An Introduction to Bonds, Bond

Pricing, and Portfolio management

Part: A
Dewan Mostafizur Rahman
October 2014
1

Objectives
Identify the characteristics of bonds
government and corporate bonds
Develop a framework for valuing bonds
Determine the price sensitivity of bonds to
interest rate changes
Develop the analysis of interest rates and
portfolio management of bonds

Bonds
Bonds are financial instruments that are issued by bodies such as Governments and corporations
to raise funds by promising to pay interest and to repay the amount borrowed at some point in the
future
The future cash flows promised to the investors in conventional bonds are contractually defined
as
Periodic interest payments
Repayment of principal
The value of a bond will be given by the present value of cash flows that can be anticipated by
the holder of the bond
The rate of return required by investors on a bond, used to calculate the present value of the
anticipated net cash flows, will depend on the returns offered by bonds of similar risk and
duration to understand the benchmark requires an analysis of interest rates

Bond Characteristics
Face or par value
The amount the issue pays the bondholder at expiration of the
bond. (UK Government bonds: 100, US Government bonds:
$1,000.)

Bond prices are generally quoted in relation to a par value

of 100
Coupon rate of interest (rc)
Periodic interest payment on bond (r CB)

Zero coupon bonds

These bonds do not make interest payments
The return is in the form of capital appreciation

Other features include risk exposure, option features (call

and convertible provisions)
4

Valuation of a Bond
The value of a bond will be given by the present value
of cash flows that can be anticipated by the holder of
the bond
The rate of return required by investors on a bond will
depend on return offered by bonds of similar risk and
duration.
Interest Payment Interest Payment
Interest Payment Principal
P0

2
1 r
1 r
1 r n
r B
r B
r BB
P0 C C 2 C
1 r 1 r
1 r n
Bisthefaceorparvalueofabond
rcisthecouponrateofinterestandiscontractuallydefined
ristheprevailinginterestrate,theratethatinvestorscan
expecttoearnonsimilarriskinvestments.
5

A bond prices as a function of the

required yield
Bond price

When issued bonds tend to offer a coupon rate of

return equal to the required rate of return, and
are consequently valued at or close to the par
value.

100

P0= f (y)

rc=y

Required yield
6

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

Valuation of a Bond An Illustration

A bond, issued 8 years ago with a nominal or face value of 100 promises
to pay a coupon interest payment of 7 per cent on an annual basis and has
12 years to run to maturity. The prevailing interest rate at the time the bond
was issued was 7 per cent, but this has increased to 9 per cent today.
The interest yield on comparable risk bonds being issued today with 12
years to run to maturity is 9 per cent this will be the rate of return
required by investors in the bond under consideration.
Determine its current price.
1
1
1
1
1
P0 7
7

......
7

100
(1 0.09)
(1 0.09) 2
(1 0.09) 3
(1 0.09)12
(1 0.09)12

P0 7 PVAF12 / .09 100 PVF12 / .09

7 7.1607 100 0.3555 85.6785
8

Valuation as the Present Value of the Bonds

NCF

Price Interest Rate Relationship

for Bonds
Price

100.00
85.67

P = f (r)
0.07

0.09

Interest rate
Required rate of return
Required yield
10

Expected Changes in Bond Prices Over

Time
Price
100.00
85.67

Time
Maturitydate

Bondissellingatadiscountasthecouponrateisbelowtheprevailinginterestrate.
Thepriceofabondmustequalitsnominalorfacevalueatthematuritydateandits
marketvaluewillincreaseyearbyyeartoeliminatethediscountbythatdate.

Holding-Period Return: Single Period

HPR = [ I + ( P1 P0 )]

/ P0

where
I = rcB= interest payment
P1 = expected price at the end of period one
P0 = purchase price
P0 =85.6785
P1 =86.3896
HPR = [ I + ( P1 P0 )]

/P

HPR = [ 7+ ( 86.3896 85.6785 )]

85.6785 = 0.09
12

Expected Price Adjustments

Above Par

Capital depreciation
Annual return (t 1)

rc B Pt 1 Pt

Pt
Pt

where Pt Pt 1
Time

Annual return (t 1)

Capital appreciation
Below Par

rc B Pt 1 Pt

Pt
Pt

where Pt 1 Pt
13

Expected annual return on the bond

(assuming no change in interest rates over time)

Thecouponrateis7percentandtherequiredrateofreturn
is9percentthereforetheappropriatediscountrate.

