BOND MARKET, BOND VALUATION AND RISK

MUHAMMAD NASIRUDDIN
Definition of a Bond
A bond is a security that obligates the issuer to
make specified interest and principal payments to
the holder on specified dates.
 Coupon rate
 Face value (or par)
 Maturity (or term)
 Bonds are sometimes called fixed income

securities as it pays predetermined (fixed) coupon

or interest payments.
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Types of Bonds
 Pure Discount or Zero-Coupon Bonds
 Pay no coupons prior to maturity.
 Pay the bond’s face value at maturity.

 Coupon Bonds

 Pay a stated coupon at periodic intervals prior to maturity.

 Pay the bond’s face value at maturity.

 Perpetual Bonds (consols)

 No maturity date.
 Pay a stated coupon at periodic intervals.

 Self-Amortizing Bonds

 Pay a regular fixed amount each payment period over the life of the
bond.
 Principal repaid over time rather than at maturity.
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Bond Issuers
 Federal Government and its Agencies

 Local Municipalities

 Corporations

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U.S. Government Bonds
 Treasury Bills
 No coupons (zero coupon security)
 Face value paid at maturity
 Maturities up to one year
 Treasury Notes
 Coupons paid semiannually
 Face value paid at maturity
 Maturities from 2-10 years
 Treasury Bonds
 Coupons paid semiannually
 Face value paid at maturity
 Maturities over 10 years
 The 30-year bond is called the long bond.
 Treasury Strips
 Zero-coupon bond
 Created by “stripping” the coupons and principal from Treasury bonds and notes.
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U.S. Government Bonds

 No default risk; considered to be risk-free

 Exempt from state and local taxes

 Sold regularly through a network of primary dealers

 Traded regularly in the over-the-counter market

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Municipal Bonds
 Maturities from one month to 40 years
 Exempt from federal, state, and local taxes

 Generally two types:

 Revenue bonds – backed by the cashflow of the specific

project
 General Obligation bonds – backed by the full faith and
credit of the municipality
 Riskier than U.S. Government bonds

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Agencies Bonds
 Mortgage-Backed Bonds
 Bonds issued by U.S. Government agencies that are
backed by a pool of home mortgages
 Self-amortizing bonds
 Maturities up to 20 years

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Corporate Bonds
 Secured Bonds (Asset-Backed)
 Secured by real property
 Ownership of the property reverts to the bondholders
upon default

 Debentures (Unsecured)
 General creditors
 Have priority over stockholders, but are subordinate to
secured debt

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Common Features of Corporate Bonds
 Senior versus subordinated bonds
 Convertible bonds

 Callable bonds

 Putable bonds

 Sinking funds

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Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially

vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the
future.
Caa CCC Poor quality. Clear danger of default .

Ca CC High specullative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

D - In default.
Bond Valuation: An Example
 What is the market price of a U.S. Treasury bond that has a
coupon rate of 9%, a face value of $1,000 and matures exactly
10 years from today if the required yield to maturity is 10%
compounded semiannually?

0 6 12 18 24 ... 120 Months

$45 $45 $45 $45 $1045

45  1  1000

B 1  20   20  $937.69
0.05  1.05  1.05
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Valuing Coupon Bonds: The General Formula
 What is the market price of a U.S. Treasury bond that has a
coupon rate of 9%, a face value of $1,000 and matures exactly
10 years from today if the required yield to maturity is 10%
compounded semiannually?

0 1 2 3 4 ... n

C C C C C+F

C 1  F
 CAn  F 1  rd 
n
B  1  
n

rd   1  rd    1  rd  n
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Valuing Coupon Bonds (cont.)

New Semi-annual yield = 8%/2 = 4%

C   1  n F
B  1    
r   1  r    1  r n
What is the price of the bond if the yield to maturity is 8%
compounded semiannually?

