Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 18
Chapter 18 - The Analysis and
Valuation of Bonds
Questions to be answered:
• How do you determine the value of a bond
based on the present value formula?
• What are the alternative bond yields that are
important to investors?
Chapter 18 - The Analysis and
Valuation of Bonds
• How do you compute the following yields
on bonds: current yield, yield to maturity,
yield to call, and compound realized
(horizon) yield?
• What are spot rates and forward rates and
how do you calculate these rates from a
yield to maturity curve?
• What is the spot rate yield curve and
forward rate curve?
Chapter 18 - The Analysis and
Valuation of Bonds
• How and why do you use the spot rate curve
to determine the value of a bond?
• What are the alternative theories that
attempt to explain the shape of the term
structure of interest rates?
• What factors affect the level of bond yields
at a point in time?
• What economic forces cause changes in
bond yields over time?
Chapter 18 - The Analysis and
Valuation of Bonds
• When yields change, what characteristics of
a bond cause differential price changes for
individual bonds?
• What is meant by the duration of a bond,
how do you compute it, and what factors
affect it?
• What is modified duration and what is the
relationship between a bond’s modified
duration and its volatility?
Chapter 18 - The Analysis and
Valuation of Bonds
• What is effective duration and when is it
useful?
• What is the convexity for a bond, how do
you compute it, and what factors affect it?
• Under what conditions is it necessary to
consider both modified duration and
convexity when estimating a bond’s price
volatility?
Chapter 18 - The Analysis and
Valuation of Bonds
• What happens to the duration and convexity
of bonds that have embedded call options?
• What are effective duration and effective
convexity and when are they useful?
• What is empirical duration and how is it
used with common stocks and other assets?
• What are the static yield spread and the
option-adjusted spread?
 Chapter 18 - The Analysis
and Valuation of Bonds
• What are effective duration and effective
convexity and when are they useful?
• What is empirical duration and how is it
used with common stocks and other assets?
• What are the static yield spread and the
option-adjusted spread?
 The Fundamentals of Bond Valuation
The present-value model

Where:
Pm=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
Pp=the par value of the bond
 The Fundamentals of Bond
Valuation
• If yield < coupon rate, bond will be priced
at a premium to its par value
• If yield > coupon rate, bond will be priced
at a discount to its par value
• Price-yield relationship is convex (not a
straight line)
 The Present Value Model
The value of the bond equals the present
value of its expected cash flows

where:
Pm = 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
Pp = the par value of the bond
 The Yield Model
The expected yield on the bond may be
computed from the market price

where:
i = the discount rate that will discount the cash flows to
equal the current market price of the bond
 Computing Bond Yields
Yield Measure Purpose
Nominal Yield Measures the coupon rate

Current yield Measures current income rate

Promised yield to maturity Measures expected rate of return for bond held
to maturity
Promised yield to call Measures expected rate of return for bond held
to first call date
Realized (horizon) yield Measures expected rate of return for a bond
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.
 Nominal Yield
Measures the coupon rate that a bond
investor receives as a percent of the bond’s
par value
 Current Yield
Similar to dividend yield for stocks
Important to income oriented investors
CY = Ci/Pm
where:
CY = the current yield on a bond
Ci = the annual coupon payment of bond i
Pm = the current market price of the bond
 Promised Yield to Maturity
• Widely used bond yield figure
• Assumes
– Investor holds bond to maturity
– All the bond’s cash flow is reinvested at the
computed yield to maturity
 Computing the
Promised Yield to Maturity