14

Actual changes in bond prices over time

with unanticipated changes in interest rates)
Bond prices

Bond prices evolving through to maturity

Constant required rate of return

Years

15

B
r
B
c
P

y
)
(1

y
)(1

T
0
t
t
1
Yield to Maturity

The yield to maturity of a bond is the interest

rate that makes the present value of the bonds
cash flows equal to its price
Solve the bond formula for y (IRR)

16

.
3
5
1
0
9
5
y
)
(1

y
)(
2
0

T
t
t
1

Yield to Maturity Example: Interest

paid twice a year

A bond offers a coupon rate of interest of 7 per cent, with interest being paid
on a semi-annual basis. If the bond is trading at 95.00 and has ten years to
run to maturity determine its yield to maturity. (Use Excel)

10 yr Maturity Coupon Rate = 7%

Semi-annual payment = 3.50

Par value = 100 Current market price = 95

Solve for y = semi-annual rate

y = 3.8635%

17

Yield Measures
Calculation of yield

Bond Equivalent Annual Yield

7.72% = 3.86% x 2
Effective Annual Yield (Allows for compounding)
(1.0386)2 - 1 = 7.88%
Current Yield
Annual Interest / Market Price
7 / 95 = 7.37 %
18

Pricing a Bond :an illustration

The principles of bond pricing can be illustrated using Gilts (UK
Government bonds).
Example taken from 1st March 2012 (at close of trade)
Gilt with a 6% coupon maturing in 2028.
Quoted price is 142.57
Redemption yield (=YTM) is 2.8%
Coupon interest paid twice a year, 7th June & 7th Dec
Matures on 7th December 2028.
Bond
Price
Tr 6pc 2028 142.57

Red yield
2.80

Interest due
7 Jun / Dec

Illustration: Details of a Bond

On 1st March the future cash flows from a bond are as follows:
Coupon
3 is due on 7th June 2012 (in 98 days)
followed by 33 more payments every 6 months until 7th
December 2028
Redemption payment
100 on 7th December 2028
Look ahead to next coupon date 7th June 2012:
3 + (3 AF33, 1.4% ) + (100 DF33,1.4% )
Now discount back to 1st March @ 1.4%

3 (3xPVAF 33 | 0.014) 100 xPVF 33 | 0.014

1.01498 / 183

Trade price and quoted price

The trade price is 143.976
However, the quoted price is 142.57.
Prices are quoted after deducting accrued interest, which is the
interest built up since the last payment on 7 Dec 2011, 85 days ago.
Accrued interest = 1.40
Quoted price = trade price + accrued interest

21

Spot Rates and Zeros(1)

A zero coupon bond pays no coupon rate of
interest
These bonds are issued at a discount to their
face value and the return is obtained in the form
of capital appreciation
These bonds provide the benchmark for the
evaluation of cash flows for a particular period
a coupon bond can be viewed as a portfolio of
zeros
22

Zero Coupon or Discount Bonds

A zero coupon bond, also referred to as a pure
discount bond, offers no interest payments, but
simply the payment of the nominal value of the
bond at maturity.
-P0

Bn
Time

23

Spot Rates and Zeros(2)

Price and nominal value
100

A 10 year zero is issued at a market

determined price of 32.1973
Nominal value

Determine the yield

32.1973

Maturity date
(10)

Time
24

Deriving the Yield on a Zero and thereby

the relevant spot rate for that maturity
B
y rsn =
P
y rs10

100

32.1973

y rs10

1/ n

10

1
10

1 0.12

100
1 0.12
32.1973
25

Yield to maturity and Spot rates

While there is only one value for y, the
yield to maturity, the spot rates may differ
from one period to the next :
rs1 rs 2 rs 3 .......... rsn
For
y rs1 rs 2 rs 3 .......... rsn
the yield curve must be flat.
Yield/,Spot rates