1  1  1,000
B 1   * 45   $1067.95
0.04
Similarly: 1.04 20 
1.04 20

If r=12%: B=$ 827.95

If r= 9%: B=$1,000.00
Valuing Zero Coupon Bonds
 What is the current market price of a U.S. Treasury strip that
matures in exactly 5 years and has a face value of $1,000. The
yield to maturity or rd = 7.5%
1000
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= $696.56
1.075

 What is the yield to maturity on a U.S. Treasury strip that pays

$1,000 in exactly 7 years and is currently selling for $591.11?

1000
591.11 = 7
(1+ r)
D

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Bond Yields and Prices: The case of zero coupon bonds

 Consider three zero-coupon bonds with three different maturities,

all with
 Face value or FV =100
 Yield to Maturity or r =10%, compounded annually.

We obtain the following price table:

Time (r=10%) 1-yr Zero 3-yr Zero 5-yr Zero
0 $90.91 $75.13 $62.09
1 $100.00 $0 $0
2 $0 $0
3 $100.00 $0
4 $0
5 $100.00
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Bond Yields and Prices: The case of zero coupon bonds

 Suppose the yield would drop suddenly to 9%, or increase to

11%. How would prices respond?
Yield 1-yr Zero 3-yr Zero 5-yr Zero
10% $90.91 $75.13 $62.09
9% $91.74 $77.22 $64.99
% Change 0.91% 2.70% 4.46%
11% $90.09 $73.12 $59.35
% Change - 0.91% - 2.75% - 4.63%

 Bond prices move up if the yield drops, decrease if yield rises

 Prices respond more strongly for higher maturities
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Bond Yields and Prices: The case of coupon bonds
 Consider two bonds with the same 10% annual coupon with
different maturities of 5 years and 10 years.
 Both have yield of 10%

 What are the responses to a 1% yield change?

Yield 5-yr; 10% bond10-yr; 10% bond

10% $1,000.00 $1,000.00
11% $963.04 $941.40
% Change - 3.70% - 5.86%
9% $1,038.89 $1,064.17
% Change 3.89% 6.42%
 Price sensitivity of a coupon bond increases with the maturity just

like zero coupon bond in the last slide

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Bond Yields and Prices: The case of coupon bonds
 Now consider the following two bonds with same maturity of 5
years but different coupon rates; 6% annual coupon and 8%
annual coupon
 Both have yield of 10%

 Then, what are the price sensitivities of these bonds to a 1%

increase (decrease) in bond yields?

Yield 5-yr; 6% bond 5-yr; 8% bond
10% $848.37 $924.18
11% $815.20 $889.12
% Change - 3.91% -3.79%
9% $883.31 $961.10
% Change 4.12% 3.99%
 Why do we get different answers? 19
Key Bond-Interest Rate Relationship
 Bond prices are inversely related to changes in market interest
rates (yields) - bond sells at par if coupon equals the interest
rate (yield) , bond sells at discount if interest rate (yield) is
greater than coupon and bond sells at premium if interest rate
(yield) is lower than the coupon rate

 All else equal, long-term bonds are more sensitive to interest

rate changes than short-term bonds

 All else equal, low-coupon bonds are more sensitive to interest

rate changes than high-coupon bonds

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Do it Yourself: Bond Yields and Prices

 Suppose you purchase the U.S. Treasury bond (9% US treasury

bond w/ 10 year maturity and YTM 10%) and immediately
thereafter interest rates fall so that the new yield to maturity
on the bond is 8% compounded semiannually. What is the
bond’s new market price?
 Suppose the interest rises, so that the new yield is 12%

compounded semiannually. What is the market price now?