Solve for i that will equate the current price to all

cash flows from the bond to maturity, similar
to IRR
 Computing Promised Yield to Call

where:
Pm = market price of the bond
Ci = annual coupon payment
nc = number of years to first call
Pc = call price of the bond
Realized (Horizon) Yield
Present-Value Method
Calculating Future Bond Prices

where:
Pf = 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

Where:
FTEY = fully taxable yield equivalent
i = the promised yield on the tax exempt bond
T = the amount and type of tax exemption
(i.e., the investor’s marginal tax rate)
 Bond Valuation Using Spot Rates

where:
Pm = the market price of the bond
Ct = the cash flow at time t
n = the number of years
it = the spot rate for Treasury securities at
maturity t
What Determines Interest Rates
• Inverse relationship with bond prices
• Forecasting interest rates
• Fundamental determinants of interest rates
i = RFR + I + RP
where:
– RFR = real risk-free rate of interest
– I = expected rate of inflation
– RP = risk premium
 What Determines Interest Rates
• Effect of economic factors
– real growth rate
– tightness or ease of capital market
– expected inflation
– or supply and demand of loanable funds
• Impact of bond characteristics
– credit quality
– term to maturity
– indenture provisions
– foreign bond risk including exchange rate risk and country risk
 Term Structure of Interest Rates

• It is a static function that relates the term to

maturity to the yield to maturity for a
sample of bonds at a given point in time.
• Term Structure Theories
– Expectations hypothesis
– Liquidity preference hypothesis
– Segmented market hypothesis
• Trading implications of the term structure
Spot Rates and Forward Rates
• Creating the Theoretical Spot Rate Curve
• Calculating Forward Rates from the Spot
Rate Curve
 Expectations Hypothesis
• Any long-term interest rate simply
represents the geometric mean of current
and future one-year interest rates expected
to prevail over the maturity of the issue
 Liquidity Preference Theory
• Long-term securities should provide higher
returns than short-term obligations because
investors are willing to sacrifice some yields
to invest in short-maturity obligations to
avoid the higher price volatility of
long-maturity bonds
Segmented-Market Hypothesis
• Different institutional investors have
different maturity needs that lead them to
confine their security selections to specific
maturity segments
 Trading Implications of the
Term Structure
• Information on maturities can help you
formulate yield expectations by simply
observing the shape of the yield curve
 Yield Spreads
• Segments: government bonds, agency
bonds, and corporate bonds
• Sectors: prime-grade municipal bonds
versus good-grade municipal bonds, AA
utilities versus BBB utilities
• Coupons or seasoning within a segment or
sector
• Maturities within a given market segment or
sector
 Yield Spreads
Magnitudes and direction of yield spreads
can change over time
 What Determines the
Price Volatility for Bonds
Bond price change is measured as the
percentage change in the price of the bond

Where:
EPB = the ending price of the bond
BPB = the beginning price of the bond
 What Determines the
Price Volatility for Bonds
Four Factors
1. Par value
2. Coupon
3. Years to maturity
4. Prevailing market interest rate
 What Determines the
Price Volatility for Bonds
Five observed behaviors
1. Bond prices move inversely to bond yields (interest rates)
2. For a given change in yields, longer maturity bonds post larger
price changes, thus bond price volatility is directly related to
maturity
3. 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
5. Higher coupon issues show smaller percentage price fluctuation for
a given change in yield, thus bond price volatility is inversely
related to coupon
 What Determines the
Price Volatility for Bonds
• The maturity effect
• The coupon effect
• The yield level effect
• Some trading strategies
 The Duration Measure
• Since price volatility of a bond varies
inversely with its coupon and directly with
its term to maturity, it is necessary to
determine the best combination of these two
variables to achieve your objective
• A composite measure considering both
coupon and maturity would be beneficial
 The Duration Measure

Developed by Frederick R. Macaulay, 1938

Where:
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 Macaulay
Duration
• Duration of a bond with coupons is always less
than its term to maturity because duration gives
weight to these interim payments
– A zero-coupon bond’s duration equals its maturity
• There is an inverse relationship between duration
and coupon
• There is a positive relationship between term to
maturity 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 and Bond Price
Volatility
An adjusted measure of duration can be used
to approximate the price volatility of an
option-free (straight) bond

