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Chapter 17
Fixed Income Securities
Are Available Worldwide

Chapter 18
Managing Bond
Portfolios : Some Issues
Affect All Investors
 Member of Group

Ovilia Nina Liando George Lando Geraldi Rukmayanti Lolo Munte Teungku Alief Ambya
023001801019 023001801028 023001801034 023001801175
Let's Discuss
and Analyze
Together
CHAPTER
17 Available
Fixed Income Securities Are

Worldwide
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
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.
 RF≈rr+ei
Where
Rf = short-term Treasury bill rate
rr = the real risk-free rate of interest
ei = the expected rate of inflation over the term of the instrument

IR=rr+ei+rp
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
 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.
 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.
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.
 Theories traditionally advanced are

1 2
Expectation Theory Liquidity Preference
Theory
States that the long-term rate of interest
States that interest rates reflect the sum
is equal to an average of the short-term
of current and expected short rates, as in
rates that are expected to prevail over
the expectations theory, plus liquidity
the long-term period.
(risk) premiums.
 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
 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 un-
observable but anticipated future rates. Forward rates cannot
be easily measured, but they can be inferred for any one-year
future period. The expectations theory, however, does not say
that these future expected rates will be correct; it simply says
that there is a relationship between rates today and rates
expected in the future
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:
• Differences in quality
• Differences in time to maturity
• Differences in call features
• Differences in coupon rates
• Differences in marketability
• Differences in tax treatments
• Differences between countries.
 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
 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
 GET

REALIZED COMPOUND
YIELD
After the investment period for a bond is over, an investor
can calculate the Realized Compound Yield (RCY). This
rate measures the compound yield on the bond investment
actually earned over the investment period, taking into
account all intermediate cash flows and reinvestment
rates.
GET

Horizon Return
After theAs we have seen, each of the yield measures has
problems. Current yield is clearly not a correct measure of the
return that will be received on a bond. Both the yield to
maturity and the yield to first call have potential problems
because of the reinvestment rate assumptions made, which are
basically unrealistic.
 EXAMPLE Ex am p l e 1 7 - 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
Yie ld Yiel d on an a nnua l ba si s, de ri ved by dou bling the
se miann ua l c ompou nd
y ield
EXAMPLE
 RUMUS RCY
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.
 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 The
YTM calculation assumes that the reinvestment rate on all cash flows during the life
of the bond is the calculated yield to maturity for that bond. If the investor spends the
coupons, or reinvests them at a rate different from the assumed reinvestment rate, the
realized compound yield that will actually be earned when the bond matures will
differ from the calculated YTM which is only a promised rate.

Reinvestment Rate Risk

That part of interest rate risk resulting from uncertainty about the rate
at which future interest coupons can be reinvested
 BOND PRICES
The price of a bond should equal the present value of its
expected cash flows

U N D E R L I E S S TA N D A R D B O N D P R A C T I C E S . T H E P R E S E N T VA L U E P R O C E S S
F O R A T Y P I C A L C O U P O N - B E A R I N G B O N D I N V O LV E S T H R E E S T E P S , G I V E N
T H E D O L L A R C O U P O N O N T H E B O N D , T H E FA C E VA L U E , A N D T H E C U R R E N T
M A R K E T Y I E L D A P P L I C A B L E T O A PA RT I C U L A R B O N D :
1 . D E T E R M I N E T H E P R E S E N T VA L U E O F T H E C O U P O N S ( I N T E R E S T
PAY M E N T S ) .
2 . D E T E R M I N E T H E P R E S E N T VA L U E O F T H E M AT U R I T Y ( PA R ) VA L U E O F T H E
B O N D ; F O R O U R P U R P O S E S , T H E M AT U R I T Y VA L U E W I L L A LWAY S B E $ 1 , 0 0 0 .
3 . A D D T H E P R E S E N T VA L U E S D E T E R M I N E D I N S T E P S 1 A N D 2 T O G E T H E R
BOND PRICE
CHANGES
BOND PRICE CHANGES OVER
TIME
 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
 BONDS PRICE 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.
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.
 CHAPTER 18
MANAGING BOND
PORTFOLIOS: SOME ISSUES
AFFECT ALL INVESTORS
 BUYING FOREIGN
BONDS
Why do U.S. investors consider foreign bonds for possible inclusion in their portfolios?

• 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.
• Foreign bonds can expand diversification possibilities. Diversification is extremely
important, both in a stock portfolio and a Bond portofolio.
 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
IMPORTANT CONSIDERATIONS
IN MANAGING A
BOND PORTFOLIO
 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
 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
 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
 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.
Thank
You