CHAPTER 10

Bond Prices and Yields

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

10.1 BOND CHARACTERISTICS

10-2
 Bond Characteristics

Face or par value

Coupon rate
– Zero coupon bond
Compounding and payments
– Accrued Interest
Indenture

10-3
 Treasury Notes and Bonds

T Note maturities range up to 10 years

T bond maturities range from 10 – 30
years
Bid and ask price
– Quoted in points and as a percent of par
Accrued interest
– Quoted price does not include interest
accrued

10-4
Figure 10.1 Listing of Treasury Issues

10-5
 Corporate Bonds

Registered
Bearer bonds
Call provisions
Convertible provision
Put provision (putable bonds)
Floating rate bonds
Preferred Stock

10-6
Figure 10.2 Investment Grade Bonds

10-7
 Other Domestic Issuers

Federal Home Loan Bank Board

Farm Credit Agencies
Ginnie Mae
Fannie Mae
Freddie Mac

10-8
 Innovations in the Bond Market

Reverse floaters
Asset-backed bonds
Pay-in-kind bonds
Catastrophe bonds
Indexed bonds
– TIPS (Treasury Inflation Protected Securities)

10-9
10.2 BOND PRICING

10-10
 Bond Pricing


T

P B = Ct T + Par Value T

(1+ r ) (1+ r )
T
t =1

PB = Price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual yield
to maturity

10-11
Price of 8%, 10-yr. with yield at 6%
20
= 40  
1 1
+ 1000 
P B
t =1 (1 .03)
t
(1.03)
20

= 1,148 .77
P B

Coupon = 4%*1,000 = 40 (Semiannual)

Discount Rate = 3% (Semiannual)
Maturity = 10 years or 20 periods
Par Value = 1,000

10-12
10.3 BOND YIELDS

10-13
 Bond Prices and Yields

Prices and Yields (required rates of return)

have an inverse relationship
When yields get very high the value of the
bond will be very low
When yields approach zero, the value of
the bond approaches the sum of the cash
flows

10-14
 Yield to Maturity

YTM is the discount rate that makes the

present value of a bond’s payments equal to
its price
8% coupon, 30-year bond selling at $1,276.76:

60
$40 $1, 000
$1, 276.76 =  +
t =1 (1 + r ) (1 + r )
t 60

10-15
Figure 10.3 The Inverse Relationship
Between Bond Prices and Yields

10-16
 Alternative Measures of Yield

Current Yield
Yield to Call
– Call price replaces par
– Call date replaces maturity
Holding Period Yield
– Considers actual reinvestment of coupons
– Considers any change in price if the bond is
held less than its maturity

10-17
Figure 10.4 Bond Prices:
Callable and Straight Debt

10-18
Figure 10.5 Growth of Invested Funds

10-19
10.4 BOND PRICES OVER TIME

10-20
 Premium and Discount Bonds

Premium Bond
– Coupon rate exceeds yield to maturity
– Bond price will decline to par over its maturity
Discount Bond
– Yield to maturity exceeds coupon rate
– Bond price will increase to par over its
maturity

10-21
Figure 10.6 Premium and Discount
Bonds over Time

10-22
Figure 10.7 The Price of a Zero-
Coupon Bond over Time

10-23
10.5 DEFAULT RISK AND BOND
PRICING

10-24
 Default Risk and Ratings

Rating companies
– Moody’s Investor Service
– Standard & Poor’s
– Fitch
Rating Categories
– Investment grade
– Speculative grade

10-25
Figure 10.8 Definitions of Each Bond Rating
Class

10-26
Factors Used by Rating Companies

Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt

10-27
 Protection Against Default

Sinking funds
Subordination of future debt
Dividend restrictions
Collateral

10-28
Figure 10.9 Callable Bond
Issued by Mobil

10-29
 Accrued interest and clean price

Interest since the last coupon payment

Expressed in % of facial value.
Facial value: 1000 €
AI = 0,68 means that accrued interest are:
0.68%*1000 = 6.8 €.

30
10-30
Figure: Accrued interest

60 €

6,8 €
Accrued
Date of coupon pay
Interest at
the 31
10-31
valuation
 Example

Data of previous example. What is the

date of valuation in the schema?
You are 228 days after last coupon
payment, what is the value of accrued
interest?