 Suppose the interest equals the coupon rate of 9%. What do

you observe?
Note:
 Coupon bonds can be regarded as portfolios of zero-coupon

bonds (how?)
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Major Risk in Bond Investment

 Price Risk Bond prices are inversely related to the

market rate of interest.
 Reinvestment Rate Risk The return we can earn from

reinvesting our coupon payments is positively related to

the market rate of interest.
Say, we are looking at a 10 year 10% coupon bond. Now if
we are interested only holding the bond for a year we will
more concerned with the Price Risk but if we choose to
hold it till maturity then we would be more concerned
about the reinvestment Risk
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Interest Rate Sensitivity
We established earlier:
 All else equal, long-term bonds are more sensitive to

interest rate changes than short-term bonds and

 All else equal, low-coupon bonds are more sensitive to

interest rate changes than high-coupon bonds

Now, given the two bonds as follows:
 20 year 9% coupon bond
 10 year 3% coupon bond
Which bond is more sensitive to interest rate changes?
 Is longer time to maturity going to be big factor or
 Is lower coupon rate going to be driving factor 23
 Interest Rate Sensitivity measurement - Duration
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 The answer of these previous questions are answered by

Duration. It measures the combined effect of maturity,
coupon rate, and YTM on bond’s price sensitivity

 Duration tells us that the bond with longer duration is going

to be more sensitive to interest rate changes than the bond
with shorter duration.

 Duration is also the holding period where the price risk offsets
the reinvestment risk

Muhammad Nasiruddin
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Duration: A Definition
 Duration is defined as a weighted average of the maturities of the individual
payments:
If we write the value of bond as
C1 C2 Ct Cn  F
B  ...   ... 
(1  r ) (1  r ) 2 (1  r ) t (1  r ) n
Then Duration is calculated as
C1 C2 Ct Cn  F
D 2  ...  t  ...  n
B(1  r ) B(1  r ) 2 B(1  r ) t B(1  r ) n
This definition of duration is sometimes also referred to as Macaulay
Duration.
 The duration of a zero coupon bond is equal to its maturity.
 Coupon bond is like portfolio of zero coupon bonds
 Compute average maturity of this portfolio

 Give each zero coupon bond a weight equal to the proportion in the total

value of the portfolio

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 Duration: A Definition
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 In short, we can express the Duration

T
 PV (Ct ) 
D   t
t 1  P0 
where P0 = the current market price of the bond
PV(Ct ) = the present value of the coupon payments
t = time periods
 Duration is expressed in unit of times; usually in years

 For example, if the duration of a bond is 8 years, the price of the bond

will change approximately 8% for a 1% change in interest rate or yield

to maturity

Muhammad Nasiruddin
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Calculating Duration
 Calculate the duration of the 10-year 5% annual coupon bond when Yield is
7%:
Year CF PV of CF PV/B0 Year*(PV/B0)
1 $50 $46.73 0.0544 0.054
2 $50 $43.67 0.0508 0.102
3 $50 $40.81 0.0475 0.142
4 $50 $38.14 0.0444 0.177
5 $50 $35.65 0.0415 0.207
6 $50 $33.32 0.0388 0.233
7 $50 $31.14 0.0362 0.254
8 $50 $29.10 0.0339 0.271
9 $50 $27.20 0.0316 0.285
10 $50 $25.42 0.0296 0.296
10 1000 $508.35 0.5914 5.914
    B0= 859.53   D = 7.935
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Do it yourself: Calculating Duration
 What is the interest rate sensitivity of the following two
bonds. Assume coupons are paid annually.
Bond A Bond B
Coupon rate 10% 0%
Face value $1,000 $1,000
Maturity 5 years 10 years
YTM 10% 10%
Price $1,000 $385.54

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 Duration and Change in Bond Price: Modified Duration
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 Modified Duration gives us more accurate (still approximate)

estimation of change in bond prices given a change in interest rates. It
is calculated as follows:

Mod D = D/(1+Y/m), where Y= Yield to Maturity or interest rate

m = number of coupons in a year
So we can calculate the Modified Duration of the previous bond as
Mod D = 7.935/(1+ .07/1) = 7.416%; meaning if the interest rate changes
1% then this bond’s price is expected to change 7.416%!

To reiterate, Duration is expressed in Years and Modified Duration is

expressed in Percentage. And we will ALWAYS use Modified Duration to
calculate the predicted change in bond price for change in interest rate!
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 Duration and Change in Bond Price: Modified Duration
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 You have a 10 year 8% annual coupon bond and current market rate of
interest is 7.25%. The bond will have a duration of 7.32 years. If interest
rate falls by 80 basis points, what will happen to bond price?

