Chapter 17

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

17-1
 Rental rate for loanable funds
 Basis point
◦ 100 basis points equals one percentage point
 Riskless rate is foundation for other rates
◦ Approximated by rate on Treasury securities
◦ Other rates differ because of
 Maturity differentials
 Security risk premiums

17-2
 Opportunity cost of foregoing consumption
 Real risk-free rate (real rate) unaffected by
price changes or risk factors
 Nominal (observed) risk-free rate (RF)
includes a real component (rr) and expected
inflation (ei)

17-3
 All interest rates are described according to
the following formula

 Where rp incorporates all risk premiums

associated with features such as time to
maturity, liquidity, credit quality, etc.

17-4
 Relationship between time to maturity and
yield to maturity (yield curve)
 Yield curves
◦ Graphical depiction of the relationship
between yields and time to maturity
 Default risk held constant
 Observations involve tendencies rather than
exact relationships

18-5
18-5
 Upward-sloping yield curve
◦ Typical, interest rates rise with maturity
 Downward-sloping yield curves
◦ Unusual, predictor of recession?
 Term structure theories
◦ Explanations of the shape of the yield curve
◦ Pure expectations, liquidity preference, and
preferred habitat

18-6
18-6
 Forward rates are unobservable rates
expected to prevail in the future
 Are not observable, but are commonly
estimated from longer-term bond rates
 For example, the rate on a 3-yr bond can be
decomposed into the current 1-yr rate and
2 1-yr forward rates

17-7
 Long-term rates are an average of current
and expected future short-term rates
◦ No other considerations matter
 According to the theory, forward rates derived
from current longer-term rates equal expected
future rates
◦ Theory is not that forward rates will be
correct, but that there is a relationship
between them and current rates

18-8
18-8
 Slope of the Yield Curve:

> upward - investors expect interest rates

to increase
>downward - investors expect interest
rates to drop
>flat - investors expect interest rates to
remain constant
 Rates reflect current and expected short
rates, plus liquidity risk premiums
◦ Uncertainty increases with time
◦ Investors prefer to lend for short run,
borrowers to borrow for long run
 Liquidity premium is required to induce long-
term lending
 Derived forward rates do not equal expected
future rates

18-10
18-10
 Market participants have preferred maturity
segments
 Must be induced to move out of their
preferred segment
 Market segmentation theory is a more
extreme version
 Interest rates are determined by supply and
demand in each segment

17-11
Yield Spreads
 Risk premiums
 Result from differences in
◦ Default risk (bond rating), maturity, call
features, coupon rates, marketability, taxes
◦ Borrower actions
◦ Interest rates
 Function of variables associated with issue
or issuer
 Inversely related to business cycle
17-12
Bond Ratings - S&P/Moody’s
AAA Aaa Highest Quality
AA Aa High Quality
A A Upper Medium Grade
BBB Baa Medium Grade
BB Ba Speculative Elements
B B Speculative
CCC Caa Poor Standing
CC Ca Highly Speculative
C C Extremely Poor Prospects of
D ever attaining investment standing
 Premium: price > par value
 Discount: price < par value
 Interest payments (coupons) on bonds
usually paid semi-annually
 Current yield: ratio of coupon interest to
current market price
◦ Does not account for difference between
purchase price and redemption value

17-14
 Yield to maturity (YTM)
◦ Most commonly used measure of bond return
◦ Promised return received from a bond
purchased at the current market price
 If held to maturity
 And coupons reinvested at YTM
 Likelihood of meeting second condition is
extremely small

17-15
  Solve for YTM:

2n
Ct / 2 FV
P  t  2n
t 1 (1 YTM/2) (1 YTM/2)

 ◦ For a zero coupon bond the first term in the

equation does not exist.

17-16
Yield to First Call
 Some bonds are callable after deferred call
period
◦ YTM unrealistic for bonds likely to be called
 Often uses end of deferred call period
 Substitute number of periods until first call
for date and call price for face value
2c Ct / 2 CP
P  t
 2c
t 1( 1  YTC/ 2 ) ( 1  YTC/ 2 )

17-17
  Rate of return actually earned on a bond
given the reinvestment of coupons at
varying rates
◦ Determined after investment concluded

 Total dollar return 1/n 

RCY  2    1.0 

Purchase price of bond  


 Rarely equal to YTM


17-18
Reinvestment Risk
 Interest-on-interest
 Reinvestment rate risk
◦ Risk that future reinvestment rates will be less
than the YTM when bond is purchased
 Total dollar return on a bond consists of
◦ Coupons paid
◦ Capital gains or losses
◦ Interest income from reinvestment of coupons

17-19
Reinvestment Risk
 Reinvestment increase in importance as
coupon or time to maturity (or both) increase
◦ For long-term bonds, interest-on-interest can be
most important part of total return
◦ Zero-coupon bonds eliminate reinvestment rate
risk
 Horizon return analysis
◦ Bond returns based on assumptions about
reinvestment rates and yield-to-maturity at end of
investment horizon

17-20
 Intrinsic value
◦ An estimated value
◦ Present value of the expected cash flows
◦ Required to compute intrinsic value
 Expected cash flows
 Timing of expected cash flows
 Discount rate, or required rate of return by
investors

17-21
 Value of a coupon bond:
2n
Ct /2 FV
P  t  2n
t 1
(1 r/2) (1 r/2)

 Biggest problem is determining the discount

rate or required yield

 Required yield is the current market rate

earned on comparable bonds with same

maturity and credit risk

17-22
 Over time, bond prices move toward face
◦ On bond’s maturity date, it must be worth its
face value
 Bond prices move inversely to market yields
◦ Long-term bond prices fluctuate more than
short-term
 The change in bond prices due to a yield
change is directly related to time to maturity
and inversely related to coupon rate

17-23
B
o
n
d $1000

p
r
i
c
e 30 25 20 15 10 5 1
s Passage of time – Time left to maturity in years

17-24
  Holding maturity
constant, a rate
decrease raises prices
Price

a greater percent
than a corresponding
increase in rates
lowers prices
Market yield

17-25
Implications for Investors
 If anticipating a rate decrease, bond buyers
should purchase low-coupon, long-
maturity bonds
 If interest rates are expected to increase,
investors should consider bonds with large
coupons or short maturities or both

17-26
Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of

this work beyond that permitted in section 117 of
the 1976 United States Copyright Act without
express permission of the copyright owner is
unlawful. Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the
use of the information herein.

