BONDS

SMU Classification: Restricted SMU Classification: Restricted
Chapter Fourteen
Bond Prices and

FNCE102: Financial Markets and Investments
(FMI)
Yields
WEEK 10
INVESTMENTS | BODIE, KANE,MARCUS

©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
SMU Classification: Restricted

Restricted SMU Classification: Restricted
Restricted
Chapter Overview Bond Characteristics
• Debt (i.e., fixed-income) securities promise • A bond is a security that is issued in

either a fixed stream of income or one that is connecting with a borrowing arrangement
determined according to a specified formula • Issuer agrees to make specified payments to the
bondholder on specified dates
• Bond markets
• Par value (i.e., face value) is the payment to
• Treasury, corporate and international bonds the bondholder on the bond’s maturity date
• Bond pricing and returns
• Coupon rate is a bond’s interest payments per
• Impact of default or credit risk on bond pricing dollar of par value
• Fixed-income derivatives • Bond indenture is the contract between the
• Credit default swaps or collateralized debt obligations issuer and the bondholder
INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS
©2021 McGraw-Hill Education 14-3 ©2021 McGraw-Hill Education 14-4

Restricted
Treasury Bonds and Notes Corporate Bonds

• Maturity • Callable bonds typically come with a period of call
• Treasury notes – 1 to 10 years protection
• Treasury bonds – 10 to 30 years • Convertible bonds give holders option to exchange
each bond for a specified number of shares of the
• Both bonds and notes may be purchased firm’s stock
directly from the Treasury • Put bond gives holder option to exchange for par
value at some date or to extend for a given number
of years
• Denominations
• Floating-rate bond has interest rate that is reset
• As small as $100, but $1,000 is more common
periodically according to a specified market rate
Restricted
Preferred Stock International Bonds
• Considered to be equity, but often included in Foreign bonds Eurobonds

the fixed-income universe • Issued by a borrower from a • Denominated in one
• Like bonds, preferred stock promises to pay a country other than the one currency, usually that of the
in which the bond is sold issuer, but sold in other
specified cash flow stream
• Denominated in the national markets
• Unlike bonds, failure to pay the promised dividend currency of the country in – Euroyen bonds
does not result in corporate bankruptcy which it is marketed – Eurosterling bonds
• Dividends owed simply cumulate – Samurai bonds • Not regulated by U.S.
• Preferred stock commonly pays a fixed dividend – Bulldog bonds federal agencies
• Rarely gives holders full voting privileges in firm


Restricted
Principal and Interest

Innovation in the Bond Market
Payments for TIPS
• Inverse floaters are like floating-rate bonds,
except coupon rate falls when the general level of
interest rates rises
• Asset-backed bonds use income from a specified
group of assets to service the debt
• Catastrophe bonds’ final payment depends on
whether there has been a catastrophe
• Indexed bonds make payments that are tied to a
general price index or the price of a commodity
• Treasury Inflation Protected Securities (TIPS)


Restricted
Bond Pricing Bond Pricing

(1 of 2) (2 of 2)
• First term of right-hand side of equation is the

present value of an annuity
• Second term is the present value of a single
amount, the final payment of the bond’s par
value
INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE, MARCUS
Restricted
Bond Prices and Yields

• Inverse relationship between price and yield is
a central feature of fixed-income securities
• Interest rate fluctuations represent the main
source of risk in the fixed-income market
• The price curve is convex and becomes flatter
at higher interest rates
• The longer the maturity of the bond, the more
sensitive the bond’s price to changes in
market interest rates
©2021 McGraw-Hill Education 14-14

Restricted
The Inverse Relationship Bond Prices at

Between Bond Prices and Yields Different Interest Rates


Restricted
Bond Yields: Yield to Maturity Yield to Maturity Example
• Yield to maturity (YTM) is the interest rate • Suppose an 8% coupon, 30-year bond is
that makes the present value of a bond’s selling for $1,276.76. What is the YTM?
payments equal to its price
$1276.76  
60
• Interpreted as a measure of the average rate of $40
return that will be earned on a bond if it is bought
now and held until maturity
• To calculate YTM, solve the bond price • r = 3% per half year
equation for the interest rate given the bond’s • Bond equivalent yield = 6%
price • EAR = ((1.03)2) - 1 = 6.09%
Restricted
Bond Yields: YTM vs. Current Yield Bond Yields: Yield to Call
• Yield to maturity • Low interest rates
• Bond’s internal rate of return • The price of the callable bond is flat since the risk
• Interpreted as compound rate of return over life of repurchase or call is high
of the bond assuming all coupons can be
reinvested at that yield
• Proxy for average return • High interest rates
• Current yield is the bond’s annual coupon • The price of the callable bond converges to that of
payment divided by its price a normal bond since the risk of call is negligible
• Premium bonds: Coupon rate > Current yield > YTM
• Discount bonds: Coupon rate < Current yield < YTM

