CHAPTER 6

BOND ANALYSIS AND VALUATION

Table of Contents
BOND ANALYSIS AND VALUATION ..................................................................................... 67
Table of Contents ...................................................................................................................... 67
Chapter Overview ...................................................................................................................... 68
Learning objectives: .................................................................................................................. 68
6.1 Bond Valuation.................................................................................................................. 68
6.2 Relationship Between Required Yield and Price at a Given Time .................................... 69
6.3 Relationship Among Coupon Rate, Required Yield and Price.......................................... 70
6.4 Bond Price Volatility ......................................................................................................... 74
6.4.1 Macaulay Duration .................................................................................................... 76
6.4.2 Bond Convexity ......................................................................................................... 77
6.5 Bond Portfolio ................................................................................................................... 78
6.6 Bond Portfolio Immunization ............................................................................................ 81
Study Questions ......................................................................................................................... 81

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Chapter 6 Bond analysis and evaluation

Chapter Overview

Bond Analysis and Valuation

Bond valuation

What determine interest rate

Price volatility of a bond

Bond portfolio

Immunization

Learning objectives:

After studying this chapter, students should be able to:

1. Determine the value of bonds

2. Describe the relationship between required yield and price of a bond
3. Describe the relationship among coupon rate, required yield and price of a bond

6.1 Bond Valuation

To value a bond, we discount its expected cash flows by the appropriate discount rate. The cash
flow from a bond consists of coupon payments until maturity plus the final payment of par value.

Bond Value = Present value of coupons + Present value of par value.

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VB = ∑ Ct /(1 + i)n + PV/ (1 + i)n

where ; VB = Value of bond

Ct = Coupon payment ($)
PV = Par Value (Principle)
i = required rate of return (interest rate)
n = number of Years to maturity

Example

Compute the price of a 9% coupon bond with 20 years to maturity and a par value of $1000 if the
required yield is 12% and coupon payment (i) pay annually and, (ii) pay semiannually.

i) VB = C (PVIFA 12%, 20) + PV (PVIF 12%,20)

= 90 1 – [ 1/ (1 + 0.12 )20] + 1000 [ 1/ (1 + 0.12 )20]
0.12
= 90 ( 7.4694 ) + 1000 ( 0.1037 )
= $775.95

i) if the coupon pay semiannually,

VB = C/2 (PVIFA 12%/2, 20 X 2 ) + PV (PVIF 12%/2, 20 X 2 )

= 90/2 1 – [ 1/ (1 + 0.12/2 )20 X 2] + 1000 [ 1/ (1 + 0.12/2 )20 X 2]
0.12/2
= 45 ( 15.0462 ) + 1000 ( 0.0972 )
= $774.28

6.2 Relationship Between Required Yield and Price at a Given

Time
The price of bond changes in the direction opposite from the change in the required yield. The
reason is that the price of bond is the present value of the cash flows. As the required yield
increases, the present value of the cash flows decreases; hence, the price decreases. The opposite
is true when the required yield decreases; the present value of cash flows increases and therefore,
the price of bond increases.

Exhibit 1: Price/Yield Relationship for a 20-year, 9% semiannual coupon bond

Required Present Value of Present of Price of Bond

Yield coupon payment Par Value
($) ($) ($)
5 1129.62 372.43 1502.05
6 1040.16 306.56 1346.72
7 960.98 252.57 1213.55
8 890.67 208.29 1098.96
9 828.07 171.93 1000.00
10 772.16 142.05 914.21
11 722.08 117.46 839.54

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12 677.08 97.22 774.30

13 636.55 80.54 717.09
14 599.93 66.78 666.71

If we graph the price relationship for any noncallable bond, we will find it has the “bowed”
shape. This shape is referred to as convex.

Price/Yield Relationship

Price

Required Yield

6.3 Relationship Among Coupon Rate, Required Yield and

Price
When the coupon rate equals the required yield, then the price equals the par value.

When the coupon rate is less than the required yield, then the price is less than the par value.

When the coupon rate is higher than the required yield, then the price is higher than the par
value.

