1

Chapter 12

Bond Prices and the
Importance of Duration
2



We cannot gamble with anything
so sacred as money.


- William McKinley
3
Outline
Introduction
Review of bond principles
Bond pricing and returns
Bond risk
4
Introduction
The investment characteristics of bonds
range completely across the risk/return
spectrum

As part of a portfolio, bonds provide both
stability and income
Capital appreciation is not usually a motive for
acquiring bonds
5
Review of Bond Principles
Identification of bonds
Classification of bonds
Terms of repayment
Bond cash flows
Convertible bonds
Registration

6
Identification of Bonds
A bond is identified by:
The issuer
The coupon
The maturity

For example, five IBM eights of 10
means $5,000 par IBM bonds with an 8%
coupon rate and maturing in 2010
7
Classification of Bonds
Introduction
Issuer
Security
Term

8
Introduction
The bond indenture describes the details of
a bond issue:
Description of the loan
Terms of repayment
Collateral
Protective covenants
Default provisions
9
Issuer
Bonds can be classified by the nature of the
organizations initially selling them:
Corporation
Federal, state, and local governments
Government agencies
Foreign corporations or governments
10
Security
Definition
Unsecured debt
Secured debt
11
Definition
The security of a bond refers to what backs
the bond (what collateral reduces the risk of
the loan)
12
Unsecured Debt
Governments:
Full faith and credit issues (general obligation
issues) is government debt without specific
assets pledged against it
E.g., U.S. Treasury bills, notes, and bonds
13
Unsecured Debt (contd)
Corporations:
Debentures are signature loans backed by the
good name of the company

Subordinated debentures are paid off after
original debentures
14
Secured Debt
Municipalities issue:
Revenue bonds
Interest and principal are repaid from revenue
generated by the project financed by the bond

Assessment bonds
Benefit a specific group of people, who pay an
assessment to help pay principal and interest
15
Secured Debt (contd)
Corporations issue:
Mortgages
Well-known securities that use land and buildings as
collateral
Collateral trust bonds
Backed by other securities
Equipment trust certificates
Backed by physical assets
16
Term
The term is the original life of the debt
security
Short-term securities have a term of one year or
less
Intermediate-term securities have terms ranging
from one year to ten years
Long-term securities have terms longer than ten
years
17
Terms of Repayment
Interest only
Sinking fund
Balloon
Income bonds

18
Interest Only
Periodic payments are entirely interest

The principal amount of the loan is repaid at
maturity
19
Sinking Fund
A sinking fund requires the establishment
of a cash reserve for the ultimate repayment
of the bond principal
The borrower can:
Set aside a potion of the principal amount of the
debt each year

Call a certain number of bonds each year
20
Balloon
Balloon loans partially amortize the debt
with each payment but repay the bulk of the
principal at the end of the life of the debt

Most balloon loans are not marketable
21
Income Bonds
Income bonds pay interest only if the firm
earns it

For example, an income bond may be
issued to finance an income-producing
project
22
Bond Cash Flows
Annuities
Zero coupon bonds
Variable rate bonds
Consols

23
Annuities
An annuity promises a fixed amount on a
regular periodic schedule for a finite length
of time

Most bonds are annuities plus an ultimate
repayment of principal
24
Zero Coupon Bonds
A zero coupon bond has a specific maturity
date when it returns the bond principal

A zero coupon bond pays no periodic
income
The only cash inflow is the par value at
maturity
25
Variable Rate Bonds
Variable rate bonds allow the rate to
fluctuate in accordance with a market index

For example, U.S. Series EE savings bonds
26
Consols
Consols pay a level rate of interest
perpetually:
The bond never matures
The income stream lasts forever

Consols are not very prevalent in the U.S.
27
Convertible Bonds
Definition
Security-backed bonds
Commodity-backed bonds
28
Definition
A convertible bond gives the bondholder
the right to exchange them for another
security or for some physical asset

Once conversion occurs, the holder cannot
elect to reconvert and regain the original
debt security
29
Security-Backed Bonds
Security-backed convertible bonds are
convertible into other securities
Typically common stock of the company that
issued the bonds

Occasionally preferred stock of the issuing
firm, common stock of another firm, or shares
in a subsidiary company
30
Commodity-Backed Bonds
Commodity-backed bonds are convertible
into a tangible asset

For example, silver or gold
31
Registration
Bearer bonds
Registered bonds
Book entry bonds
32
Bearer Bonds
Bearer bonds:
Do not have the name of the bondholder printed
on them
Belong to whoever legally holds them
Are also called coupon bonds
The bond contains coupons that must be clipped
Are no longer issued in the U.S.
33
Registered Bonds
Registered bonds show the bondholders
name