Restricted
Bond Prices: Callable and Bond Yields:

Straight Debt Realized Compound Return vs YTM
• YTM will equal the rate of return realized over
the life of the bond if all coupons are
reinvested to earn the bond’s YTM
• Realized compound return is the compound
rate of return assuming that coupon payments
are reinvested until maturity
• Forecasting the realized compound yield over
various holding periods or investment
horizons is horizon analysis

Restricted
Prices Path of Two

Growth of Invested Funds
30-Year Maturity Bonds

Restricted
Bond Prices Over Time: Price of a 30-Year Zero-Coupon

YTM vs. HPR Bond Over Time
YTM HPR
• Average return if the • Rate of return over a
bond is held to maturity particular investment
• Depends on coupon period
rate, maturity, and par • Depends on the bond’s
value price at the end of the
• All of these are readily holding period, an
observable unknown future value
• Can only be forecasted


Restricted
Default Risk and Bond Pricing Default Risk and Bond Pricing
(1 of 2) (2 of 2)
• Credit risk, or default risk, is the risk the bond • Determinants of bond safety
will not make all promised payments • Coverage ratios
• Rating companies • Leverage (e.g., debt-to-equity) ratios
• Moody’s Investor Service, Standard & Poor’s, and • Liquidity ratios
Fitch Investor Service
• Profitability ratios
• Rating categories
• Cash flow-to-debt ratio
• Highest rating is AAA (or Aaa)
• Investment grade bonds are rated BBB/Baa or above
• Speculative-grade/junk bonds are rated below
BBB/Baa

Restricted
Financial Ratios by Rating Class Discriminant Analysis

• Can financial ratios can
be used to predict
default risk?
• Edward Altman used
discriminant analysis to
predict bankruptcy
• Firm is assigned a score
based on its financial
characteristics
• If score exceeds cut-off
value, the firm is
deemed creditworthy
Restricted
Altman Z-Score Bond Indentures

• Sinking fund calls for the issuer to periodically
repurchase some proportion of the
outstanding bonds prior to maturity
• Subordination clauses restrict the amount of
additional borrowing by the firm
• Z-scores below 1.2 indicate vulnerability to • Dividend restrictions limit the payment of
bankruptcy dividends by firms
• Scores between 1.23 and 2.90 are a gray area • Collateral is a particular asset that the
bondholders receive if the firm defaults
• Scores above 2.90 are considered safe

Restricted
YTM and Default Risk Yield Spreads

• Must distinguish between the bond’s
promised YTM and its expected YTM
• Promised YTM will be realized only if the firm
meets the obligations of the bond issue
• Expected YTM must consider the possibility of a
default
• Default premium is a differential in promised
yield that compensates the investor for the
risk inherent in purchasing a corporate bond
that entails some risk of default

Restricted
Credit Default Swaps (CDSs) Credit Default Swaps (CDSs)

(1 of 2) (2 of 2)
• Credit default swap (CDS) • Natural buyers of CDSs would be large

• Acts like an insurance policy on the default risk of bondholders or banks that wish to enhance
a bond or loan the creditworthiness of their outstanding
• Allows lenders to buy protection against default
loans
risk • But, CDSs can also be used to speculate on the
• Risk structure of interest rates and CDS prices financial health of particular issuers
ought to be tightly aligned • An example of this behavior would be an investor
in early 2008 who predicted the imminent
• CDS contracts trade on corporate as well as financial crisis and purchased CDS contracts on
sovereign debt mortgage bonds

Restricted
Credit Risk and Collateralized Debt

Collateralized Debt Obligations
Obligations (CDOs)
• Collateralized debt obligations (CDOs)
• Major mechanism to reallocate credit risk in the fixed-
income markets
• To create a CDO, a legally distinct entity to buy/resell a
portfolio of bonds must be established
• Structured Investment Vehicle (SIV)
• Loans are pooled together and split into tranches, where
each tranche is given a different level of seniority in
terms of its claims on the underlying loan pool
• Mortgage-backed CDOs were an investment disaster in
2007-2009