See Exhibit 1.

Time Path of a Bond

For a bond selling at par value, the coupon rate is equal to the required yield. Thus, the price of a
bond selling at par will remain at par as the bond moves toward the maturity date.

When a bond selling at discount; as the bond moves toward maturity, its price will increase if
required yield does not change.

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Exhibit 2 : Time Path of a Discount Bond: 20-year, 9% semiannual Coupon,

12% required yield

Years Present Value of Present Value of Price of bond

remaining to coupon payment ($) par value
maturity ($) ($)
20 677.08 97.22 774.30
18 657.94 122.74 780.68
16 633.78 154.96 788.74
14 603.28 195.63 798.91
12 564.77 256.98 811.75
10 516.15 311.80 827.95
8 454.77 393.65 848.42
6 377.27 496.97 874.24
4 279.44 627.41 906.85
2 155.93 792.09 948.02
1 82.50 890.00 972.50
0 0.00 1000.00 1000.00

Price

Par Value

Market
Price

Number of years remaining to maturity 0

For a bond selling at premium, the price of bond declines as it moves toward maturity.

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Chapter 6 Bond analysis and evaluation

Exhibit 3 : Time path of premium Bond: 20-year, 9% semiannual coupon,

7% Required Yield

Years Present Value of Present Value of Price of bond

remaining to coupon payment ($) par value
maturity ($) ($)
20 960.98 252.57 1213.55
18 913.07 289.83 1202.90
16 858.10 332.59 1190.69
14 795.02 381.65 1176.67
12 722.63 437.96 1160.59
10 639.56 502.57 1142.13
8 544.24 576.71 1120.95
6 434.85 661.78 1096.63
4 309.33 759.41 1068.74
2 165.29 871.44 1036.73
1 85.49 933.51 1019.00
0 0.00 1000.00 1000.00

Price

Market
Price

Par Value

Number of years remaining to maturity 0

The price of a Zero-Coupon Bond

VB = PV/ (1 + i)n

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Example.

Compute the price of a zero-coupon bond that matures 10 years from now if the maturity value is
$1000 and the required yield is 8%.

VB = 1000/ (1 + 0.08)10
= $ 463.19

Current Yield

The current yield relates the annual coupon interest to the market price.

CY = Annual dollar coupon interest

Market Price

Example.

Compute the current yield for an 18-year, 6% coupon bond selling for $750.

CY = 6% X 1000
750
= 0.08 @ 8%

Yield To Maturity

The yield (YTM) is the interest rate that will make the present value of the cash flows equal to the
price (initial investment). To compute the YTM for a bond, we solve the rate i in the formula of
bond valuation.

VB = ∑ Ct /(1 + i)n + PV/ (1 + i)n

The easy way to calculate the YTM for a bond using formula Average YTM:

AYTM = Ct + [ ( PV - MPB) /n ]
(PV + MPB) /2

Example.

Compute YTM for an 18-year , 6% coupon bond selling for $700 if the coupon paid i) annually
and, ii) semiannually. The par value for this bond is $1000.

AYTM = 60 + [ ( 1000 - 700) /18 ]

(1000 + 700) /2
= 0.09 @ 9%

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Semiannually

AYTM = 60/2 + [ ( 1000 - 700) /18 X 2 ]

(1000 + 700) /2
= 0.045 @ 4.5 %

Yield To Call

For a callable bond, investor also compute another yield (or internal rate of return) measure, the
yield to call (YTC). The cash flows for computing the YTC are those that would result if the issue
were called on its first call date. The YTC is the interest rate that will make the present value of
the cash flows if the bond is held to the first call date equal to the price of the bond (or dirty
price).

The formula for Average YTC is

AYTC = Ct + [ ( CP - MPB) /nc ]

(CP + MPB) /2

where;
CP = the call price
nc = number of years to the first call date

Example.

Suppose a 20-year, 12 % coupon bond that is trading at 110 ($1100) with 5 years remaining to its
first call and a call price at 102 ($1020). Compute AYTC for this bond.