Where:
m = number of payments a year
YTM = nominal YTM
Modified Duration and Bond Price
Volatility
• Bond price movements will vary proportionally with
modified duration for small changes in yields
• An estimate of the percentage change in bond prices equals
the change in yield time modified duration

Where:
ΔP = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
Δi = yield change in basis points divided by 100
 Trading Strategies Using Modified
Duration
• Longest-duration security provides the maximum price
variation
• If you expect a decline in interest rates, increase the average
modified duration of your bond portfolio to experience
maximum price volatility
• If you expect an increase in interest rates, reduce the average
modified duration to minimize your price decline
• Note that the modified duration of your portfolio is the
market-value-weighted average of the modified durations of the
individual bonds in the portfolio
Bond Duration in Years for Bonds
Yielding 6 Percent Under Different
Terms
 Bond Convexity
• Modified duration is a linear approximation
of bond price change for small changes in
market yields

• However, price changes are not linear, but a

curvilinear (convex) function
Price-Yield Relationship for Bonds
• 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, or any stream of future cash flows
• The convex price-yield relationship will differ
among bonds or other cash flow streams
depending on the coupon and maturity
• The convexity of the price-yield relationship
declines slower as the yield increases
• Modified duration is the percentage change in
price for a nominal change in yield
 Modified Duration

For small changes this will give a good

estimate, but this is a linear estimate on the
tangent line
 Determinants of Convexity
The convexity is the measure of the curvature
and is the second derivative of price with
resect to yield (d2P/di2) divided by price
Convexity is the percentage change in dP/di
for a given change in yield
 Determinants of Convexity
• Inverse relationship between coupon and convexity
• Direct relationship between maturity and convexity
• Inverse relationship between yield and convexity
Modified Duration-Convexity Effects

• Changes in a bond’s price resulting from a

change in yield are due to:
– Bond’s modified duration
– Bond’s convexity
• Relative effect of these two factors depends
on the characteristics of the bond (its
convexity) and the size of the yield change
• Convexity is desirable
 Duration and Convexity
for Callable Bonds
• Issuer has option to call bond and pay off with
proceeds from a new issue sold at a lower yield
• Embedded option
• Difference in duration to maturity and duration to
first call
• Combination of a noncallable bond plus a call
option that was sold to the issuer
• Any increase in value of the call option reduces
the value of the callable bond
 Option Adjusted Duration
• Based on the probability that the issuing
firm will exercise its call option
– Duration of the non-callable bond
– Duration of the call option
 Convexity of Callable Bonds
• Noncallable bond has positive convexity
• Callable bond has negative convexity
 Limitations of Macaulay and
Modified Duration
• Percentage change estimates using modified
duration only are good for small-yield
changes
• Difficult to determine the interest-rate
sensitivity of a portfolio of bonds when
there is a change in interest rates and the
yield curve experiences a nonparallel shift
• Initial assumption that cash flows from the
bond are not affected by yield changes
 Effective Duration
• Measure of the interest rate sensitivity of an asset
• Use a pricing model to estimate the market prices
surrounding a change in interest rates
Effective Duration Effective Convexity

P- = the estimated price after a downward shift in interest rates

P+ = the estimated price after a upward shift in interest rates
P = the current price
S = the assumed shift in the term structure
 Effective Duration
• Effective duration greater than maturity
• Negative effective duration
• Empirical duration
 Empirical Duration
• Actual percent change for an asset in
response to a change in yield during a
specified time period
Yield Spreads With Embedded
Options
• Static Yield Spreads
– Consider the total term structure
• Option-Adjusted Spreads
– Consider changes in the term structure and
alternative estimates of the volatility of interest
rates
 The Internet
Investments Online
http://www.bondcalc.com
http://www.bondmarkets.com
http://www.pimco.com
http://www.bonds-online.com
End of Chapter 18
–The Analysis and Valuation of
Bonds
 Future topics
Chapter 19
• Bond Portfolio Management
Strategies