Restricted
Chapter Overview
• Examine various fixed-income portfolio
Chapter Sixteen strategies
• Distinguish between passive and active
approaches
Managing Bond • Discuss sensitivity of bond prices to interest

rates fluctuations
Portfolios • Sensitivity is measured by duration
• Consider refinements in the way interest rate
sensitivity is measured, focusing on bond
convexity
©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. ©2021 McGraw-Hill Education 16-40

Restricted
Interest Rate Sensitivity (1 of 2) Interest Rate Sensitivity (2 of 2)

1. Bond prices and yields are inversely related 4. Interest rate risk is less than proportional to
bond maturity
2. An increase in a bond’s yield to maturity
results in a smaller price change than a 5. Interest rate risk is inversely related to the
decrease in yield of equal magnitude bond’s coupon rate
3. Prices of long-term bonds tend to be more 6. The sensitivity of a bond’s price to a change
sensitive to interest rate changes than prices in its yield is inversely related to the YTM at
of short-term bonds which the bond is currently selling
Restricted
Change in Bond Price as aFunction Prices of 8% Coupon Bond

of Change in Yield to Maturity (Coupons Paid Semiannually)


Restricted
Prices of Zero-Coupon Bond Duration

(Semiannual Compounding)
• A measure of the average maturity of a bond’s
promised cash flows
• Macaulay’s duration equals the weighted
average of the times to each coupon or principal
payment
• Weight applied to each payment time is proportion of
total value of bond accounted for by that payment
(i.e., the PV of the payment divided by the bond price)
• Duration = Maturity for zero coupon bonds

• Duration < Maturity for coupon bonds


Restricted
Duration Calculation Duration Calculation
• Duration calculation:
T
D  t w t
t 1
CFt 1  y t
wt 
P
CFt  Cash Fl
P  Pric
y
Restricted
Interest Rate Risk Duration Rules

(1 of 2)
• Duration as a measure of interest rate • Rule 1

sensitivity • The duration of a zero-coupon bond equals its
time to maturity
• Price change is proportional to duration
• Rule 2
P    1 y   • Holding maturity constant, a bond’s duration is
 D    lower when the coupon rate is higher
P  1 y 
• Rule 3
• D* = Modified duration • Holding the coupon rate constant, a bond’s
P duration generally increases with its time to
  D * y maturity
P

Restricted
Duration Rules Bond Duration versus Bond Maturity

(2 of 2)
• Rule 4
• Holding other factors constant, the duration of a
coupon bond is higher when the bond’s yield to
maturity is lower
• Rule 5
• The duration of a level perpetuity is equal to:
1 y
y

Restricted
Bond Durations Convexity

(Yield to Maturity = 8% APR; Semiannual Coupons) (1 of 2)
• Relationship between bond prices and yields

is not linear
• Duration rule is a good approximation for only
small changes in bond yields
• Bonds with higher convexity exhibit higher
curvature in the price-yield relationship
• Convexity is measured as the rate of change of the
slope of the price-yield curve, expressed as a
fraction of the bond price
Restricted
Bond Price Convexity Convexity

(30-Year Maturity; 8% Coupon; Initial YTM = 8%) (2 of 2)
𝑻
𝟏 𝑪𝑭𝒕
𝑪𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 = ෍ (𝒕𝟐 + 𝒕)
𝑷 × (𝟏 + 𝒚)𝟐 (𝟏 + 𝒚)𝒕
𝒕=𝟏
• Accounting for convexity changes the equation:

𝜟𝑷 𝟏
= −𝑫 ∗ 𝜟𝒚 + [Convexity × (𝜟𝒚) 𝟐 ]
𝑷 𝟐


Restricted
The b o n d 1n F i g u r e 1 6 . 3 h 30-y r ff l u t u n t y < nd n 8 % c o u p o n . a n d s 11s t an Initial

