Bond Yields and Prices

Chapter 8

Interest Rates
Interest rates measure the price paid by a borrower to a lender for the use
of resources over time
Interest rates are the price for loanable funds
Price varies due to supply and demand for these funds
Rate variation is measured in basis points
Rates and basis points
100 basis points are equal to one percentage point
Determinants of Interest Rates
Required rate of return:
risk-free rate + a risk premium
Short-term riskless rate
Provides foundation for other rates
Approximated by rate on Treasury bills---risk-free rate
Fisher hypothesis
o RFRR+EI
Nominal short-term rate rises with anticipated inflation
Expected real rate estimates obtained by subtracting the expected
inflation rate from the observed nominal rate
Realized real short term rate may be less than expected if
experience unanticipated inflation
Real interest rate is an ex ante concept
Other rates differ because of
Maturity differentials
Security risk premiums
Maturity differentials
Term structure of interest rates
Accounts for the relationship between time and yield for
bonds that are the same in every other respectLiquidity
Premium Theory
Risk premium
Yield spread or yield differential
Associated with issuers particular situation or particular market
Measuring Bond Yields
Current Yield
annual coupon interest in dollars = C

Current yield =

Does not account for capital gain (loss)

Yield to maturity
Most commonly used
Promised compound rate of return received from a bond purchased
at the current market price and held to maturity
Assumes:
o Interest payments reinvested
o Reinvested at computed YTM

Current Price

Equates the present value of the expected future cash flows to the
initial investment
Similar to internal rate of return
Yield to Maturity

Solve for YTM:

Approximation formula:
Par Value - Current Price
coupon interest in dollars
+
n___________
Current Price + Par Value
2

Exact formula:

Pr ice

C1
C2
C ParValue

.... 2n
(1 (r / 2)) (1 ( r / 2)) 2
(1 (r / 2)) 2n

Solve for r by trial and error.

For a zero coupon bond

where n is the number of years to maturity

YTM= (Par Value/Price)1/n -1

Investors earn the YTM if the bond is held to maturity, all coupons are
reinvested at YTM, and rates do not change
Other Yields

Treasury bill yields:

Discount yield (d):

360 100 Pr ice

*(
)
n
100

o where n is number of days to maturity; price is

expressed in dollars per $100 of par value or face
amount.

Equivalent bond or coupon yield (i):

I

360 100 Pr ice

*(
)
n
Pr ice

Yield compounding:
For Finite compounding
Realized yield (Effective Yield) = (l + r/m)m - 1
where
o r = stated interest rate per year,
o m = number of times interest is compounded per year.
For continuous compounding:
Realized yield (Effective Yield) = er - 1
Yield to Call
Use the YTC when bond is likely to be called (selling at a premium)
Yield based on the deferred call period
Deferred period: Callable bonds often have a deferred period during
which the bond cannot be called
Call Value: Bonds are called at a price different than the maturity value.
The call value may be stated as a flat amount or as a percentage of par.
Calculate YTC: substitute number of periods until first call date for the
number of periods until maturity and call price for face value
Approximation formula:
Call Value - Current Price
coupon interest in dollars
+
n___________
Current Price + Call Value
2

where n is the number of years to first call

Exact formula:

Pr ice

C1
C2
C Call Pr ice

.... 2 n
2
(1 (r / 2)) (1 (r / 2))
(1 (r / 2)) 2n

Solve for r by trial and error.

Realized Compound Yield

Rate of return actually earned on a bond given the reinvestment of the
coupons at varying rates
RCY= (Total dollars Received/Purchase price of Bond)1/2n 1
Where n = # of years
RCY is the semi-annual rate
Reinvestment Risk
Holding everything else constant, the longer the maturity of a
bond, the greater the reinvestment risk
For long term bonds, the interest on interest compounding
affect may account for more than three-quarters of bonds
total return
Holding everything else constant, the higher the coupon rate, the
greater the dependence of the total dollar return from the bond on
the reinvestment of the coupon payments
Zero Coupon bonds have no reinvestment risk
Horizon return analysis
Bond returns based on assumptions about reinvestment rates
Estimate:
o Time will hold bond (planning horizon)
o Interest rate over the period
o Calculate the value of interest payment and
compounded interest on payments given interest
assumptions
o Estimate the YTM that will prevail at the end of the
period
o Calculate the price of the bond at the end of the
holding period
Valuation Principle

