the formula, C is the annual coupon rate, M is

the bond maturity (in years), and YTM is the yield
to maturity, assuming semiannual coupons.
 97
Calculating Macaulay’s Duration
for Par Bonds

• If a bond is selling for par value, the

duration formula can be simplified to:

1  YTM  1

Par Value Bond Duration  2  1 
YTM 
 1 YTM 
2M 

2 
 98
Example
 99

Calculating Duration Using Excel

• We can use the DURATION and MDURATION

functions in Excel to calculate Macaulay Duration and
Modified Duration.

• The Excel functions use arguments like we saw

before:

=DURATION(“Today”,“Maturity”,Coupon Rate,YTM,2,3)

• You can verify that a 5-year bond, with a 9% coupon

and a 7% YTM has a Duration of 4.17 and a Modified
Duration of 4.03.
 100
Calculating Macaulay and Modified
Duration
 101

Rules for Duration

Rule 1 The duration of a zero-coupon bond

equals its time to maturity

Rule 2 Holding maturity constant, a bond’s

duration is higher when the coupon rate
is lower

Rule 3 Holding the coupon rate constant,

a bond’s duration generally increases
with its time to maturity
 102

Rules for Duration

Rule 4 Holding other factors constant,

the duration of a coupon bond is higher
when the bond’s yield to maturity is
lower

Rules 5 The duration of a level perpetuity

is equal to: (1+y) / y
 103
Bond Duration versus
Bond Maturity
 104
Bond Durations (Yield to Maturity = 8%
APR; Semiannual Coupons)