Chapter 16
The Analysis and
Valuation of Bonds
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Innovative Financial Instruments 1
2
4
Dr. A. DeMaskey
The Fundamentals of Bond Valuation
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The present-value model
2n
Ct 2 M
V0
t 1 (1 i 2)
t
(1 i 2) 2n
1
2
4
Where:
V0 = the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
M = the par value of the bond
The Yield Model
The expected yield on the bond may be
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computed from the current market price V0.
2n
Ct 2 M
V0
t 1 (1 i 2)
t
(1 i 2) 1
2n
2
4
Where i is the discount rate that will discount
the cash flows to equal the current market price
of the bond.
Computing Bond Yields
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Yield Measure Purpose
Nominal Yield Measures the coupon rate
Current yield Measures current income rate
1
2
Promised yield to maturity Measures expected rate of return for bond held
to maturity
4
Promised yield to call Measures expected rate of return for bond held
to first call date
Realized (holding period) Measures expected rate of return for a bond
yield 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.
Computing Bond Yields
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Yield Measure Calculation
Nominal Yield
Current yield
1
2
Promised yield to maturity
Coupon Bond
4
Discount Bond
Promised yield to call
Realized (holding period)
yield
Calculating Future Bond Prices
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2 n 2 hp
Ci / 2 M
Vf
t 1
(1 i 2) (1 i 2)
t 2 n 2 hp
Where:
1
2
4
Vf = estimated future price of the bond
Ci = annual coupon payment
n = number of years to maturity
hp = holding period of the bond in years
i = expected semiannual rate at the end of the holding period
Yield Adjustments
for Tax-Exempt Bonds
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The fully taxable equivalent yield (FTEY) takes into
account the bond’s tax exemptions:
FETY
annual return
1- T 1
2
Where:
T = amount and type of tax exemption
4
Holding Period Yield With
Differential Reinvestment Rates
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• Estimate potential reinvestment rates
• Calculate the ending wealth position
– Find the ending value of the coupons
– Find the future price of the bond 1
2
4
• Compute the estimated holding period yield
by equating the initial investment to the
ending wealth position
What Determines Interest Rates?
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• Inverse relationship with bond prices
• Forecasting interest rates
1
2
• Fundamental determinants of interest rates
i = RFR + I + RP
4
where:
– RFR = real risk-free rate of interest
– I = expected rate of inflation
– RP = risk premium
Loanable Funds Theory
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• Interest rates are the price for loanable
funds
• Supply of loanable funds
1
2
– Federal Reserve
– Domestic saving
– Foreign saving
• Demand for loanable funds
– Government
– Corporations
– Consumers
4
Fundamental Determinants of
Interest Rates
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• i = f (Economic Forces + Issue Characteristics)
• Effect of economic factors
–
2
real growth rate
–
–
–
tightness or ease of capital market
expected inflation
1
4
or supply and demand of loanable funds
• Impact of bond characteristics
– credit quality
– term to maturity
– indenture provisions: collateral, call feature, sinking fund
– foreign bond risk: exchange rate risk and country risk
Term Structure of Interest Rates
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• Maturity of a security
1
2
• Relationship between yields and maturity
4
Types of Yield Curves
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• Normal or upward sloping yield curve
1
2
• Inverted or downward sloping yield curve
• Horizontal or flat yield curve
• Humped yield curve
4
Theories of Term Structure of
Interest Rates
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• Expectations hypothesis
• Liquidity preference hypothesis
1
2
• Segmented market hypothesis
4
Expectations Hypothesis
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• Investor expectations of future interest rates
• Long-term interest rates are the geometric
average of current and future 1-year interest
1
2
rates
• Shape of yield curve
4
– Rising
– Declining
– Horizontal
– Humped
Liquidity Preference Hypothesis
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• Preference for short-term rather than long-
term securities
1
2
• Shape of yield curve
– Upward sloping
4
– Downward sloping
Segmented Markets Hypothesis
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• Strong preference for securities of a
particular maturity
1
2
– Preferred habitat, or institutional, or hedging
pressure theory
4
• Shape of yield curve
– Upward sloping
– Downward sloping
Trading Implications of the Term
Structure
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• The shape of the yield curve alone may
contain information that is useful in
predicting interest rates
• A downward sloping yield curve may 1
2
4
indicate strong expectations of falling
interest rates
Yield Spreads
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• Difference in promised yields between two issues
or segments of the market
• There are four major yield spreads:
1
2
– Segments: government bonds and corporate bonds
– Sectors: high and low grade municipal bonds
4
– Coupons or seasoning within a segment or sector
– Maturities within a given market segment or sector
• Magnitudes and direction of yield spreads can
change over time
Bond Price Volatility
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• Interest rate sensitivity refers to the effect that
yield changes have on the price and rate of return
for different bonds.
1
2
• A bond’s percentage price change is:
Ending price of bond
%PB 1
4
Beginning price of bond
• The market price of a bond is a function of its par
value (M), coupon (PMT), time to maturity (N),
and prevailing market rate (i).
Malkiel Bond Theorems
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• Bond prices move inversely to bond yields (interest rates).
• For a given change in yields, longer maturity bonds post
larger price changes. Thus, bond price volatility is directly
1
2
related to maturity.
• 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.
• Higher coupon bonds show smaller percentage price
fluctuations for a given change in yield. Thus, bond price
volatility is inversely related to coupon.
