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 RF≈RR+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 respect—Liquidity
Premium Theory
 Risk premium
 Yield spread or yield differential
 Associated with issuer’s particular situation or particular market

Measuring Bond Yields

 Current Yield

annual coupon interest in dollars = C

 Current yield = Current Price P
 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

 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

 where n is the number of years to maturity

 Exact formula:
C1 C2 C  ParValue
Pr ice    ....  2 n
(1  (r / 2)) (1  (r / 2)) 2 (1  (r / 2)) 2n

 Solve for r by trial and error.

 For a zero coupon bond

 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
 d *( )
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):

360 100  Pr ice

I *( )
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:
C1 C2 C  Call Pr ice
Pr ice    ....  2 n
(1  (r / 2)) (1  (r / 2)) 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 bond’s
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
CFt
o Price = 
t 1 (1  k ) t

Bond Valuation

 Value of a coupon bond:

 t m
CFt
o Bond Price = 
t 1 (1  k ) t

C1 C2 C 2n  ParValue
Pr ice    .... 
(1  (YTM / 2)) (1  (YTM / 2)) 2 (1  (YTM / 2)) 2n

 Remember—Most 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 change—they 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 bond’s 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
 Can’t control interest rates but can control the coupon and maturity
of the portfolio
o Maturity is a poor measurement for a bond’s 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 bond’s 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 bond’s 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

 PV (CFt )(t ) t 1 PV (CF )(t )

t
D  t 1
t m

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 2x3 1x4
(1+i)n Unweighted Weight
where PV PV
i=10%
.5 $40 .9533 38.13 19.06
1 $40 .9091 36.36 36.36
1.5 $40 .8668 34.67 52.01
2 $1040 .8264 859.50 1719.01
968.66
1826.44
Duration Calculation: 1826.44/968.66 = 1.89

Present value formula is

Present value  1
where n is the number of compound periods.
(1  r)n

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 bond’s percentage price change
for a given change in interest rates

P
   D * r
P

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

4.31 years rates go to 71/2%

 ΔP/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 market–value weighted average of each
individual bond’s modified duration
 Duration measures volatility which isn’t 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 stock’s current market price
 Conversion Ratio= (Par Value of Bond)/(Conversion Price)
 Parity Price of Bond=(Conversion ratio) X (Stock’s 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 after-
tax dividends
o to shareholder - dilution/ lower stock price