Chapter 18

FIXED-INCOME ANALYSIS
 Chapter 18 Questions
How is the value of a bond determined, based
on the present value formula?
What alternative bond yields are important to
investors?
How are the following major yields on bonds
computed: current yield, yield to maturity, yield
to call, and compound realized (horizon) yield?
What factors affect the level of bond yields at a
point in time?
 Chapter 18 Questions
What economic forces cause changes in the
yields on bonds over time?
When yields change, what characteristics of a
bond cause differential price changes for
individual bonds?
What do we mean by the duration of a bond,
how is it computed, and what factors affect it?
What is modified duration and what is the
relationship between a bond’s modified
duration and its volatility?
Chapter 18 Questions
What is the convexity for a bond, what
factors affect it, and what is its effect on
a bond’s volatility?
Under what conditions is it necessary to
consider both modified duration and
convexity when estimating a bond’s
price volatility?
 The Fundamentals of
Bond Valuation
Like other financial assets,the value of a
bond is the present value of its
expected future cash flows:
Vj = CFt/(1+k)t
 The Fundamentals of
Bond Valuation
To incorporate the specifics of bonds:
Pm = (Ci/2)/(1+Ym/2)t + Pp /(1+Ym/2)2n
This is the present value model where:
 Pm is the current market price of the bond
 n is the number of years to maturity
 Ci is the annual coupon payment
 Ym is the yield to maturity of the bond
 Pp is the par value of the bond
 Bond Price/Yield
Relationships
Bond prices change as yields change, and
have the following relationships:
 When yield is below the coupon rate, the bond will
be priced at a premium to par value
 When yield is above the coupon rate, the bond will
be priced at a discount from its par value
 The price-yield relationship is not a straight line,
but rather convex (This is convexity)
 As yields decline, prices increase at an increasing rate
 As yield increase, prices fall at a declining rate
 The Yield Model
The yield on the bond may be computed
when we know the market price
n
1
P   Ct
t i (1  Y ) t

Where:
P = the current market price of the bond
Ct = the cash flow received in period t
Y = the discount rate that will discount the cash flows to
equal the current market price of the bond
 Computing Bond Yields
Yield Measure Purpose
Coupon rate Measures the coupon rate or the percentage
of par paid out annually as interest
Current yield Measures current income rate
Promised yield to maturity Measures expected rate of return for bond held
to maturity
Promised yield to call Measures expected rate of return for bond held
to first call date
Realized (horizon) yield 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.
 Current Yield
Similar to dividend yield for stocks, this
measure is important to income oriented
investors
CY = C/P
where:
 CY = the current yield on a bond
 C = the annual coupon payment of the bond
 P = 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
n Solve for Y that will equate the
1
P   Ct current price to all cash flows
t i (1  Ym) t from the bond to maturity, similar
to IRR
 Promised Yield to
Maturity
For zero coupon bonds, the only cash
flow is the par value at maturity. This
simplifies the calculation of yield.
P = 1,000/(1+Ym/2)2n
 Where n is the number of years to maturity.
Promised Yield to Call
When a callable bond is likely to be
called, yield to call is the more
appropriate yield measure than yield to
maturity
 As a rule of thumb, when a callable bond is
selling at a price equal to par value plus
one year of interest, the value should be
based on yield to call
 Calculating Promised
Yield to Call
2 nc
Ct / 2 Pc
P 
t 1 (1  Yc / 2) (1  Yc / 2)
t 2 nc

Where:
P = market price of the bond
Ct = annual coupon payment
nc = number of years to first call
Pc = call price of the bond
 Realized Yield
The horizon yield measures yield when
the investor expects to sell the bond
( for a price of Pf in hp time periods)
prior to maturity or call
2 hp
Ct / 2 Pf
Pm   
t 1 (1  YR / 2) (1  YR / 2)
t 2 hp
Calculating Future Bond
Prices
Expected future bond prices are an
important calculation in several
instances:
 When computing horizon yield, we need an
estimated future selling price
 When issues are quoted on a promised
yield, as with municipals
 For portfolio managers who frequently
trade bonds
 Calculating Future Bond
Prices
2 n  2 hp
Ci / 2 Pp
Pf    2 n  2 hp
t 1 (1  Ym / 2) (1  Ym / 2)
t

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
Ym = expected semiannual rate at the end of the holding period
Adjusting for Differential
Reinvestment Rates
The yield calculations implicitly assume
reinvestment of early coupon payments at the
calculated yield
If expectations are not consistent with this
assumption, we can compound early cash
flows at differential rates over the life of the
bond and then find the yield based on an
“Ending wealth” measure, which is calculated
from the differential rates
Yield Adjustments for
Tax-Exempt Bonds
In order to compare taxable and tax-
exempt bonds on an “equal playing
field” for an investor, we calculate the
fully taxable equivalent yield (FTEY) for
tax-free bonds based on their returns
FTEY = Tax-Free Annual Return/(1-T)
Where T is the investor’s marginal tax
rate
 What Determines
Interest Rates?
Inverse relationship with bond prices
 Changes in interest rates have an impact
on bond portfolios, in particular rising
interest rates
 It is therefore important to learn about what
determines interest rates and to gain some
insight as to forecasting future interest
rates
 Forecasting interest
rates
Interest rates are the cost of borrowing
money, or the cost of “loanable funds”
Factors that affect the supply of loanable
funds (through saving) and the demand for
loanable funds (borrowing) affect interest
rates
 The goal is to monitor these factors, and to
anticipate changes in interest rates and to be well-
positioned to either benefit from the forecast or at
least be protected from adverse changes in rates
Determinants of Interest
Rates
Nominal interest rates (i) can be broken down
into the following components:
i = RFR + I + RP
where:
 RFR = real risk-free rate of interest
 I = expected rate of inflation
 RP = risk premium