Maturity

26

Use Spot Rates to Value Bonds (1)

Determine a fair price for a 4 year bond with a coupon rate
of 8 per cent given the following prices and spot rates for
zeros:

27

Use Spot Rates to Value Bonds (2)

Determine a fair price for a 4 year bond with a coupon rate
of 8 per cent given the following prices and spot rates for
zeros:

28

Use Spot Rates to Value

Bonds(3)
Valuing a 4 year bond with a coupon rate of 8 per
cent given spot rates of 10, 11, 11.50. and 12 per
cent for years one to four.

88.1727

29

Using a portfolio of zero coupon

bonds to replicated a Bond
Valuing a 4 year bond with a coupon rate of 8 per cent.

30

Spot Rates and Yields

The 4 year bond with a coupon rate of 8 per cent trading
at a price of 88.1729 yields 11.88 per cent (a weighted
average of the spot rates).

31

Using Spot Rates to Value Bonds Without

Zeros
How should bonds be valued in the absence of
zeros ?
How can spot rates be determined using coupon
bonds?

32

Bootstrapping and Spot Rates

Given

Determine the spot rates for years 1, 2, and

3.

33

Bootstrapping and Spot Rates

Given

Determine the spot rates for years 1, 2, and

3.
106
rs1

97.3636

1 1.100 1 0.10

P 95.6028

7
107

1.1000 (1 rs 2 ) 2

(1 rs 2 ) 2 107 / 89.2392 1.19903

rs 2 (1 rs 2 ) 2 1 1.1990 1 0.0950
34

Bootstrapping and Spot Rates

Given
Determine the spot rates for years 1, 2, and
3.
rs1 0.1000
rs 2 0.0950
105
P 89.3501 5 / 1.1 5 / 1.095
(1 rs 3 ) 3
2

rs 3 3 (1 rs 2 ) 2 1 3

105
1 0.092
2
89.3501 5 / 1.1 5 /(1.095)
35

Forward rates
The forward rate of interest is the short term (one
period) rate of interest for year n that will make an
investor indifferent between
investing in a zero for n-1 years and re-investing the
proceeds at maturity in a one year investment and
investing in a n year zero

36

Forward and Expected Future Rates

The forward rate for some future time period is not
necessarily the short term rate expected for this period
The expected rate is often referred to as the expected
future rate rather than the forward rate
The relationship between the expected future and
forward rates depends on the interpretation of the term
structure of interest rates the yield curve
If the yield on a two year bond exceeds the yield on a
one year bond as a result of a risk premium there is no
good reason to expect next years one year yield will
exceed the rate for the coming year.
37

n
(W
1h

rersfn
)fsnn1is(1
rthensffnp

)ro

(w
rt1a
1

)dersfo
itm
n
p
e
slfrpeiodn.
r
o
d
Forward Rates from Observed Spot Rates

An investor with a investment horizon of n years could invest in a

n year zero, or alternatively invest in a n-1 zero and re-invest in a
one year zero after n-1 years. The rate for the nth year that will
leave the investor equally well off is referred to as the forward
rate.

38

Calculating Forward Rates

4 year spot rate = 12%

3 year spot rate = 11.5%

Determine the forward rate for year 4

(1.12)4 = (1.115)3 (1+ rf4)

(1.5735) / (1.3862) = (1+rf4)
r

f4

= .1351 or 13.51%
39

Alternative two year investment strategies

Invest in a one year instrument and reinvest the
proceeds at the end of the year for a further year

1(1+rs1)
0

1(1+rs1)(1+r2,s1)
1

Invest in a two year zero

1(1+rs2)2
0

A risk neutral investor will be indifferent between the two investment

strategies
A risk averse investor with a two year investment horizon will prefer
the two year investment
40