y i e l d t o rn at u n ty of 8 0t,. B c a u s t h e c o u p o n , u t c q u u l s y i e l d t o r n a t u r i t y. t h b o n d s 11sot
par v a l u e . or $1 , 0 0 0 . Tl1c n1od1 1 d du, at1on of th b o n d a t i t s i n i t l I y l I d I s 1 1 2 6 y e r s , a n d
i t s c o n v c ' i t y i s 2 1 2 4 . vh1c h CfH'l be rifi d u s1n th e f o r m u l a n f o o t n o t 7 . ( Yo u c n f i n d a r
s p r e a d s h e t t o c a l c u l a t t h c o n v e 1ty of a 3 0 -y b o n d In C o n n ct or through yo u r c o u r s e
instructor.) If t h b o n d 's, 1Id in c, !) r m 8% to 1 0 %. th b o n d p n c wrll f II t o $ 8 1 1 . 4 6 , a
d e c l i n e o f 1 8 . s sc- . The dur at ionrul . E q u n t1o n 16 . 2 , v v o u l d p r d i e t a p r i c d c l l n e o f
p
P = -o· } =,- 1. 26 x .0 2 = - .2 2 5 2 . or - 2 2 .5 2 %
w h i c h i s c o n s i d e r a b l y n1or th n n tl'l b o n d p n c c t u a l l y falls. T h e durat1o n-wl th-conv xity
r u l e . Eq u a tio n 1 6 .4 , 1s fur n,o, n c c u r n tE>
C o n e 1ty x ( 6 y ) . i
=- 1 1.2 6 x .0 2 + :- x 1 2 . 4 x (.0 2) 2 = -.1827. o r - 18.2796
w h i c h i s f a r c l o s e r t o t11e a c t u a l c h a n g e t n b o n d p1,c (Notic t h t, h n w e u s e E q u a t i o n 1 6 . 5 .

w e m u s t e x p r e s s i n t e r e s t r a t s a s d e c i m a l s rat11e r th a n p re n ta g e s . The c h n n g e I n r a t e s f r o m
8 % to 1 0 % is r e p r e s e n t d a s 6 y = .0 2 .)
If th e c h a n g I n y i e l d w r e s m I I r. sa y. . 1 o. c o n v, •it y w o u l d m u t t e r l e s s . T h e p r i c e o f t h e
b o n d a c t u a l l y w o u l d f a l l t o $ 9 8 8 . 8 5 . a d e c l l n o f 1 . 11 5 % . W i t h o u t a c c o u n t i n g f o r c o n v e x i t y,
w e w o u l d predict a price decline of
6;= -o· 6y = - 1 1.26 x .oo 1 = - .o 1 1 26. or - 1 . 1 26%

A c c o u n t i n g f o r c o n v e x i t y. w e g e t a l m o s t t h prec,s ly corr ct a n s w r:
6; = - 1 1 . 2 6 x . 0 0 1 -r.' x 2 1 2 .4 x (.0 0 1 ) 2 = - .0 1 1 1 5 . o r - 1 . 1 1 5 %
INVESTMENTS | BODIE, KANE,MARCUS
Nevertheless. the duration r u l e I s quite accur at In this c a s . v n without accounting for
convex(™

Restricted
Convexity of Two Bonds Why Do Investors Like Convexity?
• Bonds with greater curvature gain more in

price when yields fall than they lose when
yields rise
• The more volatile interest rates, the more
attractive this asymmetry
• Investors must pay higher prices and accept

lower yields to maturity on bonds with greater
convexity
Restricted
Duration and Convexity of Callable

Bonds
• As rates fall, there is a ceiling on the bond’s
market price, which cannot rise above the call
price
• As rates fall, the bond is subject to price
compression
• Use effective duration:
P P
Effective Duration 
r

Restricted
Price–Yield Curve for a

Duration and Convexity: MBS
Callable Bond
• Mortgage-Backed Securities (MBS)
• Though the number of outstanding callable
corporate bonds has declined, the MBS market
has grown rapidly
• MBS are a portfolio of callable amortizing loans
• Homeowners may repay their loans at any time
• MBS have negative convexity
• Often sell for more than their principal balance
• Homeowners do not refinance as soon as rates drop, so
implicit call price is not a firm ceiling on MBS value

Restricted
Price-Yield Curve for a

Duration and Convexity: CMO
Mortgage-Backed Security
• Collateralized Mortgage Obligation (CMO)
• Further redirects the cash flow stream of the MBS
to several classes of derivative securities called
“tranches”
• Tranches may be designed to allocate interest rate
risk to investors most willing to bear that risk
• Different tranches may receive different coupon rates
• Some may be given preferential treatment in terms of
uncertainty over mortgage prepayment speeds

Restricted
Passive Bond Management Bond-Index Funds
• Passive managers take bond prices as fairly set • Similar to stock market indexing
and seek to control only the risk of their fixed- • Idea is to create a portfolio that mirrors the
income portfolio composition of an index that measures the broad
market
• Two classes of passive management:
• Challenges in construction:
• Indexing strategy
• Very difficult to purchase each security in the index in
• Immunization techniques proportion to its market value
• Both classes accept market prices as being • Many bonds are very thinly traded
correct, but differ greatly in terms of risk • Difficult rebalancing problems
exposure • Due to challenges, a cellular approach is pursued

