Chapter 12

Bond Prices and the Importance of Duration

Prof. Rushen Chahal

Prof. Rushen Chahal

We cannot gamble with anything so sacred as money.

- William McKinley

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Outline
Introduction Review of bond principles Bond pricing and returns Bond risk

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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

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Review of Bond Principles

Identification of bonds Classification of bonds Terms of repayment Bond cash flows Convertible bonds Registration

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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

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Classification of Bonds
Introduction Issuer Security Term

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Introduction
The bond indenture describes the details of a bond issue:
Description of the loan Terms of repayment Collateral Protective covenants Default provisions

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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

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Security
Definition Unsecured debt Secured debt

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Definition
The security of a bond refers to what backs the bond (what collateral reduces the risk of the loan)

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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

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Unsecured Debt (cont d)

Corporations:
Debentures are signature loans backed by the good name of the company Subordinated debentures are paid off after original debentures

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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

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Secured Debt (cont d)

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

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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

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Terms of Repayment
Interest only Sinking fund Balloon Income bonds

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Interest Only
Periodic payments are entirely interest The principal amount of the loan is repaid at maturity

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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

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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

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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

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Bond Cash Flows

Annuities Zero coupon bonds Variable rate bonds Consols

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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

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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

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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

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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.

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Convertible Bonds
Definition Security-backed bonds Commodity-backed bonds

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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

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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

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Commodity-Backed Bonds
Commodity-backed bonds are convertible into a tangible asset For example, silver or gold

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Registration
Bearer bonds Registered bonds Book entry bonds

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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.

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Registered Bonds
Registered bonds show the bondholder s name Registered bondholders receive interest checks in the mail from the issuer

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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

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Bond Pricing and Returns

Introduction Valuation equations Yield to maturity Realized compound yield Current yield Term structure of interest rates Spot rates
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Bond Pricing and Returns (cont d)

The conversion feature The matter of accrued interest

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Introduction
The current price of a bond is the market s estimation of what the expected cash flows are worth in today s dollars There is a relationship between:
The current bond price The bond s promised future cash flows The riskiness of the cash flows

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Valuation equations
Annuities Zero coupon bonds Variable rate bonds Consols

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Annuities
For a semiannual bond:
P0 !
t !1 2N

Ct

?1  ( R / 2)A

where N ! term of the bond in years Ct ! cash flow at time t R ! annual yield to maturity P0 ! current price of the bond
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Annuities (cont d)
Separating interest and principal components:

P0 !
t !1

2N

C
t

?1  ( R / 2)A ?1  ( R / 2)A

Par
2N

where C ! coupon payment

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Annuities (cont d)
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?

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Annuities (cont d)
Example (cont d)
Solution: Using a financial calculator and the following input provides the solution: N PV PMT FV CPT I = 20 = $870 = $35 = $1,000 = 4.50

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

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Zero Coupon Bonds

For a zero-coupon bond (annual and semiannual compounding):
Par P0 ! t (1  R) Par P0 ! 2t (1  R / 2)
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Zero Coupon Bonds (cont d)

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)?

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Zero Coupon Bonds (cont d)

Example (cont d)
Solution:

Par P0 ! (1  R / 2) 2t $1, 000 $400 ! (1  R / 2) 40 R ! 4.63%

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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:
Ct P0 ! (1  I t )t t !1 where I t ! interest rate at time t
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2N

Consols
Consols are perpetuities:
C P0 ! R

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Consols (cont d)
Example
A consol is selling for $900 and pays $60 annually in perpetuity. What is this consol s rate of return?

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Consols (cont d)
Example (cont d)
Solution:

C P0 ! R $60 R! ! 6.67% $900

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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

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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  ( R / x) A  1 where R ! yield to maturity x ! number of payment periods per year
x

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Realized Compound Yield (cont d)

Example
A bond has a yield to maturity of 9.00% and pays interest semiannually. What is this bond s effective annual rate?

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Realized Compound Yield (cont d)

Example (cont d)
Solution:

Effective annual rate ! ?1  ( R / x) A  1 ! ?1  (.009 / 2) A  1 ! 9.20%

2

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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

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Current Yield (cont d)

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

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Current Yield (cont d)

Example
A bond pays annual interest of $70 and has a current price of $870. What is this bond s current yield?

