Bond Yields and

Prices
Reference: Chapter 17

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

17-1
Interest Rate

 Rental rate for loanable funds

 Basis point
 100 basis points equals one percentage
point
 Riskless rate is foundation for other rates
 Approximated by rate on Treasury securities
 Other rates differ because of
 Maturity differentials
 Security risk premiums
17-2
 Opportunity cost of foregoing consumption
 Realrisk-free rate (real rate) unaffected
by price changes or risk factors
 Nominal (observed) risk-free rate (RF)
includes a real component (rr) and
expected inflation (ei)

17-3
Interest Rates

 Allinterest rates are described

according to the following formula

 Where rp incorporates all risk premiums

associated with features such as time to
maturity, liquidity, credit quality, etc.
17-4
Term Structure of Interest Rates
 Relationship between time to maturity
and yield to maturity (yield curve)
 Yield curves
 Graphicaldepiction of the relationship
between yields and time to maturity
Default risk held constant
Observations involve tendencies rather
than exact relationships

18-5
18-5
Term Structure of Interest Rates
 Upward-sloping yield curve
 Typical, interest rates rise with maturity
 Downward-sloping yield curves
 Unusual, predictor of recession?
 Term structure theories
 Explanations of the shape of the yield curve
 Pure expectations, liquidity preference, and
preferred habitat

18-6
18-6
 Forward Rates
 Forward rates are unobservable rates
expected to prevail in the future
 Are not observable, but are commonly
estimated from longer-term bond rates
 For example, the rate on a 3-yr bond can
be decomposed into the current 1-yr rate
and 2 1-yr forward rates

17-7
 Pure Expectations Theory

 Pure Expectations Theory : Long-term

rates are an average of current and
expected future short-term rates
 No other considerations matter
 According to the theory, forward rates
derived from current longer-term rates equal
expected future rates
 Theory is not that forward rates will be
correct, but that there is a relationship
between them and current rates

18-8
18-8
What does the Yield Curve tell us?

 What does the slope of the Yield

Curve tell us?
>upward - investors expect interest rates
to increase
>downward - investors expect interest
rates to drop
>flat - investors expect interest rates to
remain constant
 0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
1 Mth

YIELD
[% P.A.]
2Mths

3Mths

4Mths

5Mths

6Mths

7Mths

8Mths

9Mths

10Mths
Govt. (31/03/19)

Stat Corp (31/03/19)

11Mths

1Yr

2 Yrs

3 Yrs

4 Yrs

5 Yrs

6 Yrs

7 Yrs

MATURITY
8 Yrs

9 Yrs

10Yrs

11Yrs

12Yrs

13Yrs

14Yrs
Fiji Yield Curve : RBF

YIELD CURVE: As at 31 March 2019

15Yrs

16Yrs

17Yrs

18Yrs

19Yrs

20Yrs

21Yrs

22Yrs

23Yrs

24Yrs

25 Yrs

26Yrs

27 Yrs

28Yrs

29 Yrs

30Yrs
US Yield Curve
US Yield Comparisons
What does an inverted yield curve
mean? (CMBC News, 29th March 2019)
An inverted yield curve is generally considered a recession predictor. It won’t be
immediate, but recessions have followed inversions a few months to two years later
several times over many decades.
The U.S. Treasury yield curve has inverted before each recession in the past 50 years
and has only offered a false signal just once in that time, according to data from
Reuters.
A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006,
and again in 2007 before U.S. equity markets collapsed. The curve also inverted in
late 2018.
When short-term yields climb over longer-dated yields, it shows that borrowing costs
in the shorter-term are more than the longer term. In these cases, businesses could
find it more expensive to expand their operations. Meanwhile, consumer borrowing
could also fall, thus leading to lesser consumer spending in the economy. All of these
could lead to a subsequent contraction in the economy and a rise in unemployment.
Liquidity Preference Theory

 Rates reflect current and expected short

rates, plus liquidity risk premiums
 Uncertainty increases with time
 Investorsprefer to lend for short run,
borrowers to borrow for long run
 Liquiditypremium is required to induce
long-term lending
 Derivedforward rates do not equal
expected future rates

18-14
18-14
Preferred Habitat Theory
 Market participants have preferred
maturity segments
 Must be induced to move out of their
preferred segment
 Marketsegmentation theory is a more
extreme version
 Interest
rates are determined by supply
and demand in each segment