Assessing Bond Price Sensitivity:

Duration and Convexity

Bond Pricing Relationships

Inverse relationship between price and yield
An increase in a bonds yield to maturity results
in a smaller price decline than the gain
associated with a decrease in yield
Long-term bonds tend to be more price sensitive
than short-term bonds to interest rate changes
42

Bond Pricing Relationships

(contd)
As maturity increases, price sensitivity increases
at a decreasing rate
Price sensitivity is inversely related to a bonds
coupon rate
Price sensitivity is inversely related to the yield
to maturity at which the bond is selling
43

Price -yield relationship

Price

P
Price-yield curve
y

Yield

44

Price sensitivity and bond maturity

Price
Longer maturity bond

Shorter maturity bond

Required Yield

Duration
A measure of the effective maturity of a bond takes into account the
timing of all the cash flows promised by a bond
It is defined as the weighted average of the time until each payment
is received, with the weights being given by the present value of the
cash flow of each period in relation to the price of the bond
Duration is shorter than maturity for all bonds except zero coupon
bonds, where the duration is equal to maturity of the bond.

46

Price -yield relationship

Price
Slope measures price sensitivity to yield
changes

Slope provides the basis of

the duration measure
P
Price-yield curve
y

Yield

47

Price -yield relationship sensitivity

varies with the yield
Price

Relatively high price sensitivity

Relatively low price sensitivity

PH

PL

Price-yield curve

yL

yH

Yield

48

C
ia
P
r
c
e
(C
)
1

y
w
F
shF
low
fpriodt

t
tD
tt
T
tt1
w
t

Duration: Calculation of the weights applied to the

time of the NCF

49

Propositions relating to duration

The duration of a zero-coupon bond equals its time to
maturity
Holding maturity constant, a bonds duration is higher
when the coupon rate is lower
Holding the coupon rate constant, a bonds duration
generally increases with its time to maturity
Holding other factors constant, the duration of a coupon
bond is higher when the bonds yield to maturity is lower

50

Duration and the Price Sensitivity of a Bond to

Changes in the Required Yield
Consider the derivative of the price of a bond in relation to its yield:
P

B
r c B + r c B + .... + r c B +
(1 + y )
(1 + y )2
(1 + y )n (1 + y )n

P r c B(1 + y )1 + r c B(1 + y ) 2 + .... + r c B(1 + y ) n + B(1 + y ) n

dP
1rC B(1 + y ) 2 2 rC B(1 + y ) 2 .... n r c B(1 + y )(n 1) n B(1 + y )(n 1)
d (1 y )
dP
(-1) r c B (-2) r c B
(-n) r c B
(-n)B
=
+
+
....
+
+
d (1 y ) (1 + y )2 (1 + y )3
(1 + y )n+1 (1 + y )n+1
dP
1
(1) r c B + (2) r c B2 + ....+ (n) r c Bn + (n)B n
=
d (1 y )
(1 y ) (1 + y )
(1 + y )
(1 + y )
(1 + y )

51

Macaulays Duration
dP
1
(1) r c B
(2) r c B
(n) r c B
(n)B

=
+
+ .... +
+
2
n
d (1 y )
(1 y ) (1 + y ) (1 + y )
(1 + y ) (1 + y )n

dP / P
=
d (1 y ) /(1 y )

(1) r c B
(2) r c B
(n) r c B
(n)B
+
+
....
+
+
(1 + y ) (1 + y )2
(1 + y )n (1 + y )n
P

dP/P
NCF/(1 y)t
t x
Macaulay's Duration
d(1 y)/(1 y)
P
The proportionate change in the price in relation to a very small proportionate
change in the yield factor
52

Macaulays Duration and Modified Duration(3)

Macaulay's Duration
n

MacD ()

t 1

t (r C B)
nB

t
(1 y) (1 y)t
P

The approximat e percentage change in price is given by

dP
1
1
x
x Macaulay's Duration
d (1 y ) P
(1 y)
The ratio of Macaulay's Duration to the yield factor ( 1 y)is refer red to as Modified Duration
dP
1
Macaulay's Duration
x
Modified Duration
d (1 y ) P
(1 y )

53

Calculating Duration
A three year bond offering a coupon of 15 per cent has
a yield of 15 per cent and is selling at par.