AYTC = 120 + [ ( 1020 - 1100) /5 ]

(1020 + 1100) /2
= 0.098 @ 9.8%

6.4 Bond Price Volatility

Bond value is influenced by many factors. When these factors change its direct or indirectly will
affected to the bond value or prices. This frequency changes is call bond price volatility. The
more volatile of the bond price, the higher the risk it is. And other wise, if the bond price is less
volatile, the lower the risk is.

Fund manager needs to have a way to measure a bond’s price volatility in managing the fund
strategies. The measures are commonly employed are:

1) Price value of basis point

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2) Yield value of a price change

3) Bond duration

Price value of basis point is the change in the price of the bond if the required yield changes
by 1 basis point (note: 100 basis point = 1%). It is express as the absolute value of the change
in price. Price value of basis point can be measure by dividing between the change in price
after changes in required yield over the changes in required yield.

Price value of basis point = BP1 - BPO

RY1 – RYO

where BP1 Bond price after changes in required yield

BPO Bond price before changes in required yield
RY1 New required yield
RYO Old required yield

Higher ratio of price value of basis point indicate that the bond is very volatile and sensitive
to the required yield and lower ratio indicate that the bond price is less sensitive to the
changes in required yield.

Yield value of a price change measure the changes in the yield for a specified changes in
bond value. This is estimated by first calculating the bond’s yield to maturity if the bond’s is
decreased by, say, $X . Then the difference between the initial yield and the new yield is the
yield value of an X ringgit price change.

Yield value of price change = YTM1 - YTMO

BP1 - BPO
Where BP1 New bond price
BPO Old bond price
YTM1 New yield to maturity after changes in bond price
YTMO Old yield to maturity before changes in bond price

The smaller this value, the greater the dollar price volatility, because it would take a smaller
change in yield to produce a price change of $ X.Bond duration is a period for investor to get
back the principal of his investment. It also known as a effective maturity term of the bond.
Duration is calculated by finding the weighted of a bond’s life where the various time periods in
which the bond generate cash flows are weighted according to the relative sizes of the present
value of these cash flows.

In most cases, the coupon bond duration is less than bond maturity term. Also, the lower the
coupon, generally the greater the duration of the bond. There is a consistency between the
properties of bond price volatility. That is the longer the maturity term, the greater the bond
price volatility. And the lower the coupon rate, the greater the bond price volatility. As we seen
before, the lower the coupon, generally the greater the duration of the bond. Thus we can
concluded that the greater the bond duration, the greater the price volatility.

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6.4.1 Macaulay Duration

Macaulay showed that the duration of a bond was a more appropriate measure of time
characteristics than the term to maturity of the bond because duration considers both the
repayment of capital at maturity and the size and timing of coupon payment prior to final
maturity. Using annual compounding, Duration (D) is

D = ∑ Ct (t) / (1 + i )t
∑ Ct / (1 + i )t

and Modified Duration (DMOD)

DMOD = D/ (1+ i )

Exhibit 4 : Calculation of Macaulay Duration and Modified Duration for a 4%, 10 year
selling to yield 8%.

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV at 8% PV of Flow PV as % of
(2) X (3) Price (1) X (5)
1 $40 0.9259 $37.04 0.0506 0.0506
2 40 0.8573 34.29 0.0469 0.0983
3 40 0.7938 31.75 0.0434 0.1302
4 40 0.7350 29.40 0.0402 0.1608
5 40 0.6806 27.22 0.0372 0.1860
6 40 0.6302 25.21 0.0345 0.2070
7 40 0.5835 23.34 0.0319 0.2233
8 40 0.5403 21.61 0.0295 0.2360
9 40 0.5002 20.01 0.0274 0.2466
10 40 0.4632 481.73 0.6585 6.5850
Sum 731.58 1.0000 8.1193

Macaulay Duration = 8.12

Modified Duration = D/ (1+ i )

= 8.12 / (1 + 0.08)
= 7.52

An estimate of the percentage change in bond price equals the change in yield times
modified duration:

% P = - DMOD X i

where,
i = the yield change in basis points divided by 100

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Example.