Price-Yield Relationships
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• The price volatility of a bond for a given
change in yield is affected by:
1
2
– The maturity effect
– The coupon effect
4
– The yield level effect
Trading Strategies
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• If a decline in interest rates is expected:
– Long-maturity bond with low coupons
1
2
– 30-year zero-coupon bond
• If an increase in interest rates is expected:
4
– Short-maturity bond with high coupons
– 1-year 8% coupon bond
Duration
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• Price volatility of a bond varies
– inversely with its coupon and
1
2
– directly with its term to maturity
• A composite measure, which considers both
4
variables would be beneficial.
• Duration is a measure of the bond’s interest
rate sensitivity.
Duration Measures
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• Macaulay Duration
• Modified Duration
• Effective Duration 1
2
• Empirical Duration
4
The Macaulay Duration
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n n
Ct (t )
t 1 (1 i )
t t PV (C ) t
D n t 1
1
2
Ct
price
t 1 (1 i )
t
Developed by Frederick R. Macaulay, 1938
Where:
4
t = time period in which the coupon or principal payment occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond
Characteristics of Duration
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• The duration of a coupon bond is always less than its term
to maturity because duration gives weight to these interim
payments.
2
• A zero-coupon bond’s duration equals its maturity.
1
• There is an inverse relation between duration and coupon.
• There is a positive relationship between term to maturity
4
and duration, but duration increases at a decreasing rate
with maturity.
• There is an inverse relationship between YTM and
duration.
• Sinking funds and call provisions can have a dramatic
effect on a bond’s duration.
Modified Duration
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• An adjusted measure of duration can be
used to approximate the price volatility of a
1
2
bond.
• Modified duration is defined as:
4
D
D mod
YTM
1
m
Where: m = number of payments a year
YTM = nominal YTM
Modified Duration and Bond
Price Volatility
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• Bond price movements will vary proportionally with
modified duration for small changes in yields.
• An estimate of the percentage change in bond prices equals
1
2
the change in yield times modified duration.
P
100 Dmod i
4
P
Where:
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
i = yield change in basis points divided by 100
Trading Strategies Using
Modified Duration
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• Longest-duration security provides the maximum price
variation.
• If you expect a decline in interest rates, increase the
1
2
average duration of your bond portfolio to experience
maximum price volatility.
• If you expect an increase in interest rates, reduce the
4
average duration to minimize your price decline.
• Note that the duration of your portfolio is the market-
value-weighted average of the duration of the individual
bonds in the portfolio.
Bond Convexity
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• Modified duration is a linear approximation
of bond price changes for small changes in
1
2
market yields.
P
100 Dmod i
P
4
• Price changes are not linear, but a curvilinear
(convex) function.
Price-Yield Relationship for
Bonds
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• 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,
1
2
or any stream of future cash flows.
• The convex price-yield relationship will differ among
4
bonds or other cash flow streams depending on the coupon
and maturity.
• Modified duration is the percentage change in price for a
nominal change in yield
Desirability of Convexity
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• The greater the convexity of a bond, the better its
price performance.
2
• Based on the convexity of the price-yield
relationship:
1
– As yield increases, the rate at which the price of the
4
bond declines becomes slower
– As yield declines, the rate at which the price of the
bond increases becomes faster
Modified Duration
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dP
Dmod di
P
1
• For small interest rate changes, this will give a good
estimate.
2
4
• For larger changes, it will underestimate price increases
and overestimate price decreases.
• This misestimate arises because the modified duration line
is a linear estimate of a curvilinear relationship.
Determinants of Convexity
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• Convexity is a measure of the curvature of the
price-yield relationship.
• Since modified duration is the slope of the curve
1
2
at a given yield, convexity indicates changes in
duration.
4
• Thus, convexity is the second derivative of price
with respect to yield (d2P/di2) divided by price.
• Specifically, convexity is the percentage change in
dP/di for a given change in yield.
Determinants of Convexity
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• The lower the coupon, the higher the
convexity (-)
1
2
• The longer the maturity, the higher the
convexity (+)
4
• The lower the yield to maturity, the higher
the convexity (-)
Modified Duration-Convexity
Effects
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• Changes in a bond’s price resulting from a
change in yield are due to:
1
2
– Bond’s modified duration
– Bond’s convexity
4
• The relative effect of these two factors
depends on the characteristics of the bond
(its convexity) and the size of the yield
change.
Duration and Convexity
for Callable Bonds
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• The call provision is an example of an embedded option.
• Option-adjusted duration is an estimate of duration based
1
2
on the probability that the bond will be called.
– If interest rates > coupon rate, call is unlikely
– If interest rates < coupon rate, call is likely
4
• A callable bond is a combination of a noncallable bond
plus a call option that was sold to the issuer.
• The option has a negative value to the bond investor.
• Thus, any increase in value of the call option reduces the
value of the callable bond.
Option-Adjusted Duration
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• Based on the probability that the issuing
firm will exercise its call option
– Duration of the non-callable bond
1
2
4
– Duration of the call option
Convexity of Callable Bond
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• Noncallable bond has positive convexity
1
• Callable bond has negative convexity
2
4
Limitations of Macaulay and
Modified Duration
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• Percentage change estimates using modified
duration are good only for small-yield changes.
1
2
• Difficult to determine the interest-rate sensitivity
of a portfolio of bonds when there is a change in
4
interest rates and the yield curve experiences a
nonparallel shift.
• Callable bond duration depends on market
conditions.
Effective and Empirical Duration
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• Effective Duration
– A direct measure of the interest rate sensitivity
1
2
of a bond where it is possible to estimate price
changes for an asset using a valuation model.
• Empirical Duration
4
– Actual percent change for an asset in response
to a change in yield during a specified time
period.