Intrinsic 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
t m

Price =
t 1

CFt
(1 k ) t

Bond Valuation

Value of a coupon bond:

t m

o Bond Price =
t 1

Pr ice

CFt
(1 k ) t

C1
C2
C 2 n ParValue

....
2
(1 (YTM / 2)) (1 (YTM / 2))
(1 (YTM / 2)) 2n

RememberMost bonds pay semiannual then c must be the

semiannual interest payment, YTM must be divided by 2 and n
must be multiplied by 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
Coupon Rate - YTM Relationship
Coupon Rate > YTM sell at premium
Coupon Rate < YTM sell at discount
Coupon Rate = YTM sell at par or face value
Bond Price Changes

Over time, with everything else held constant, bond prices that differ from
face value must changethey must converge to Par value at maturity
Bonds sold at premium must decrease in value to Par
Bonds sold at a discount must increase in value to Par
How do the bond prices change given a change in interest rates?
As rates change prices of bonds change
Malkiel Five Theorems:
Bond prices move inversely to market yields
As interest rates rise, bond prices decline,
but this is not 1-1 relationship.
Holding maturity constant, a decrease in rates will
raise bond prices more on a percentage basis than a
corresponding increase in rates will lower bond
prices
The change in bond prices due to a yield change is
directly related to time to maturity. For a given

change in the market yield, changes in bond prices

are directly related to time to maturity
Long-term bonds change more than the prices of
short-term bonds

The percentage price change that occurs as a result

of the direct relationship between a bonds maturity
and its price volatility increases at a diminishing
rate as the time to maturity increases.
The percentage change in prices decreases
Rate changes from 8-10%
Two bonds selling at 8% market rate:
o 15 year 10% bond
-Price= $1,172.92
o 30 year 10% bonds
-Price = $1,226.23
Same bonds at 10% -both sell at par
o 15 year change is 11.73%
o 30 year change is 12.26% (30 year
percentage change in price does not
equal twice the 15 year percentage
change in price)

The change in bond prices due to a yield change is

indirectly related to coupon rate. Bond price
fluctuations (volatility) and bond coupon rates are
inversely related.

Implications
A decline (rise) in interest rates will cause a rise (decline) in bond prices, with
the most volatility in bond prices occurring in longer maturity bonds and bonds
with low coupons.

To receive maximum price impact of an expected drop in interest

rates- bond buyer should purchase low-coupon, long-maturity
bonds
If rates are expected to increase, buy large coupons and short
maturities
Cant control interest rates but can control the coupon and maturity
of the portfolio
o Maturity is a poor measurement for a bonds price
change
Measurement of Timing of Cash Flows

Term to Maturity
Number of years to final payment
Ignores interim cash flows
Ignores Time Value

Weighted Average Term to Maturity

Computes the proportion of each individual payment as a
percentage of all payments and makes this proportion the weight
for the year the payment is made

WATM = (CF1/TCF)(1) + (CF2/TCF)(2) + (CFm/TCF)(m)

Cft = the cash flow in year t
m = maturity
TCF = Total Cash Flow

e.g. 10 year 4% bond TCF = 1400

WATM=(40/1400) (1) + (40/1400)(2) +(40/1400)(9)
+(1040/1400)(10) = 8.71 years

Considers timing of all cash flow

Does not consider time value of the flows

Important considerations
The effects of yield changes on the prices and rates of return for
different bonds
Change in rates can result in very different percentage price changes for
various bonds

Maturity inadequate measure of bonds lifetime

Focuses only on return of principal at the maturity date
May not have identical economic lifetime
Two 20 year bonds, one with an 8% coupon and one with 15% coupon
have different economic lifetimes (investor recovers the purchase price
much faster with a 15% coupon than a 8% coupon)

A measure is needed that accounts for both size and timing of cash
flows

DURATION
Weighted Average number of years until an initial cash investment
is recovered with the weight expressed as the relative present value
of each payment of interest and principle.
A measure of a bonds lifetime, stated in years, that accounts for
the entire pattern (both size and timing) of the cash flows over the
life of the bond

The weighted average maturity of a bonds cash flows needed to recover

the cost of the bond
Weights determined by present value of cash flows

Duration depends on three factors

Maturity of the bond
Coupon payments
Current Yield to maturity (discount factor)
Need to weight present value of cash flows from bond by time received

t m

D t 1

t m

PV (CFt )(t )
PV (CFt )(t )
t 1

PV (CFt )
Market Price

In order for a bond to be protected from the changes in interest rates after
purchase, the price risk and coupon reinvestment must offset each other.