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Current Yield (cont d)

Example (cont d)
Solution: Current yield = $70/$870 = 8.17%

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Term Structure of Interest Rates

Yield curve Theories of interest rate structure

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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

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Information Used to Build A Yield Curve

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Theories of Interest Rate Structure

Expectations theory Liquidity preference theory Inflation premium theory

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Expectations Theory
According to the expectations theory of interest rates, investment opportunities with different time horizons should yield the same return:
(1  R2 ) 2 ! (1  R1 )(1  1 f 2 ) where 1 f 2 ! the forward rate from time 1 to time 2
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Expectations Theory (cont d)

Example
An investor can purchase a two-year CD at a rate of 5 percent. Alternatively, the investor can purchase two consecutive oneyear 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?

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Expectations Theory (cont d)

Example (cont d)
Solution:

(1  R2 ) 2 ! (1  R1 )(1  1 f 2 ) (1.05) ! (1.045)(1  1 f 2 )

2

(1.05) (1  1 f 2 ) ! (1.045) 1 f 2 ! 5.50%

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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 longterm money (the liquidity premium)

Under this theory, forward rates are higher than the expected interest rate in a year
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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

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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 security s life

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Spot Rates (cont d)

Spot Rate Curve

Interest Rate

Yield to Maturity

Time Until the Cash Flow

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Spot Rates (cont d)

Example
A six-month T-bill currently has a yield of 3.00%. A one-year Tnote with a 4.20% coupon sells for 102. Use bootstrapping to find the spot rate six months from now.

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Spot Rates (cont d)

Example (cont d)
Solution: Use the T-bill rate as the spot rate for the first six months in the valuation equation for the T-note:
21.00 1, 021  1, 020 ! (1  .03 / 2) (1  r2 / 2) 2 999.31 ! 1, 021 (1  r2 / 2) 2

(1  r2 / 2) 2 ! 1.022 r2 ! 2.16%
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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

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The Conversion Feature (cont d)

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

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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

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The Matter of Accrued Interest (cont d)

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

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The Matter of Accrued Interest (cont d)

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?

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The Matter of Accrued Interest (cont d)

Example (cont d)
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

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Bond Risk
Price risks Convenience risks Malkiel s interest rate theories Duration as a measure of interest rate risk

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Price Risks
Interest rate risk Default risk

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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

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Default Risk
Default risk measures the likelihood that a firm will be unable to pay the principal and interest on a bond Standard & Poor s Corporation and Moody s Investor Service are two leading advisory services monitoring default risk

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Default Risk (cont d)

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

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Convenience Risks
Definition Call risk Reinvestment rate risk Marketability risk

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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

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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

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Call Risk (cont d)

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 year s interest and then gradually declining to zero as the bond approaches maturity

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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

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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

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Malkiel s Interest Rate Theorems

Definition Theorem 1 Theorem 2 Theorem 3 Theorem 4 Theorem 5

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Definition
Malkiel s interest rate theorems provide information about how bond prices change as interest rates change Any good portfolio manager knows Malkiel s theorems

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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

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Theorem 2
Bonds with longer maturities will fluctuate more if interest rates change Long-term bonds have more interest rate risk

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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

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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

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Theorem 5
Capital gains from an interest rate decline exceed the capital loss from an equivalent interest rate increase

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Duration as A Measure of Interest Rate Risk

The concept of duration Calculating duration

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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

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The Concept of Duration (cont d)

Duration is a direct measure of interest rate risk:
The higher the duration, the higher the interest rate risk

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Calculating Duration
The traditional duration calculation:
Ct (1  R)t v t D ! t !1 Po where D ! duration Ct ! cash flow at time t R ! yield to maturity Po ! current price of the bond N ! years until bond maturity t ! time at which a cash flow is received
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Calculating Duration (cont d)

The closed-end formula for duration:
(1  R ) N 1  (1  R)  ( R v N ) F v N C  (1  R ) N 2 N R (1  R ) D! Po where F ! par value of the bond N ! number of periods until maturity R ! yield to maturity of the bond per period
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Calculating Duration (cont d)

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 bond s duration?

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Calculating Duration (cont d)

Example (cont d)
Solution: Using the closed-form formula for duration:
(1  R ) N 1  (1  R)  ( R v N ) F v N C  (1  R) N N 2 R (1  R ) D! Po (1.052)31  (1.052)  (0.052 v 30) 1, 000 v 30 50  (1.052)30 2 30 0.052 (1.052) ! 985 ! 15.69 years
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