Chapter 18 - The Analysis and Valuation of Bonds The Fundamentals of Bond Valuation The present-value model 2n t m t t 1 Pp C 2 P 2n (1 i 2) (1 i 2) Where: Pm=the current market price of the bond n = the number of years to maturity Ci = the annual coupon payment for bond i i = the prevailing yield to maturity for this bond issue Pp=the par value of the bond The Fundamentals of Bond Valuation • If yield < coupon rate, bond will be priced at a premium to its par value • If yield > coupon rate, bond will be priced at a discount to its par value • Price-yield relationship is convex (not a straight line) The Yield Model The expected yield on the bond may be computed from the market price Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2) 2n Where: i = the discount rate that will discount the cash flows to equal the current market price of the bond Computing Bond Yields Yield Measure Purpose Nominal Yield Measures the coupon rate Current yield Measures current income rate Promised yield to maturity Measures expected rate of return for bond held to maturity Measures expected rate of return for bond held to first call date Measures expected rate of return for a bond likely to be sold prior to maturity. It considers specified reinvestment assumptions and an estimated sales price. It can also measure the actual rate of return on a bond during some past period of time. Promised yield to call Realized (horizon) yield Nominal Yield Measures the coupon rate that a bond investor receives as a percent of the bond’s par value Current Yield Similar to dividend yield for stocks Important to income oriented investors CY = Ci/Pm where: CY = the current yield on a bond Ci = the annual coupon payment of bond i Pm = the current market price of the bond Promised Yield to Maturity • Widely used bond yield figure • Assumes – Investor holds bond to maturity – All the bond’s cash flow is reinvested at the computed yield to maturity Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2) 2n Solve for i that will equate the current price to all cash flows from the bond to maturity, similar to IRR Computing the Promised Yield to Maturity Two methods • Approximate promised yield – Easy, less accurate • Present-value model – More involved, more accurate Approximate Promised Yield APY Ci Pp Pm n Pp Pm 2 = Coupon + Annual Straight-Line Amortization of Capital Gain or Loss Average Investment Present-Value Model Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2) 2n Promised Yield to Call Approximation • May be less than yield to maturity • Reflects return to investor if bond is called and cannot be held to maturity Pc Pm C t P = call price of the bond nc AYC P = market price of the bond Pc Pm C = annual coupon payment nc = the number of years to first call date 2 Where: AYC = approximate yield to call (YTC) c m t Promised Yield to Call Present-Value Method 2 nc Ci / 2 Pc Pm t 2 nc (1 i ) t 1 (1 i ) Where: Pm = market price of the bond Ci = annual coupon payment nc = number of years to first call Pc = call price of the bond Realized Yield Approximation ARY Ci Where: Pf P hp Pf P 2 ARY = approximate realized yield to call (YTC) Pf = estimated future selling price of the bond Ci = annual coupon payment hp = the number of years in holding period of the bond Realized Yield Present-Value Method 2 hp Pf Ct / 2 Pm t 2 hp (1 i 2) t 1 (1 i 2) Calculating Future Bond Prices Pf 2 n 2 hp t 1 Pp Ci / 2 t 2 n 2 hp (1 i 2) (1 i 2) Where: Pf = estimated future price of the bond Ci = annual coupon payment n = number of years to maturity hp = holding period of the bond in years i = expected semiannual rate at the end of the holding period What Determines Interest Rates • Inverse relationship with bond prices • Forecasting interest rates • Fundamental determinants of interest rates i = RFR + I + RP where: – RFR = real risk-free rate of interest – I = expected rate of inflation – RP = risk premium What Determines Interest Rates • Effect of economic factors – – – – real growth rate tightness or ease of capital market expected inflation or supply and demand of loanable funds • Impact of bond characteristics – – – – credit quality term to maturity indenture provisions foreign bond risk including exchange rate risk and country risk What Determines Interest Rates • • • • • Term structure of interest rates Expectations hypothesis Liquidity preference hypothesis Segmented market hypothesis Trading implications of the term structure Expectations Hypothesis • Any long-term interest rate simply represents the geometric mean of current and future one-year interest rates expected to prevail over the maturity of the issue Liquidity Preference Theory • Long-term securities should provide higher returns than short-term obligations because investors are willing to sacrifice some yields to invest in short-maturity obligations to avoid the higher price volatility of longmaturity bonds Segmented-Market Hypothesis • Different institutional investors have different maturity needs that lead them to confine their security selections to specific maturity segments Trading Implications