The key is to anticipate changes in any of

these factors
Determinants of Interest
Rates
Alternatively, we can break down interest rate
factors into two groups of effects:
 Effect of economic factors
 real growth rate
 tightness or ease of capital market
 expected inflation
 supply and demand of loanable funds
 Impact of bond characteristics
 credit quality
 term to maturity
 indenture provisions
 foreign bond risk (exchange rate risk and country risk)
Determinants of Interest
Rates
Term structure of interest rates
 One important source of interest rate variability is the
time to maturity
 The yield curve shows the relationship between bond
yields and time to maturity at a point in time
Yield curve shapes
 Rising curve (common) when rates are modest
 Declining curve when rates are relatively high
 Flat curves can happen any time
 Humped when high rates are expected to decline
 Note: usually relatively flat beyond 15 years
Determinants of Interest
Rates
Term Structure Theories (what explains the
changing shape of the yield curve?)
Expectations hypothesis
 The shape of the yield curve depends on expected
future interest rates and inflation rates
 An upward-sloping curve indicates expectations of
higher rates in the future
 We can use this hypothesis to compute implied
future (forward) interest rates
 Yields of different maturities continually adjusting to
estimates of future interest rates
Determinants of Interest
Rates
Term Structure Theories
Liquidity preference hypothesis
 Indicates that long term rates have to pay a
premium over short term rates because:
 Investors need a premium to compensate for the added
price risk associated with long-term bonds
 Borrowers are willing to pay higher rates on long-term
debt to avoid refinancing risk
 Works well in combination with the expectations
hypothesis to explain the normal upward slope of
the yield curve
Determinants of Interest
Rates
Term Structure Theories
Segmented market hypothesis
 Asserts that different investors, in particular
institutions, have different maturity needs,
so have “preferred habitats” along the yield
curve
 Interest rates in differentiated maturity
markets are determined by unique supply
and demand factors in those markets
Determinants of Interest
Rates
Term Structure and Trading
 Knowledge of the term structure can aid in
bond market trading strategies
 For example, if the yield curve is sharply
downward sloping, rates are likely to fall –
lengthen bond maturities to take the most
advantage of price appreciation as interest
rates fall in the future
Determinants of Interest
Rates
Yield Spreads
Bond investing strategies can focus on
predicting various changing yield spreads, which
exist between:
 Segments: government bonds, agency bonds, and
corporate bonds
 Sectors: prime-grade municipal bonds versus good-
grade municipal bonds, AA utilities versus BBB
utilities
 Different coupons within a segment or sector
 Maturities within a given market segment or sector
 Bond Price Volatility
As interest rates and bond yields change, so
do bond prices (that’s we we’ve been talking
about interest rates!)
What determines how much a bond’s price
will change as a result of changing yields
(interest rates)?
Percentage Change = (EPB/BPB) – 1
 EPB = Ending Price of the Bond
 BPB = Beginning Price of the Bond
 Determinants of Bond
Price Volatility
Four factors determine a
bond’s price volatility
to changing interest
rates:
1. Par value
2. Coupon
3. Years to maturity
4. Prevailing level of
market interest rate
 Determinants of Bond
Price Volatility
Malkiel’s five bond relationships:
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
Determinants of Bond
Price Volatility
The maturity effect
 The longer the time to maturity, the greater
a bond’s price sensitivity
 Price volatility increases at a decreasing
rate with maturity
The coupon effect
 The greater the coupon rate, the lower a
bond’s price sensitivity
Determinants of Bond
Price Volatility
The yield level effect
 For the same change in basis point yield,
there is greater price sensitivity of lower
yield bonds
Some trading implications
 If our interest rate forecast is for lower
rates, invest in bonds with the greatest
price sensitivity, and do the opposite if we
expect higher interest rates
Determinants of Bond
Price Volatility
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,
and that’s what this measure provides
 Determinants of Bond
n
Price Volatility
n
Ct (t )
t 1 (1  Ym )
t  t  PV (C ) t
D n  t 1
Ct Price
t 1 (1  Ym )
t

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
Ym = yield to maturity on the bond
Determinants of Bond
Price Volatility
Characteristics of Macaulay 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
the coupon rate
 A positive relation between term to maturity and
duration, but duration increases at a decreasing
rate with maturity
Determinants of Bond
Price Volatility
Characteristics of Macaulay Duration
 There is an inverse relation between YTM
and duration
 Sinking funds and call provisions can have
a dramatic effect on a bond’s duration
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 
Ym
Where: 1
m
m = number of payments a year
Ym = nominal YTM
Duration and Bond Price
Volatility
Bond price movements will vary
proportionally with modified duration for
small changes in yields:
P
100   Dmod  Ym
Where: P
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
Ym = yield change in basis points divided by 100
 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
Duration of a portfolio is the market-value-
weighted average of the duration of the
individual bonds in the portfolio
 Bond Convexity
The percentage price change formula using
duration is a linear approximation of bond
price change for small changes in market
yields

P
 100   Dmod  Ym
P
Price changes are not linear, but a curvilinear
(convex) function
 Bond Convexity
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
 Bond Convexity
 The convexity is the measure of the
curvature and is the second derivative of
price with resect to yield (d2P/di2)
 Convexity is the percentage change in
dP/di for a given change in yield
2
d P
2
Convexity  di
P
 Bond Convexity
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
 Greater price appreciation if interest rates fall,
smaller price drop if interest rates rise