17-27
 Chapter 18

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

18-28
18-28
 Attractive to investors seeking steady
income and investors speculating on
interest rate decreases
◦ Yield appeals to long-term investors
◦ Price change appeals to short-term investors
 Promised yield to maturity is known at the
time of purchase
 Tend to have a low correlation with equities

18-29
18-29
 Attractive because foreign bonds:
◦ often offer higher yields than alternative
domestic bonds
◦ offer considerable diversification (low
correlation)
 Can be difficult to buy, so most investors buy
foreign-bond mutual funds or ETFs
 Subject to currency risk, which can be
hedged

18-30
18-30
 Bonds often benefit from a weak economy
 Interest rates reflect expected inflation
◦ Increased expected inflation tends to reduce
bond prices, increase yields
 These relationships do not always hold
 Both exchange rates and global economic
conditions affect bond prices

18-31
18-31
 Based on idea that bond market is rational
◦ Risk is the portfolio variable to control
 Have lower costs than active strategies
 Returns are based on known inputs, not
expectations
 Investors must still assess market
conditions
 Evidence tends to support passive approach

18-32
18-32
 Buy and hold
◦ No attempt to trade in search of higher
returns
◦ Ladder and barbell methods help reduce risk
 Indexing
◦ Attempt to match performance of a well-
known bond index
◦ Mutual funds, ETFs offer bond index funds

18-33
18-33
 Can be based on
◦ Forecasting interest rate changes
◦ Identifying abnormal yield spreads
◦ Identifying relative mis-pricing
 Requires expectations/forecasting
◦ Inputs not known at time of analysis

18-34
18-34
 Forecasting interest rate changes
◦ Notoriously difficult to do accurately
◦ Involves tradeoffs
◦ Shape of yield curve contains valuable information
 Horizon analysis
◦ Project bond performance over planned investment
horizon
◦ Investor selects bond expected to perform best

18-35
18-35
 Yield spread analysis
◦ Yield spread is difference between two
segments of bond market
◦ Assumes there is a “normal” spread level
◦ Attempts to profit from expected changes in
differences
◦ Investors sell bonds in one sector and buy in
another to profit as yield spread moves to
“normal” level

18-36
18-36
 Identifying mis-pricing
◦ Temporary mis-pricings do occur
◦ Bond swaps
 Simultaneous buying and selling of different
bonds
 Bond market now more accessible to
individual investors

18-37
18-37
 Duration is a weighted measure of a bond’s
lifetime
◦ Commonly stated in years
◦ Accounts for both size and timing of the bond’s
cash flows
 Present-value weighted average of the number
of years that investors receive cash flows
◦ Describes weighted average time to all payments

18-38
 Sum of time-weighted PV of cash flows
n PV(CFt )
D  t
t 1Market Price

 Duration depends on three factors:

◦ Maturity of the bond
◦ Coupon payments
◦ Yield to maturity

18-39
 Duration increases with time to maturity but
at a decreasing rate
◦ For coupon paying bonds, duration is always less
than maturity
◦ For zero coupon-bonds, duration equals time to
maturity
 Duration is inversely related to yield-to-
maturity
 Duration is inversely related to coupon rate

18-40
 Allows comparison of effective lives of
alternative bonds
 Used in bond management strategies,
particularly immunization
 Direct measure of interest rate risk
◦ Measures bond price sensitivity to interest
rate movements
◦ This characteristic is most important for bond
investors

18-41
 Bond price changes are directly related to
duration
◦ Duration indicates change in bond’s price for a
given change in interest rates
 Modified duration = D* = D/(1+ytm)
 D* can be used to calculate the bond’s
percentage price change for a given change
in yield

P / P   D *  r
18-42
 As size of yield change increases, modified
duration becomes poorer approximation
◦ Duration equation assumes a linear price-yield
relationship, but true relationship is curvilinear
 Refers to the degree to which duration
changes as the yield to maturity changes
 Convexity largest for bonds with low coupon,
long-maturity, and low yield to maturity

18-43
Managing
Managing Price
Price Volatility
Volatility
 To obtain maximum (minimum) price
volatility, investors should choose bonds with
the longest (shortest) duration
 Duration is additive
◦ Portfolio duration is just a weighted average
 Duration measures volatility due to interest
rate changes
◦ Liquidity and default are also prominent types of
risk

18-44
 Used to protect a bond portfolio against
interest rate risk
◦ Interest rate risk composed of price and
reinvestment risk
 Move in opposite directions, offset each other

◦ Price risk result of relationship between bond

prices and rates
◦ Reinvestment risk result of uncertainty about
rate at which future coupon income invested

18-45
18-45
 Risk components move in opposite directions
◦ Favorable results on one side can be used to
offset unfavorable results on the other
 Portfolio immunized if the duration (not
maturity) of the portfolio is equal to investment
horizon
 In reality, immunization not easy to implement
◦ Immunization requires frequent rebalancing

18-46
18-46
 Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of

this work beyond that permitted in section 117 of
the 1976 United States Copyright Act without
express permission of the copyright owner is
unlawful. Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the
use of the information herein.

18-47
18-47