Registered bondholders receive interest
checks in the mail from the issuer
34
Book Entry Bonds
The U.S. Treasury and some corporation
issue bonds in book entry form only
Holders do not take actual delivery of the bond

Potential holders can:
Open an account through the Treasury Direct
System at a Federal Reserve Bank
Purchase a bond through a broker
35
Bond Pricing and Returns
Introduction
Valuation equations
Yield to maturity
Realized compound yield
Current yield
Term structure of interest rates
Spot rates
36
Bond Pricing and Returns
(contd)
The conversion feature
The matter of accrued interest
37
Introduction
The current price of a bond is the markets
estimation of what the expected cash flows
are worth in todays dollars

There is a relationship between:
The current bond price
The bonds promised future cash flows
The riskiness of the cash flows
38
Valuation equations
Annuities
Zero coupon bonds
Variable rate bonds
Consols
39
Annuities
For a semiannual bond:

| |
2
0
1
0
1 ( / 2)
where term of the bond in years
cash flow at time
annual yield to maturity
current price of the bond
N
t
t
t
t
C
P
R
N
C t
R
P
=
=
+
=
=
=
=

40
Annuities (contd)
Separating interest and principal
components:

| | | |
2
0
2
1 1 ( / 2) 1 ( / 2)
where coupon payment
N
t N
t
C Par
P
R R
C
=
= +
+ +
=

41
Annuities (contd)
Example

A bond currently sells for $870, pays $70 per year (Paid
semiannually), and has a par value of $1,000. The bond
has a term to maturity of ten years.

What is the yield to maturity?




42
Annuities (contd)
Example (contd)

Solution: Using a financial calculator and the following input provides
the solution:

N = 20
PV = $870
PMT = $35
FV = $1,000
CPT I = 4.50

This bonds yield to maturity is 4.50% x 2 = 9.00%.



43
Zero Coupon Bonds
For a zero-coupon bond (annual and
semiannual compounding):


0
0
2
(1 )
(1 / 2)
t
t
Par
P
R
Par
P
R
=
+
=
+
44
Zero Coupon Bonds (contd)
Example

A zero coupon bond has a par value of $1,000 and
currently sells for $400. The term to maturity is twenty
years.

What is the yield to maturity (assume semiannual
compounding)?




45
Zero Coupon Bonds (contd)
Example (contd)

Solution:




0
2
40
(1 / 2)
$1, 000
$400
(1 / 2)
4.63%
t
Par
P
R
R
R
=
+
=
+
=
46
Variable Rate Bonds
The valuation equation must allow for
variable cash flows
You cannot determine the precise present
value of the cash flows because they are
unknown:

2
0
1
(1 )
where interest rate at time
N
t
t
t
t
t
C
P
I
I t
=
=
+
=

47
Consols
Consols are perpetuities:

0
C
P
R
=
48
Consols (contd)
Example

A consol is selling for $900 and pays $60 annually in
perpetuity.

What is this consols rate of return?



49
Consols (contd)
Example (contd)

Solution:


0
$60
6.67%
$900
C
P
R
R
=
= =
50
Yield to Maturity
Yield to maturity captures the total return
from an investment
Includes income
Includes capital gains/losses

The yield to maturity is equivalent to the
internal rate of return in corporate finance

51
Realized Compound Yield
The effective annual yield is useful to
compare bonds to investments generating
income on a different time schedule

| |
Effective annual rate 1 ( / ) 1
where yield to maturity
number of payment periods per year
x
R x
R
x
= +
=
=
52
Realized Compound
Yield (contd)
Example

A bond has a yield to maturity of 9.00% and pays interest
semiannually.

What is this bonds effective annual rate?
53
Realized Compound
Yield (contd)
Example (contd)

Solution:

| |
| |
2
Effective annual rate 1 ( / ) 1
1 (.009/ 2) 1
9.20%
x
R x = +
= +
=
54
Current Yield
The current yield:
Measures only the return associated with the
interest payments

Does not include the anticipated capital gain or
loss resulting from the difference between par
value and the purchase price
55
Current Yield (contd)
For a discount bond, the yield to maturity is
greater than the current yield

For a premium bond, the yield to maturity is
less than the current yield
56
Current
Yield (contd)
Example

A bond pays annual interest of $70 and has a current
price of $870.