17-15
Yield Spreads
 Risk premiums
 Result from differences in
 Default risk (bond rating), maturity, call
features, coupon rates, marketability,
taxes
 Borrower actions
 Interest rates
 Function of variables associated with
issue or issuer
 Inversely related to business cycle 17-16
 Bond Ratings - S&P/Moody’s
AAA Aaa Highest Quality
AA Aa High Quality
A A Upper Medium Grade
BBB Baa Medium Grade
BB Ba Speculative Elements
B BSpeculative
CCC Caa Poor Standing
CC Ca Highly Speculative
C CExtremely Poor Prospects of
D ever attaining investment standing
Measuring Bond Yields
 Premium (Coupon rate > YTM): price > par value
 Discount (Coupon rate < YTM): price < par value
 Par value (Coupon rate = YTM): price = par value
 Interest payments (coupons) on bonds usually
paid semi-annually
 Current yield: ratio of coupon interest to current
market price
 Does not account for difference between purchase
price and redemption value

17-18
 Yield to maturity (YTM)
 Most commonly used measure of bond
return
 Promised return received from a bond
purchased at the current market price
 1. If held to maturity, and
 2. Coupons reinvested at YTM
Likelihood of meeting second (2)
condition is extremely small

17-19
Yield to Maturity
 Solve for YTM:

2n
Ct / 2 FV
P  t  2n
t 1
(1 YTM/2) (1 YTM/2)

 For a zero coupon bond the first term

in the equation does not exist.

17-20
 Yield to First Call
 Some bonds are callable after deferred call
period
 YTM unrealistic for bonds likely to be called
 Often uses end of deferred call period
 Substitute number of periods until first call for
date and call price for face value

2c Ct / 2 CP
P  t
 2c
t 1( 1  YTC/ 2 ) ( 1  YTC/ 2 )
17-21
 Realized Compound Yield
 Rarely equal to YTM
 Rateof return actually earned on a
bond given the reinvestment of coupons
at varying rates
 Determined after investment concluded

 Total dollar return 1/n 

RCY  2    1.0 

Purchase price of bond  

17-22
Reinvestment Risk
 Interest-on-interest
 Reinvestment rate risk
 Risk that future reinvestment rates will be
less than the YTM when bond is purchased
 Total dollar return on a bond consists of
 Coupons paid
 Capital gains or losses
 Interest income from reinvestment of
coupons

17-23
Reinvestment Risk
 Reinvestment increase in importance as
coupon or time to maturity (or both)
increase
 For long-term bonds, interest-on-interest can
be most important part of total return
 Zero-coupon bonds eliminate reinvestment rate
risk
 Horizon return analysis
 Bond returns based on assumptions about
reinvestment rates and yield-to-maturity at
end of investment horizon

17-24
Bond Valuation Principle
 Intrinsic value
 An estimated value
 Present value of the expected cash flows
 Required to compute intrinsic value
Expected cash flows
Timing of expected cash flows
Discount rate, or required rate of return by
investors

17-25
 Bond Valuation
 Value of a coupon bond:
2n
Ct /2 FV
P  t  2n
t 1
(1 r/2) (1 r/2)

 Biggest problem is determining the discount

 rate or required yield
 Required yield is the current market rate
earned on comparable bonds with same
maturity and credit risk
17-26
Bond Price Changes
 Over time, bond prices move toward face value
 On bond’s maturity date, it must be worth its face value
 Bond prices move inversely to market yields i.e. other
things being equal, bond price volatility is a function of
maturity
 Long-term bond prices fluctuate more than short-
term bond prices
 The change in bond prices due to a yield change is
directly related to time to maturity and inversely related
to coupon rate
 The % price change that occurs as a result of the
direct relationship between a bond’s maturity and its
price volatility increases at a declining rate as the
time to maturity increases.
17-27
B
o
n
d $1000

p
r
i
c
e 30 25 20 15 10 5 1
s Passage of time – Time left to maturity in years

17-28
Bond Price Changes

 Holding
maturity
constant, a
rate decrease
Price

raises prices a
greater percent
than a
corresponding
Market yield increase in
rates lowers
prices
17-29
Implications for Investors

The two major important bond variable in

assessing bond prices when interest rate
changes are: bond’s coupon & its maturity
Ifanticipating a rate decrease, bond
buyers should purchase low-coupon, long-
maturity bonds
Ifinterest rates are expected to increase,
investors should consider buying bonds
with large coupons or short maturities or
both
17-30