Restricted
Stratification of Bonds into Cells Passive Management: Immunization
• Immunization techniques are used to shield

overall financial status from interest rate risk
• Widely used by pension funds, insurers, and banks
• Duration-matched assets and liabilities let the
asset portfolio meet the firm’s obligations
despite interest rate movement
• Balances reinvestment rate risk and price risk
• Rebalancing is required to realign the portfolio’s
duration with the duration of the obligation

Restricted

Restricted
Terminal Value of a 6-year Maturity

Growth of Invested Funds
Bond Portfolio After 5 Years


Restricted
Market Value Balance Sheet Immunization
INVESTMENTS | BODIE, KANE, MARCUS INVESTMENTS | BODIE, KANE,MARCUS


Restricted
Active Bond Management:

Cash Flow Matching and Dedication
Sources of Potential Profit
• Cash flow matching is a form of immunization that 1. Substitution swap – exchange of one bond for
another more attractively priced bond with similar
requires matching cash flows from a bond portfolio attributes
with those of an obligation 2. Intermarket spread swap – switching from one
• Imposes many constraints on bond selection process segment of the bond market to another (e.g., from
Treasuries to corporates)
• Cash flow matching n a multiperiod basis is referred 3. Rate anticipation swap – switch made between
to as a dedication strategy bonds of different durations in response to forecasts
of interest rates
• Manager selects either zero-coupon of coupon bonds
4. Pure yield pickup swap – moving to higher-yield,
with total cash flows in each period that match a series of longer-term bonds to capture the liquidity premium
obligations 5. Tax swap – swapping two similar bonds to capture a
• Once-and-for-all approach to eliminating interest rate risk tax benefit
Restricted
Active Bond Management:

Horizon Analysis
• Horizon analysis involves forecasting the
realized compound yield over various holding
periods of investment horizons
• Analyst selects a particular holding periods and
predicts the yield curve at the end of the period
• Given a bond’s time to maturity at the end of the
holding period, its yield can be read from the
predicted yield curve and its end-of-period price
calculated


BONDS

Uploaded by

Copyright:

Available Formats

You might also like

BONDS

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BONDS

Uploaded by

Copyright:

Available Formats

SMU Classification: Restricted SMU Classification: Restricted

Bond Prices and

INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

Chapter Overview Bond Characteristics

• Debt (i.e., fixed-income) securities promise • A bond is a security that is issued in

SMU Classification: Restricted

Treasury Bonds and Notes Corporate Bonds

Preferred Stock International Bonds

• Considered to be equity, but often included in Foreign bonds Eurobonds

• Rarely gives holders full voting privileges in firm

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

Principal and Interest

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

Bond Pricing Bond Pricing

• First term of right-hand side of equation is the

Bond Prices and Yields

SMU Classification: Restricted

The Inverse Relationship Bond Prices at

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

Bond Yields: Yield to Maturity Yield to Maturity Example

SMU Classification: Restricted

Bond Prices: Callable and Bond Yields:

SMU Classification: Restricted

Prices Path of Two

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

Bond Prices Over Time: Price of a 30-Year Zero-Coupon

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

SMU Classification: Restricted

Financial Ratios by Rating Class Discriminant Analysis

Altman Z-Score Bond Indentures

SMU Classification: Restricted

YTM and Default Risk Yield Spreads

SMU Classification: Restricted

Credit Default Swaps (CDSs) Credit Default Swaps (CDSs)

• Credit default swap (CDS) • Natural buyers of CDSs would be large

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

Credit Risk and Collateralized Debt

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted SMU Classification: Restricted

Managing Bond • Discuss sensitivity of bond prices to interest

SMU Classification: Restricted

Interest Rate Sensitivity (1 of 2) Interest Rate Sensitivity (2 of 2)

Change in Bond Price as aFunction Prices of 8% Coupon Bond

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

Prices of Zero-Coupon Bond Duration

• Duration = Maturity for zero coupon bonds

INVESTMENTS | BODIE, KANE,MARCUS INVESTMENTS | BODIE, KANE,MARCUS

SMU Classification: Restricted

Duration Calculation Duration Calculation

Interest Rate Risk Duration Rules

• Duration as a measure of interest rate • Rule 1

SMU Classification: Restricted

Duration Rules Bond Duration versus Bond Maturity