What is this bonds current yield?
57
Current
Yield (contd)
Example (contd)

Solution:

Current yield = $70/$870 = 8.17%
58
Term Structure of
Interest Rates
Yield curve
Theories of interest rate structure
59
Yield Curve
The yield curve:
Is a graphical representation of the term
structure of interest rates

Relates years until maturity to the yield to
maturity

Is typically upward sloping and gets flatter for
longer terms to maturity
60
Information Used to
Build A Yield Curve
61
Theories of
Interest Rate Structure
Expectations theory
Liquidity preference theory
Inflation premium theory
62
Expectations Theory
According to the expectations theory of
interest rates, investment opportunities with
different time horizons should yield the
same return:
2
2 1 1 2
1 2
(1 ) (1 )(1 )
where the forward rate from time 1 to time 2
R R f
f
+ = + +
=
63
Expectations Theory (contd)
Example

An investor can purchase a two-year CD at a rate of 5
percent. Alternatively, the investor can purchase two
consecutive one-year CDs. The current rate on a one-year
CD is 4.75 percent.

According to the expectations theory, what is the expected
one-year CD rate one year from now?
64
Expectations Theory (contd)
Example (contd)

Solution:
2
2 1 1 2
2
1 2
2
1 2
1 2
(1 ) (1 )(1 )
(1.05) (1.045)(1 )
(1.05)
(1 )
(1.045)
5.50%
R R f
f
f
f
+ = + +
= +
+ =
=
65
Liquidity Preference Theory
Proponents of the liquidity preference
theory believe that, in general:
Investors prefer to invest short term rather than
long term
Borrowers must entice lenders to lengthen their
investment horizon by paying a premium for
long-term money (the liquidity premium)
Under this theory, forward rates are higher
than the expected interest rate in a year
66
Inflation Premium Theory
The inflation premium theory states that
risk comes from the uncertainty associated
with future inflation rates
Investors who commit funds for long
periods are bearing more purchasing power
risk than short-term investors
More inflation risk means longer-term
investment will carry a higher yield
67
Spot Rates
Spot rates:
Are the yields to maturity of a zero coupon
security
Are used by the market to value bonds
The yield to maturity is calculated only after
learning the bond price
The yield to maturity is an average of the various
spot rates over a securitys life

68
Spot Rates (contd)
Spot Rate Curve
Yield to Maturity
Time Until the Cash Flow
I
n
t
e
r
e
s
t

R
a
t
e

69
Spot Rates (contd)
Example

A six-month T-bill currently has a yield of 3.00%. A one-
year T-note with a 4.20% coupon sells for 102.

Use bootstrapping to find the spot rate six months from
now.
70
Spot Rates (contd)
Example (contd)

Solution: Use the T-bill rate as the spot rate for the first
six months in the valuation equation for the T-note:

2
2
2
2
2
2
2
21.00 1, 021
1, 020
(1 .03/ 2) (1 / 2)
1, 021
999.31
(1 / 2)
(1 / 2) 1.022
2.16%
r
r
r
r
= +
+ +
=
+
+ =
=
71
The Conversion Feature
Convertible bonds give their owners the right to
exchange the bonds for a pre-specified amount or
shares of stock
The conversion ratio measures the number of
shares the bondholder receives when the bond is
converted
The par value divided by the conversion ratio is the
conversion price
The current stock price multiplied by the conversion
ratio is the conversion value
72
The Conversion
Feature (contd)
The market price of a bond can never be less than
its conversion value
The difference between the bond price and the
conversion value is the premium over conversion
value
Reflects the potential for future increases in the
common stock price
Mandatory convertibles convert automatically into
common stock after three or four years
73
The Matter of Accrued Interest
Bondholders earn interest each calendar day
they hold a bond
Firms mail interest payment checks only
twice a year
Accrued interest refers to interest that has
accumulated since the last interest payment
date but which has not yet been paid
74
The Matter of
Accrued Interest (contd)
At the end of a payment period, the issuer
sends one check for the entire interest to the
current bondholder
The bond buyer pays the accrued interest to the
seller

The bond sells receives accrued interest from
the bond buyer

75
The Matter of
Accrued Interest (contd)
Example

A bond with an 8% coupon rate pays interest on June 1
and December 1. The bond currently sells for $920.