The bonds duration is calculated to be 2.626.

54

Weight (t )

PV(C t )
Price

0.756

0.130

0.113

55

Calculating Duration
D = 1 x (15/1.15)/100+ 2 x 15/1.152)/100 + 3 x 115/1.153)/100
= 1 x 0.1304 + 2 x 0.1134 + 3 x 0.7561 = 2.626

2.268

3
2
1

0.226
0.130
0.130

0.756
0.113
56

Modified Duration
The proportionate change in the price in relation to the proportionate
change in the yield factor

dP/P
NCF/(1 y)t
Macaulay's Duration
t x
d(1 y)/(1 y)
P

Modified Duration

Macaulay's Duration/(1 y)

P/P Modified Duration x y

57

Using Duration
Assume required yield increased from 10 to 10.5 per cent

dP/P
NCF/(1 y)t
Macaulay's Duration
t x
d(1 y)/(1 y)
P
821.08

6.2812
130.72
Macaulay's Duration
Estimated Change in price
x y x P
1 y
6.2812

x 0.005 x 130.72 3.7322

1.10

58

Analysing the impact of changes in the yield

There is a 15 per cent coupon bond trading at 130.72 to provide a
yield of 10 per cent. What will be the impact of the required yield
increasing to 10.50 per

59

Using Duration
Determining Duration

dP/P
NCF/(1 y)t
t x
d(1 y)/(1 y)
P
821.0819

6.2812
130.72
Macaulay's Duration
Estimated Change in price
x y x P
1 y
6.2812

x 0.005 x 130.72 3.7322

1.10
Macaulay's Duration

Actual change in price:

130.72-127.07 = 3.65
Estimated change in price:3.73
Difference=0.08

60

Errors in using duration to determine the effects of a

yield change
Price

Error in estimating price change using

duration = 0.08

P0=130.72
P1=127.07
Est.P1=126.99

Price-yield curve

y0

y1

Yield

61

Assessing Duration
Modified duration provides a reasonable basis for
estimating the proportionate change in price for small
changes in the required yield
When there are more significant changes in the
required yield, modified duration fails to provide an
adequate basis to estimate the price change.
Duration will overestimate the price change when the
required yield increases, thereby underestimating the
new price.
When the required yield falls, duration will
underestimate the price change and thereby
underestimate the new price.
62

Portfolio Duration

So far we have looked at the duration of an individual bond.

The duration of a portfolio is simply the weighted average
duration of the bonds in the portfolios.
Portfolio managers look at their interest rate exposure to a
particular issue in terms of its contribution to portfolio duration.
This measure is found by multiplying the weight of the issue in
the portfolio by the duration of the individual issue given as:

contribution to portfolio duration = weight of security in portfolio

duration of security

63

Convexity and yield changes

As we have seen the first derivative can be represented by a

tangent line is drawn to the priceyield relationship at yield y.

The tangent shows the rate of change of price with respect to a

change in interest rates at that point (yield level).

Because all the duration measures are only approximations for

small changes in yield, they do not capture the effect of the
curvature of the price-yield relationship

The curvature is referred to as the bonds convexity and when yields

change by more than a small amount this needs to be taken into
account.