Consider a semiannual payment bond with Macaulay D = 10 years and yield = 8%. Assume that
the bond’s YTM to decline by 70 basis point.

DMOD = D/ (1+ i )
= 10/ (1+ 0.04 )
= 9.62

% P = - DMOD X i
= - 9.62 X - 0.70
= 6.73

It indicate that the bond price should increase by approximately 6.73 percent in respond to 70
basis-point decline in YTM. If the price of the bond before the decline in interest was $750, the
price after the decline in interest rate should be approximately:

$750 X (1.0673) = $ 800.48

6.4.2 Bond Convexity

Bond price have an indirect relationship with the yield. That means when yield is increase the
bond price will decrease and vise versa. But the actual relationship is not in the same proportion.
The price changes is greater when the yield decline, and the price changes is small when the yield
increase. These happen because bond price have a convexity relation with the yield. By refer to
the curve below, the bond price will move along the actual line if there is any changes in yield
either increase or decrease. The tangent to the actual line is the estimated bond price given
changes in yield. This estimation derives by using the Macaulay duration. We can see that, the
estimation is good when there is only a small changes in yield from the initial point. But when the
yield changes is greater, the price dispersion from actual line is higher. So its not suitable to make
the estimation.

As a solution, the estimation should included the convexity effect of the bond price and yield
relationship. Bond convexity is discussed below.

Graph to show the relationship between bond price and yield of the bond.

Price
Actual price line

Estimated price line

Yield

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6.5 Bond Portfolio

Bond portfolio means that the fund manager has decided to concentrate their investment only on
bond securities. The homogeneous investment medium in bond give an advantage for the manager to
manage the analysis and strategies since the portfolio has the same influencing factors that is the
market interest rate. Practitioners to calculate a bond’s portfolio yield have adopted two approaches:

i) Weighted average portfolio yield method (WAPY)

ii) Internal rate of return method (IRR)

WAPY method

It is found by calculating the weighted average of the yield for all the bonds in the portfolio. The
yield is weighted by proportion of the portfolio that the security makes up. In general, the bond
portfolio yield is:

k
Bp = ∑ wi . yi
1

Where Bp bond portfolio yield

wi market value of bond I relative to the total market value of the portfolio
yi the yield on bond i
k number of bond in the portfolio

Example
For example consider the bond portfolio below.

Bond Coupon rate Years Par value (RMMarket val Yield

maturity (RM) maturity
B1 7% 5 10 mil 9.209 mil 9%
B2 10.5% 7 20 mil 20 mil 10.5%
B3 6% 3 30 mil 28.05 mil 8.5%
Total 60 mil 57.259 mil

Step 1: Determine the weighted of each bond value in the portfolio

Weighted wi = Market Value i / Total Market Value

Step 2: Determine the weighted of yield for each bond

Step 3: Determine the bond portfolio yield

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Solution:

Bond Market value Weighted Yield to Weighted of yield

($) bond maturity wi.yi
wi yi
B1 9.209 mil 0.161 9% 1.45%
B2 20 mil 0.349 10.5% 3.66%
B3 28.05 mil 0.49 8.5% 4.17%
Total 57.259 mil 1.0 9.28%

The weighted average portfolio yield is then

0.161 (9%) + 0.349 (10.5%) + 0.49 (8.5%) = 9.28%

Under this method the yield calculated only rely on the market value of the bond and the bond yield
to maturity. Its do not take into consideration the investment horizon and the expected coupon to be
received during the investment period.

IRR method

IRR method is to estimate the portfolio yield based on expected cash flow for each bond. The cash
flow are in the form of coupon payment and the maturity amount. It is assumed that the cash flows
received are on the same date of payment and can be invested at the same rate of the bond yield.
Moreover, the portfolio also assumed to be held till the maturity of the longest-maturity bond in the
portfolio. From the assumption above, we can proceed with practice.

Example: Study the two-bonds portfolio which pays twice coupon per annum below.