What is the total purchase price, including accrued
interest, that the buyer of the bond must pay if he
purchases the bond on August 10?
76
The Matter of
Accrued Interest (contd)
Example (contd)

Solution: The accrued interest for 71 days is:

$80/365 x 71 = $15.56

Therefore, the total purchase price is:

$920 + $15.56 = $935.56
77
Bond Risk
Price risks
Convenience risks
Malkiels interest rate theories
Duration as a measure of interest rate risk
78
Price Risks
Interest rate risk
Default risk

79
Interest Rate Risk
Interest rate risk is the chance of loss
because of changing interest rates

The relationship between bond prices and
interest rates is inverse
If market interest rates rise, the market price of
bonds will fall
80
Default Risk
Default risk measures the likelihood that a
firm will be unable to pay the principal and
interest on a bond

Standard & Poors Corporation and
Moodys Investor Service are two leading
advisory services monitoring default risk
81
Default Risk (contd)
Investment grade bonds are bonds rated
BBB or above

Junk bonds are rated below BBB

The lower the grade of a bond, the higher its
yield to maturity
82
Convenience Risks
Definition
Call risk
Reinvestment rate risk
Marketability risk

83
Definition
Convenience risk refers to added demands
on management time because of:
Bond calls

The need to reinvest coupon payments

The difficulty in trading a bond at a reasonable
price because of low marketability
84
Call Risk
If a company calls its bonds, it retires its
debt early

Call risk refers to the inconvenience of
bondholders associated with a company
retiring a bond early
Bonds are usually called when interest rates are
low
85
Call Risk (contd)
Many bond issues have:
Call protection
A period of time after the issuance of a bond when
the issuer cannot call it

A call premium if the issuer calls the bond
Typically begins with an amount equal to one years
interest and then gradually declining to zero as the
bond approaches maturity
86
Reinvestment Rate Risk
Reinvestment rate risk refers to the
uncertainty surrounding the rate at which
coupon proceeds can be invested

The higher the coupon rate on a bond, the
higher its reinvestment rate risk

87
Marketability Risk
Marketability risk refers to the difficulty of
trading a bond:
Most bonds do not trade in an active secondary
market
The majority of bond buyers hold bonds until
maturity
Low marketability bonds usually carry a
wider bid-ask spread
88
Malkiels
Interest Rate Theorems
Definition
Theorem 1
Theorem 2
Theorem 3
Theorem 4
Theorem 5
89
Definition
Malkiels interest rate theorems provide
information about how bond prices change
as interest rates change

Any good portfolio manager knows
Malkiels theorems
90
Theorem 1
Bond prices move inversely with yields:
If interest rates rise, the price of an existing
bond declines

If interest rates decline, the price of an existing
bond increases
91
Theorem 2
Bonds with longer maturities will fluctuate
more if interest rates change

Long-term bonds have more interest rate
risk


92
Theorem 3
Higher coupon bonds have less interest rate
risk

Money in hand is a sure thing while the
present value of an anticipated future
receipt is risky
93
Theorem 4
When comparing two bonds, the relative
importance of Theorem 2 diminishes as the
maturities of the two bonds increase

A given time difference in maturities is
more important with shorter-term bonds
94
Theorem 5
Capital gains from an interest rate decline
exceed the capital loss from an equivalent
interest rate increase
95
Duration as A Measure of
Interest Rate Risk
The concept of duration
Calculating duration

96
The Concept of Duration
For a noncallable security:
Duration is the weighted average number of
years necessary to recover the initial cost of the
bond

Where the weights reflect the time value of
money
97
The Concept of
Duration (contd)
Duration is a direct measure of interest rate
risk:
The higher the duration, the higher the interest
rate risk
98
Calculating Duration
The traditional duration calculation:

1
(1 )
where duration
cash flow at time
yield to maturity
current price of the bond
years until bond maturity
time at which a cash flow is received
N
t
t
t
o
t
o
C
t
R
D
P
D
C t
R
P
N
t
=

+
=
=
=
=
=
=
=

99
Calculating Duration (contd)
The closed-end formula for duration:
1
2
(1 ) (1 ) ( )
(1 ) (1 )
where par value of the bond
number of periods until maturity
yield to maturity of the bond per period
N
N N
o
R R R N F N
C
R R R
D
P
F
N
R
+
(
+ +
+
(
+ +

=
=
=
=
100
Calculating Duration (contd)
Example

Consider a bond that pays $100 annual interest and has a
remaining life of 15 years. The bond currently sells for
$985 and has a yield to maturity of 10.20%.

What is this bonds duration?
101
Calculating Duration (contd)
Example (contd)

Solution: Using the closed-form formula for duration:
1
2
31
2 30 30
(1 ) (1 ) ( )
(1 ) (1 )
(1.052) (1.052) (0.052 30) 1, 000 30
50
0.052 (1.052) (1.052)
985
15.69 years
N
N N
o
R R R N F N
C
R R R
D
P
+
( + +
+
(
+ +

=
(
+
(

=
=