of the Term Structure • Information on maturities can help you formulate yield expectations by simply observing the shape of the yield curve What Determines the Price Volatility for Bonds Bond price change is measured as the percentage change in the price of the bond Where: EPB 1 BPB EPB = the ending price of the bond BPB = the beginning price of the bond What Determines the Price Volatility for Bonds Four Factors 1. Par value 2. Coupon 3. Years to maturity 4. Prevailing market interest rate What Determines the Price Volatility for Bonds Five observed behaviors 1. Bond prices move inversely to bond yields (interest rates) 2. For a given change in yields, longer maturity bonds post larger price changes, thus bond price volatility is directly related to maturity 3. Price volatility increases at a diminishing rate as term to maturity increases 4. Price movements resulting from equal absolute increases or decreases in yield are not symmetrical 5. Higher coupon issues show smaller percentage price fluctuation for a given change in yield, thus bond price volatility is inversely related to coupon The Duration Measure • Since price volatility of a bond varies inversely with its coupon and directly with its term to maturity, it is necessary to determine the best combination of these two variables to achieve your objective • A composite measure considering both coupon and maturity would be beneficial The Duration Measure n C t (t ) t t 1 (1 i ) D n Ct t t 1 (1 i ) n t PV (C ) t t 1 price Developed by Frederick R. Macaulay, 1938 Where: t = time period in which the coupon or principal payment occurs Ct = interest or principal payment that occurs in period t i = yield to maturity on the bond Characteristics of Duration • Duration of a bond with coupons is always less than its term to maturity because duration gives weight to these interim payments – A zero-coupon bond’s duration equals its maturity • There is an inverse relation between duration and coupon • There is a positive relation between term to maturity and duration, but duration increases at a decreasing rate with maturity • There is an inverse relation between YTM and duration • Sinking funds and call provisions can have a dramatic effect on a bond’s duration Modified Duration and Bond Price Volatility An adjusted measure of duration can be used to approximate the price volatility of a bond Macaulay duration modified duration YTM 1 Where: m m = number of payments a year YTM = nominal YTM Duration and Bond Price Volatility • Bond price movements will vary proportionally with modified duration for small changes in yields • An estimate of the percentage change in bond prices equals the change in yield time modified duration P 100 Dmod i P Where: P = change in price for the bond P = beginning price for the bond Dmod = the modified duration of the bond i = yield change in basis points divided by 100 Trading Strategies Using Duration • Longest-duration security provides the maximum price variation • If you expect a decline in interest rates, increase the average duration of your bond portfolio to experience maximum price volatility • If you expect an increase in interest rates, reduce the average duration to minimize your price decline • Note that the duration of your portfolio is the market-valueweighted average of the duration of the individual bonds in the portfolio Bond Duration in Years for Bonds Yielding 6 Percent Under Different Terms COUPON RATES Years to Maturity 8 1 5 10 20 50 100 0.02 0.04 0.06 0.08 0.995 4.756 8.891 14.981 19.452 17.567 17.167 0.990 4.558 8.169 12.980 17.129 17.232 17.167 0.985 4.393 7.662 11.904 16.273 17.120 17.167 0.981 4.254 7.286 11.232 15.829 17.064 17.167 Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies," Journal of Business 44, no. 4 (October 1971): 418. Copyright 1971, University of Chicago Press. Bond Convexity • Equation 19.6 is a linear approximation of bond price change for small changes in market yields P 100 D mod YTM P Bond Convexity • Modified duration is a linear approximation of bond price change for small changes in market yields P 100 Dmod i P • Price changes are not linear, but a curvilinear (convex) function Price-Yield Relationship for Bonds • The graph of prices relative to yields is not a straight line, but a curvilinear relationship • This can be applied to a single bond, a portfolio of bonds, or any stream of future cash flows • The convex price-yield relationship will differ among bonds or other cash flow streams depending on the coupon and maturity • The convexity of the price-yield relationship declines slower as the yield increases • Modified duration is the percentage change in price for a nominal change in yield Modified Duration Dmod dP di P For small changes this will give a good estimate, but this is a linear estimate on the tangent line Determinants of Convexity The convexity is the measure of the curvature and is the second derivative of price with resect to yield (d2P/di2) divided by price Convexity is the percentage change in dP/di for a given change in yield 2 d P 2 di Convexity P