32
10-32
 Example (solution)
Data of previous example. What is the date of
valuation in the schema?
n
6.8 = 6%  1000
365
n = 41 days
You are 228 days after last coupon payment, what is
the value of accrued interest?
228
6%  1000 = 37.48€
365

33
10-33
3. INTEREST RISK MEASURES

3.1. The full valuation approach

It is a scenarios analysis because it

involves assessing the exposure to
interest rate change scenarios (remember
point 1.2.).

34
10-34
 3.2. Interest risk

Inverse relationship between market rates

and value.
Objective: find a mathematical relationship
between interest rate and bond value.

35
10-35
 Concepts
Macaulay Duration:
– mean maturity of a bond with coupon payments,
– or generic description of the sensitivity of a bond’s price to
a change in yield in this case we also use the word
sensibility.
Modified duration:
– Modified: sensitivity assuming that the bond’s expected
cash flows do not change when yield changes, makes
sense for option free bonds,
Effective Duration
– Effective (option-adjusted or adjusted): takes into account
the fact that yield changes may change the expected cash
flows. 36
10-36
 3.3. Modified/ Effective duration

price if rate decreases - price if rate increases

EffectiveD uration =
2(initial price )(rate variation in value )
V− − V+
Deff =
2V0 (r )

37
10-37
 Example

The price of a bond is 134.6722.

If yield increases or decreases of 20 bp,
prices vary from137.5888 to 131.8439.
What is the effective duration?

38
10-38
 Example (Solution)

137.5888 − 131.8439
Deff = = 10.66
2 134.6722  0.002

39
10-39
 3.4. Macauley Duration

Present value of
Time cash flows
N N

 t  C  (1 + r )
t =1
t
−t
 t  C  (1 + r )
t =1
t
−t

D= N
=
 C  (1 + r ) −t P
t
t =1

40
10-40
 Example

What is the market price and duration of

bond B1 with the following characteristics:
– nominal value 5000 EUR,
– maturity 4 years
– coupon rate 10 %.
Market interest rate 8 %.
Same question if coupon rate is 3 %.

41
10-41
Periods Flows Present value T*(discounted CF)

1 10 3 9.26 2.78 9.26 2.78

2 10 3 8.57 2.57 17.14 5.14
3 10 3 7.94 2.38 23.82 7.14
4 110 103 80.85 75.71 323.4 302.84
Price 106.62 83.44 373.62 317;9
5 331 4172
Duratio 3.5 3.8 years
n years

42
10-42
3.5. Sensitivity (modified duration)

Modified duration is the approximate

percentage change in a bond’s price for a
100 basis point change in yield assuming
that the bond’s expected cash flows do not
change when the yield changes.

43
10-43
 Formula

dP / P 1 dP
S= =
dr P dr

44
10-44
Relationship between duration et
sensitivity

D
S =−
1+ r
Negative relationship
between price and
rates.

45
10-45
 Example

Sensitivity of the bond.

A company has 500 bonds, what is the
loss if rate increases to 8.1% or 12%.

46
10-46
 Example (solution)

3.5
S =− = −3.24
1.08

dP = S  dr  P

dP = −3.24  0.001 500  5000 1.0662 = − 8636 EUR

dP = −3.24  0.04  500  5000 1.0662 = −345 449 EUR
47
10-47
 Remark

The formula is a linear approximation of

the effective variation.
Must be used for small variation of interest
rates.
Approximation error increases with the
variations of interest rate.

48
10-48
 Example

What is the real loss for the two variation

of interest rates?

49
10-49
 Exemple (solution)

1 − 1.081−4
P(0.081) = 10 
100
+ 4
= 106.28
0.081 1.081
1 − 1.12 − 4 100
P(0.12 ) = 10  + 4
= 93.925
0.12 1.12

Effective losses:
– 8,500 € in the first case,
– 317,375 € in the second.

50
10-50
 Duration of a portfolio

Duration of a portfolio is equal to the sum

of durations weighted by the value of
each line of the portfolio.
k
DP =  xi Di
i =1

Market value of line

i on total value of
the portfolio. 51
10-51
5
2 Example
Market rate 8 %.
Market value of the portfolio: 374 280 EUR
Characteristics values of the portfolios:

% of wealth Facial Nominal Maturity

value rate
20 % 2 500 EUR 8% 3 years
40 % 5 000 EUR 9% 4 years
40 % 3 000 EUR 7,5 % 5 years
10-52
5
3
Example (solution)

Price Duration

Bond 1 2 500 EUR 2.78 years

Bond 2 5 165,6 EUR 3.53 years

Bond 3 2 940,6 EUR 4.34 years

10-53
5
4 Portfolio duration
0.2  2.78 + 0.4  3.53 + 0.4  4.34 = 3.7 y
Periods Cash flow of Present t*(PCF)
the portfolio value
1 310 287.04 287.04
2 310 265.78 531.56
3 810 643 1 929
4 2 270 1 668.52 6 674.75
5 1 290 877.95 4 389.75
Value 3 742.28 13 811.43
Duration 3,7 years 10-54
 Basic bond management

If you expect an increase in interest rate,

you must reduce your duration.
If you expect a decrease in interest rate,
you must increase your duration.