The duration measure can be supplemented with an additional

measure to capture the curvature or convexity of a bond to improve
the estimated changes in price as the yield changes.
64

Convexity (a)
The first steps in deriving the convexity of a bond is to
determine the second derivative of the price of a bonds with
respect to its yield:

B
r
r
r
cB
cB
cB
P=
+
+ .... +
+
1
2
n
n
(1 + y ) (1 + y )
(1 + y ) (1 + y )

dP
(-1) r c B (-2) r c B
(-n) r c B
(-n)B
=
+
+ .... +
+
2
3
n+1
d (1 y ) (1 + y ) (1 + y )
(1 + y )
(1 + y )n+1
65

Convexity (b)
The second derivative is given by
(1) (2)r c B (-2)(3) r c B
d 2P
(-n) (n 1) r c B (-n) (n 1)B
=
+
+ .... +
+
3
4
n +2
d(1 y) 2
(1 + y )
(1 + y )
(1 + y )
(1 + y )n + 2

1
(1 y) 2

(1 y) 2

2rc B
6rc B
n (n 1)rc B n (n 1)B

(1 y) (1 y) 2
n 2
(1 y)
(1 y) n 2

t (t 1) NCFt
t 1

1
(1 y) t

1
t(t 1)NCF t
(1 y)t 2
t1
66

Convexity (c)
Convexity is given by 1/2 the second derivative divided
by the price of a bond
1
1

2 (1 y ) 2

1
t (t 1) NCFt
/P

t
(1 y )
t 1

1 n
1
t (t 1) NCFt
/P
t 2
2 t 1
(1 y )
67

Measuring Macaulays Duration

and Convexity
A 12 per cent coupon bond is trading at 115.9708 to yield 8 per cent.
Determine its duration and convexity.

68

Calculating Convexity

Second Derivative:

Convexity is given by
1
x( Second Derivative) / Price
2
1
x 2281.7465 / 115 .9708
2
9.8376

P ( 4.11 / 1.08 x.005 9.8376 x.0052 ) x115 .9708 2.1781

69

Previous Example Add Convexity

Convexity= 6166.41/ 130.72=47.17

70

Invest to cover future liability

Liability in year n, bonds mature in year m

LIABILITY ARISES

BONDS MATURE

3..n ..m

Invest
Receive interest
and reinvest

Sell original bonds

plus bonds bought
using interest income
71

UNCERTAIN SUM

Immunisation strategy weighted average duration

of bonds equals cover duration of liability
Short Duration
Bonds Mature
0

LIABILITY ARISES

Long Duration
Bonds Mature

..n ..m

Invest
Receive interest
and reinvest. Also reinvest
the proceeds from the sale
of maturing bonds

Sell original bonds

plus bonds bought

72

Immunisation strategy weighted average duration

of bonds equals cover duration of liability (2)
INTEREST RATE FALLS
Short Duration
Bonds Mature
0

Long Duration
Bonds Mature

LIABILITY ARISES

..n ..m

Interest rate falls additional

bonds bought are more expensive
and interest income generated is
lower
but sold at higher price at time n

Interest rate falls higher price

received for long maturity bonds
at time n

+
73

Immunisation strategy weighted average duration

of bonds equals cover duration of liability (3)
INTEREST RATE RISES
Short Duration
Bonds Mature
0

Long Duration
Bonds Mature

LIABILITY ARISES

..n ..m

Interest rate rises additional

bonds bought are cheaper
and interest income generated is
higher
but sold at lower price at time n

Interest rate rises lower price

received for long maturity bonds
at time n

74

Immunisation Illustration
A pension fund has a liability of 10 million
to meet 4 years from now
The yield curve is flat and the interest rate
is 6 per cent
There are two zero bonds available for
investment, one matures after two years
and the other after 8 years
Construct an immunised portfolio

Immunisation Illustration - solution

PV of 10 m 10 x

1
7.921 m
(1.06)4

Weights
2 x (1 - w) 8w 4

6w 2

w 1/3

Invest one third in the 8 year zero and two thirds in the 2 year zero
ie 2.64 m and 5.281 m respectively
V4 2.64 m (1.06)8

1
5.281 x (1.06)2 (1.06)2 10 m
4
(1.06)

If the interest changes to 5.5 per cent the payoff from the 2 year zero
remains the same, but this will only earn 5.5 per cent for the subsequent
two years invested in the 8 year zero. However, with a lower interest rate the
the original 8 year zeros will be worth more after 4 years.
V4 2.64 m (1.06)8

1
5.281 x (1.06)2 (1.055 )2 10 m
4
(1.055 )