Answer: As Duration is given, we can calculate the Modified Duration as

Mod D = 7.32/(1+.0725/1) = 6.825%
The interest rate falls by 80 bp, so the price is expected to increase by
6.825% * (.80) = 5.46%
So the predicted bond price = Current Bond Price * 1.0546
= $1,052.07 * 1.0546 = $1,109.51

Muhammad Nasiruddin
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 Convexity
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 Note that Duration says the bond price will rise by 5.46%. Given the
annual coupon the bond was originally valued at $1,052.07, so duration
predicts a price of $1,109.51. However if we recalculate the bond price at
the new rate of 6.45% (7.25% - .80%), we get $1,111.69. What happened?

 Duration is not 100% accurate predictor of bond prices; it is a very close

approximation but still it is an approximation

 Convexity captures the degree to which the actual bond price, the solid
curved line, deviates from the estimated bond price, the dashed line,
when the interest rate changes (see the figure in next slide)

Muhammad Nasiruddin
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 Convexity
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 For larger interest rate moves, the relationship between the change in rates and the
change in bond prices is asymmetric.
 The bond price decrease resulting from a large interest rate increase will generally be
smaller than the price increase resulting from an interest rate decline of the same
magnitude. This asymmetry arises from the convex payoff pattern shown by the solid
curved line

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 Convexity
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So in short
 All else equal, the higher the duration (longer time to

maturity and lower coupon payment) , the more

error (convexity) there will be

 All else equal, the bigger the change in interest rates,

the more error there will be

Muhammad Nasiruddin
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 Duration and Immunization
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 In addition to helping us estimate how sensitive a bond is to interest

rates, duration can tell us approximate holding period where price risk
and re investment rate risk offset each other. Holding a bond to
Duration ‘immunizes‘ us from interest rate changes.
For example, if I look at a 10 year bond with one year investment horizon,
then price risk would be more important as I am not going to have much
time to reinvest the coupon. But If choose to hold the bond for 9 years,
then reinvestment rate risk would be more important to me as I need to
reinvest the coupons.
 Somewhere In between there, they are going to balance each other

out because they counteract each other. Increased in Interest rate is

good for one (reinvestment) and bad for other (price)
 Duration is the holding period where they offset each other!!

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 Immunization Example
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 Consider a 30 year 7% coupon bond whose duration is approx. 12 years

when required rate of return (yield to maturity) is 8.5%. Lets see what
happens to our ending net cash flows if interest rate drops by 1% or
increases by 1% after we buy the bond.

 While duration tells us about the price sensitivity, it also tells us that an
investor with a 12 year holding period should expect to have the same
total proceeds if interest rates increase/decrease. The extra interest
made from the reinvesting the coupon payments is almost exactly
offset by the lower selling price of the bond when interest rates rise to
9.5% as opposed to falling 7.5% (see next slide)

Muhammad Nasiruddin
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 Immunization Example
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FV at 9.5% FV at 7.5%
PMT 1 $70 $189.96 PMT 1 $70 $155.09
PMT 2 $70 $173.48 PMT 2 $70 $144.27
PMT 3 $70 $158.43 PMT 3 $70 $134.21
PMT 4 $70 $144.68 PMT 4 $70 $124.84
PMT 5 $70 $132.13 PMT 5 $70 $116.13
PMT 6 $70 $120.67 PMT 6 $70 $108.03
PMT 7 $70 $110.20 PMT 7 $70 $100.49
PMT 8 $70 $100.64 PMT 8 $70 $93.48
PMT 9 $70 $91.91 PMT 9 $70 $86.96
PMT 10 $70 $83.93 PMT 10 $70 $80.89
PMT 11 $70 $76.65 PMT 11 $70 $75.25
PMT 12 $70 $70.00 PMT 12 $70 $70.00
Selling Price $788.22 $788.22 Selling Price $951.47 $951.47

    $2,240.87     $2,241.13
Muhammad Nasiruddin
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