10-55
 3.6. CONVEXITY

For large variation of interest rates or for

instrument with highly non-linear sensibility
the duration based approach is not
sufficient.
Interest risk must integrate the curvature of
the present value function.
Convexity is the second derivative of price
relatively to yield to maturity (divided by the
price).
56
10-56
 Exhibit

Price

Effective
variation

Estimated
Variation

Approximation
error

Variation rate
57
10-57
 Generalized duration of order i is:

 t C (1 + r )
i −t
t

D(i ) =
P

Formula of convexity:

N 2 
C=
1 d 2P
=
1
2  t
−t
(
C (1 + r ) t + t  =
1
) D(1) + D(2 )
P(1 + r )  t =1  (1 + r )
2 2
P dr

58
10-58
 Interpretation

Positive convexity (long position, cash

inflows) means that:
– When rates increase, decrease in price is
lower and lower,
– when rates decreases, increase in price is
greater and greater.

59
10-59
 Convexity and price variations
Approximation is better and better when you go
further in the limited development (computation
of D(i)).
For order 2 (convexity) we have:
dP 1 d 2P 2
dP = dr + 2
dr
dr 2 dr
Dividing the equality by P, we obtain price variation in
function of sensibility and convexity.
dP 1
= Sdr + Cdr 2
P 2 60
10-60
 Example

Convexity of bond B1.

Give losses if yield is 8.1% or 12%.

61
10-61
6
2
Example (solution)
Periods Flow PV t * (PV) t2 * (PV)
1 10 9.26 9.26 9.26
2 10 8.57 17.14 34.28
3 10 7.94 23.82 71.46
4 110 80.85 323.4 1 293.6
Price 106.62 373.62 1 408.6

Duration 3.5 years 13.21

Convexity 14.33
10-62
 N 2 
C=
1 d 2P
=
1
2  t
(
−t
)
C (1 + r ) t + t  =
1
D(1) + D(2 )
P(1 + r )  t =1  (1 + r )
2 2
P dr

dP 1
= Sdr + Cdr 2
P 2

10-63
 Example

 1 
dP =  − 3.24  0.001 + 14.33  0.0012  106.62 = −0.34468
 2 
 1 2
dP =  − 3.24  0.04 + 14.33  0.04  106.62 = −12.59566
 2 

For 500 bonds, losses are of 8 617 EUR in the first

case and 314 892 EUR in the second.

64
10-64
6
5
In short

 rate  effective  sensibility  convexity

0.001 8 500 8 636 8 617

0.04 317 375 345 449 314 892

10-65
10.6 THE YIELD CURVE

10-66
Term Structure of Interest Rates

Relationship between yields to maturity

and maturity
Yield curve - a graph of the yields on
bonds relative to the number of years to
maturity
– Usually Treasury Bonds
– Have to be similar risk or other factors
would be influencing yields

10-67
Figure 10.10 Yields on
Long-Term Bonds

10-68
Figure 10.11 Treasury Yield Curves

10-69
 Theories of Term Structure

Expectations
– Long term rates are a function of expected future
short term rates
– Upward slope means that the market is expecting
higher future short term rates
– Downward slope means that the market is expecting
lower future short term rates
Liquidity Preference
– Upward bias over expectations
– The observed long-term rate includes a risk premium

10-70
Figure 10.12 Returns to Two 2-year
Investment Strategies

10-71
 Forward Rates Implied
in the Yield Curve
(1+ y n ) = (1+ y n −1) (1+ f n )
n n −1

2 1
(1 . 12 ) = (1 . 11 ) (1 . 1301 )
For example, using a 1-yr and 2-yr rates
Longer term rate, y(n) = 12%
Shorter term rate, y(n-1) = 11%
Forward rate, a one-year rate in one year = 13.01%

10-72
Figure 10.13 Illustrative Yield Curves

10-73
Figure 10.14 Term Spread

10-74