Duration is the time period at which the price risk and coupon
reinvestment risk of a bond are of equal magnitude but opposite in
direction.

Duration is measured in years

Calculating Duration

Assume an 8% coupon on 1000 Face Value bond with 2 years to maturity

and an YTM of 10%.
Duration Calculation

(1)

(2)

(3)

(4)

(5)

Periods

Coupon

1
(1+i)n
where
i=10%

2x3
Unweighted
PV

1x4
Weight
PV

.5

$40

.9533

38.13

19.06

$40

.9091

36.36

1.5

$40

.8668
.8264

36.36
34.67
859.50
968.66

1719.01

$1040

Duration Calculation: 1826.44/968.66 = 1.89

52.01
1826.44

Present value formula is

Present value

1
(1 r)n

where n is the number of compound periods.

Duration Relationships

Holding the coupon and YTM constant, duration increases with time to
maturity but at a decreasing rate (direct relationship)
For coupon paying bonds, duration is always less than maturity
For zero coupon-bonds, duration equals time to maturity
Holding the coupon and YTM constant, duration increases with lower
coupons (inverse relationship)
Holding the coupon and YTM constant, duration increases with lower yield to
maturity (inverse relationship)
Why is Duration Important?
Allows comparison of effective lives of bonds that differ in maturity, coupon
Used in bond management strategies particularly immunization
Measures bond price sensitivity to interest rate movements, which is very
important in any bond analysis
Estimating Price Changes Using Duration
Modified duration =D*=D/(1+r)
Where r is the bonds YTM
D*can be used to calculate the bonds percentage price change
for a given change in interest rates

Ex. Yield on 8% 5 year bond selling at par has duration* of

4.31 years rates go to 71/2%

P
D * r
P

P/P = - 4.31* (-.005) = .0216 =2.16%

Convexity
If you have large yield changes then modified duration becomes less accurate
Duration equation assumes a linear relationship between price and yield
Convexity refers to the degree to which duration changes as the yield to
maturity changes
Price-yield relationship is convex
Negative convexity occurs as the yield increases

Positive convexity occurs as the yield decreases

Convexity largest for low coupon, long maturity bonds, and low yield to
maturity
Duration Conclusions
To obtain maximum price volatility, investors should choose bonds with the
longest duration
Duration is additive
o Portfolio duration is just a marketvalue weighted average of each
individual bonds modified duration
Duration measures volatility which isnt the only aspect of risk in bonds

CONVERTIBLE BONDS
Bond that can be converted at the option of the owner into common stock of issuer
At issuance conversion price set at a premium to the stocks current market price
Conversion Ratio= (Par Value of Bond)/(Conversion Price)
Parity Price of Bond=(Conversion ratio) X (Stocks Market Price)
o I.e. bond convertible @ $40 share
o Conversion Ratio: 1 bond = $1000/40 = 25 shares
o Current Market Price $35 shares
o Parity Value = Current Stock Price * conversion ratio
$35 * 25 = $875.00
Trade above parity--conversion value is zero
o Trading like a straight bond
o Interest rate movements drive the price
Trade below parity-conversion has value
o conversion price $25
o Conversion ratio: 1000/25 =40 shares
o current market price $30
o parity price: 40 X $30 = $1200
o if trade below this price--have a riskless gain realized through arbitrage if convert
Arbitrage--buys the lower priced security and simultaneously sells the
equivalent higher priced security
Trade above par--usually the price is being affected by the common stock
price (trading below parity)
Trade below par-usually the price is behaving like a normal bond (trading above
parity)
Investor accepts lower interest

Call feature
o forced conversion--issuer replace the bonds with equity securities and
ceases to pay the interest payment
o Callable at the call price which is lower than the parity price of conversion
Advantages
o to bond holder-offer downside protection in relation to owning the
company stock (value as a straight bond)
price of the convertible will not decline below its value as a
straight bond
o to bond holder - possible capital gains
as common stock price rises so will the convertibles value
o to bond holder - anti-dilutive covenant
conversion price to reflect issuance of new shares, stock dividends, or
splits
Disadvantages
o to bond holder- bond may be called forcing conversion
o to bond holder - lower coupon interest rate
o to bond issuer upon conversion- replace tax deductible interest with aftertax dividends
o to shareholder - dilution/ lower stock price