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Chapter Objectives
Demonstrate how bond market prices are established and influenced by interest rate movements Identify the factors that affect bond prices Explain how the sensitivity of bond prices to interest rates is dependent on particular bond characteristics Explain the benefits of diversifying the bond portfolio internationally
Bonds:
Are debt obligations with long-term maturities issued by government or corporations to obtain long-term funds Are commonly purchased by financial institutions that wish to invest for long-term periods
The appropriate bond price reflects the present value of the cash flows generated by the bond (i.e., interest payments and repayment of principal):
Present value interest factors in Exhibit 8A.3 can be multiplied by coupon payments and the par value to determine the present value of the bond
The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturity Investors use higher discount rates to discount the future cash flows of riskier securities The value of a high-risk security will be lower than the value of a low-risk security
Funds received sooner can be reinvested to earn additional returns A dollar to be received soon has a higher present value than one to be received later First, divide the annual coupon by two Second, divide the annual discount rate by two Third, double the number of years
The bonds coupon payments represent an annuity (an even stream of payments over a given period of time)
The
If the coupon rate of a bond is below the investors required rate of return, the present value of the bond should be below par value (discount bond) If the coupon rate equals the required rate of return, the price of the bond should be equal to par value If the coupon rate of a bond is above the required rate of return, the price of the bond should be above par value
Present Value
The impact of interest rate movements depends on how the institutions asset and liability portfolios are structured
Institutions with interest rate-sensitive liabilities that invest heavily in bonds are exposed to interest rate risk Many institutions adjust the size of their bond portfolio according to interest rate expectations When rates are expected to rise, bonds can be sold and the proceeds used to purchase short-term securities When rates are expected to fall, the bond portfolio can be expanded in order to capitalize on the expectations
The price of a bond should reflect the present value of future cash flows based on a required rate of return:
Pb f (k ) f (Rf , RP )
- rate - or the general An increase in either- the risk-free level of the risk premium results in a decrease in bond prices
increase in expected inflation will increase the required rate of return on bonds Indicators of inflation are closely monitored
Consumer price index Producer price index Oil prices A weak dollar
economic growth places upward pressure on the required rate of return Signals about future economic conditions affect bond prices immediately
there is no simultaneous increase in the demand for loanable funds, an increase in money supply growth should place downward pressure on interest rates In high inflation environments, an increased money supply may increase the demand for loanable funds and place upward pressure on interest rates
The general level of credit risk on corporate or municipal bonds can change in response to a change in economic growth:
RP f ( ECON )
Strong
economic growth tends to improve a firms cash flows and reduce the probability that the firm will default on its debt payments
Other factors are also changing, making the precise impact of each factor on bond prices uncertain Impact of bond-specific characteristics
Changes in the issuing firms capital structure and factors such as call features can affect individual bond prices
In an efficient market, bond prices should fully reflect all available information In general bond prices should reflect information that is publicly available
Prices
may not reflect information about firms that is known only by managers of the firms
Sensitivity of Bond Prices to Interest Rate Movements If bonds are not held to maturity, future prices are most sensitive to changes in the risk-free rate A measurement of bond price sensitivity can indicate the degree to which the market value of bond holdings may decline in response to an increase in interest rates
Measures the sensitivity of bond prices to changes in the required rate of return:
The price sensitivity is greater for declining interest rates than rising interest rates Bond price elasticity is always negative
As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices
Duration
Duration measures the life of a bond on a present value basis The longer the bonds duration, the greater its sensitivity to interest rates
DUR
t 1 t 1 n
Ct ( t ) (1 k )t Ct (1 k )t
t 1 t 1 n
Ct ( t ) (1 k )t Ct (1 k )t
$90 $1 ,090( 2) (1.10)1 (1.10)2 $90 $1 ,090 (1.10)1 (1.10)2 1.92 years
Duration (contd)
Duration of a portfolio
Bond
portfolio managers commonly immunize their portfolio from the effects of interest rate movements A bond portfolios duration is the weighted average of bond durations, weighted according to relative market value:
DUR p
w DUR
j j 1
Duration (contd)
Modified duration
Duration can be used to estimate the percentage change in a bonds price in response to a 1 percentage point change in bond yields:
The estimate of modified duration should be applied such that the bond price moves in the opposite direction from the change in bond yields The percentage change in a bonds price in response to a change in yield is:
DUR DUR* (1 k )
%P -DUR * y
Duration (contd)
investors rely only on modified duration to estimate percentage price changes in bonds, they will tend to overestimate price declines and underestimate price increases To accurately estimate the percentage change in price, bond convexity must also be considered
Duration (contd)
Bond convexity
Modified duration estimates assume a linear relationship between bond prices and yields The actual relationship between bond prices and yields is convex
Matching strategy
The bond portfolio generates periodic income that can match expected periodic expenses Involves estimating future cash outflows and developing a bond portfolio that can generate sufficient payments to cover those outflows Funds are evenly allocated to bonds in each of several different maturity classes Achieves diversified maturities and different sensitivities to interest rate risk
Laddered strategy
Barbell strategy
Funds are allocated to bonds with a short term to maturity and bonds with a long term to maturity
Allocates
some funds to achieving relatively high returns and other funds to cover liquidity needs
Funds are allocated to capitalize on interest rate forecasts Requires frequent adjustment in the bond portfolio to reflect current forecasts
An increase in the risk-free rate of the foreign currency results in a lower value for bonds denominated in that currency An increase in risk causes a higher required rate of return on the bond and lowers the present value of the bond The most attractive foreign bonds offer a high coupon rate and are denominated in a currency that strengthens over the investment horizon
International diversification of bonds reduces the sensitivity of the overall bond portfolio to any single countrys interest rate movements Because economic cycles differ across countries, there is less chance of a systematic increase in the credit risk of internationally diversified bonds Financial institutions attempt to reduce their exchange rate risk by diversifying among foreign securities denominated in various foreign currencies