Bond Coupon rate Years to Par value (RMMarket value

maturity (RM)
B1 4% 2 years 10 mil 8 mil
B2 5% 2.5 years 20 mil 18 mil
Total 30 mil 24 mil

Step 1: Determine the coupon payment for each bond

B1 coupon = CR x Par
= 4%/2 x 10 mil
= $ 200k

B2 coupon = 5%/2 x 20 mil

= $ 500k

Step 2: Determine the total cash flow at every period

Step 3: Present value of cash flows is equal to total current market value
Step 4: Estimate the IRR of the equation

Cash flow of three bond portfolio

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Period cash flo Bond B1 Bond B2 (R Portfolio PVIF i,n

received (RM ‘000) ‘000) Cash Flow
(RM ‘000)
1 200 500 700 (1+i)-1
2 200 500 700 (1+i)-2
3 200 500 700 (1+i) -3
4 10,200 500 10,700 (1+i)-4
5 20,500 20,500 (1+i)-5
Total $ 30 mil

The portfolio’s IRR is the interest rate that will make the present value of the portfolio’s cash flow is
equal to the portfolio’s initial investment at par value of RM 30 mil. Where the equation is

5
PV of cash flow = ∑ CFn. PVIF i,n
n=1

For this case, the equation will be:

30 = 0.7 PVIFi,1 + 0.7 PVIFi,2 + 0.7 PVIFi,3 + 10.7 PVIFi,4 + 20.5 PVIFi,5

The portfolio’s internal rate of return then can be obtained through trial and error method.

Since the average coupon is 2.5%, to simplify the problem let say i=2%.

When i=2%, present value of CF is 30.47

So to reduce the present value, we need to increase the i. Let say i=3%.

When i=3%, present value of CF is 29.17.

Now summarise the finding:

i=2% ---- 30.47

i=? ---- 30.00
i=3% ---- 29.17

To do interpolation:

i – 2% = 30 – 30.47
3% - 2% 29.17 – 30.47

i % = 2% + (3% - 2%) x [(30 – 30.47)/(29.17 – 30.47)]

= 2.36% (semiannualise return)

Annualise portfolio return = 2.36 x 2

= 4.72%

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Activity

1. Investor is considering a 2 bond portfolios as below:

Bond Coupon Years to Par Value Market value Yield to

maturity maturity
A 7% 2 10 mil 9.5 mil 9%
B 8% 3 20 mil 20 mil 10%

Calculate the bond’s portfolio yield using:

a) weighted average method
b) actual cash flow method

6.6 Bond Portfolio Immunization

Portfolio manager may decide the optimal strategy to immunize the portfolio from interest rate
changes. The immunization techniques attempt to derive a specified rate of return (generally quite
close to the current market rate) during a given investment horizon regardless of what happens to
the market interest rates. That means when the portfolio is immunized, any changes in interest
rate does not effected to the bond portfolio value. One can immunize the portfolio from interest
rate risk if the duration of the portfolio is always equal to the desired investment horizon. For
example, if the investment horizon is 8 years, the duration of the bond portfolio should equal 8
years to immunize the portfolio. Then, to attain a given duration, the weighted average duration
(with weights equal to the proportion of the value) is set at the desired length following an
interest payment, and all subsequent cash flows are invested in securities to keep the portfolio
duration equal to the remaining investment horizon.

Study Questions
1. Two bonds, bond A and bond B are being examined by an investor. Both bonds have face
values of RM10,000, yield-to-maturity of 9%, and four years to maturity. Bond A has
10% coupon rate and bond B has a coupon rate of 7.5%. Coupon are paid annually.

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i. Calculate the duration of Bonds A and B

ii. Explain the difference between the two bonds

2. a) You are considering investing in two bonds, both with 10 years to maturity. Bond A ia
a zero-coupon with 8% yield to maturity. Bond B pays RM20 annually, and its yield to
maturity is 10%.

i. Calculate the market price of each bond

ii. Calculate the duration of each bond
iii. If you invest in one bond A and one bond B, what is the duration of your
portfolio?

b) How is duration on a bond related to yield to maturity and coupon rate?

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