Learning Objectives
1. Explain the fundamental characteristics of a bond
issue.
2. Explain the meaning and impact of bond ratings.
3. Understand how to read bond quotes in the
financial press.
4. Explain differences among various concepts of
yield such as: Current yield; Yield-to-maturity;
Yield-to-call; Anticipated Realized Yield.
5. Bond Duration and Portfolio Immunization
1
Bond and Fixed-Income
Fundamentals
 Secured and Unsecured Bonds
 Perpetual Bonds
 Sinking Fund Provisions
 Call provision
 Bond Ratings
 Junk Bonds
 Bond Quotes
2
The Bond Contract
 A bond normally represents a long term contractual
obligation of the firm to pay interest to the bondholder as
well as the face value of the bond at maturity.
 Par value is the face value of the bond.
 Coupon rate is the actual rate on the bond.
 Zero-Coupon bonds are deep discount bonds which
compensate the investor through capital appreciation.
Maturity date is the date on which the par value is paid.
 Serial payment under which bonds are paid off in
installments over the life of the issue.
11-2
3
Bond Indenture
 A bond indenture is a legal document which
covers the major provisions in a bond
agreement, administered by an independent
trustee.

Sinking Fund Provision

Call Provision

Put Provision
4
Secured Bonds
 A mortgage bond is backed by real property
pledged as a collateral.
 Equipment trust certificates are used by firms in
the transportation industry.
 Proceeds from the sale of certificates are used to
purchase new equipment which serves as collateral
for the certificate.
5
Unsecured Bonds
 Federal, state and local government issues are
unsecured.
 Debentures are long-term corporate unsecured
bonds. Senior, Junior, Subordinated.
 Income bonds require interest to be paid only to the
extent that it is earned as current income. Failure to
make interest payments will not force the firm into
bankruptcy.
6
The Composition of the Bond
Market
 Federal government is the single largest borrower.
 T-bills, T-notes, T-bonds and T-Strips
 Treasury Inflation Protection Securities (TIPS)
 Federally Sponsored Credit Agency Issues
 Federal Home Loan Bank
 Export-Import Bank
 Federal Intermediate Credit Banks
 Federal Farm Credit Bank
7
Bond Market Investors
 The bond market is dominated by large institutional
investors.
 They account for the more than 85% of trading.
 Individual investors are active in low denomination
($1000) corporate bonds & tax-free municipal
bonds and through bond mutual funds.
8
Bond Market Investors (Cont.)
 Banks are strong participants in the municipal bond
market.
 Foreign investors bank roll 10-15% of U.S.
Government debts.
 The bond market is a strong primary market but a
relatively weak secondary market.
 Bonds generally trade O.T.C. except for a few that
are listed on NYSE and AMEX.
9
Bond Ratings Sources
 Two major bond-rating agencies are:


Moody’s Investor Services, a subsidiary of Dunn
& Bradstreet.
Standard & Poor’s, a subsidiary of McGraw
Hill.
 Secondary bond-rating agencies are:

Fitch Investors Service

Duff & Phelp, Inc.
10
Bond Ratings
 A bond rating measures the likelihood of default.
Financial ratio analysis accounts for half of the
evaluation.
 Analysts also consider cash flow, earnings measures
and industry factors.
 Bond yields and bond ratings are inversely related.
11
Fundamentals of the bond Valuation
Process
 The Value of a Bond.
12
Computing Bond Yields
Yield Measure
Purpose
Nominal Yield
Measures the coupon rate
Current yield
Measures current income rate
Promised yield to
maturity
Promised yield to
call
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.
Realized (horizon)
yield
13
Rates of Return
 Approximate Promised Yield
APY = C + (Par – Market Price)/ NMaruity
.60 ( Market Price) + .4 (Par)
 Yield to Call:
AYC = C + (Call Price – Market Price)/ NCall
.60 ( Market Price) + .4 (Call Price)
 Approximate Realized Yield
ARY = C + (Realized Price – Market Price)/ NRealize
.60 ( Market Price) + .4 (Realize Price)
14
Corporate Bond Quotes
Cur
Bonds
Yld Vol Close
ATT 81/8 22 7.7 52 1053/8
Net
Chg
+ 1/4
52 of these bonds traded that day
Issued by AT&T
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
The closing price was 105 3/8% of par which was up 1/4
from the prior day
15
Term Structure of Interest Rates
 The relationship between maturity and
interest rates. It is also known as the Yield
Curve.
 Expectations Hypothesis suggests that the
long-term rate is an average of the
expectations of the future short-term rates
over the applicable time horizon.
 Reinforced by borrower/lender strategies.
16
Figure 12-1 Term Structure of Interest Rates
Yield
Yield
Normal
a
b
Maturity
Maturity
Yield
Yield
c
Maturity
d Maturity
17
The Movement of Interest Rates
(cont.)
 Liquidity Preference Theory states that the shape of
the yield curve is upward sloping. Investors will
pay a higher price for short-term securities because
they are more easily turned into cash without the
risk of large price changes.
 Investors demand higher returns from longer-term
securities.
18
The Movement of Interest Rates
(cont.)
 Market Segmentation Theory focuses on the
demand side of the market.


Banks tend to prefer Short Term liquid securities
to match the nature of their deposits.
Life insurance companies invest in Long-Term
bonds to match their Long-Term obligations.
19
Yield to
Maturity
Bond Value table
Coupon Rate 12 percent
Number of Years
10
20
30
8%
127.18%
139.59%
145.25%
10
112.46
117.16
118.93
12
100.00
100.00
100.00
14
89.41
86.55
85.96
Source: Reprinted by permission from the Thorndike Encyclopedia of Banking and financial tables, 1981. Copyright
©1981, Warren, Gorham and Lamont Inc. 210 South Street, boston MA. All rights reserved.
20
Investment Strategy: Interest-Rate
Considerations
 Bond Pricing Rules

1. Bond prices and interest rates are inversely
related.

2. Prices of long-term bonds are more sensitive
to a change in yields to maturity than short-term
bonds.

3. Bond price sensitivity increases at a
decreasing rate as maturity increases.
21
Investment Strategy: Interest-Rate
Considerations (cont.)




4. Bond prices are more sensitive to a decline in
market YTM than to a rise in YTM.
5. Prices of low-coupon bonds are more
sensitive to a change in YTM than high coupon
bonds.
6. Bond prices are more sensitive when YTM is
low than when YTM is high.
7. Margin trading magnifies profits and losses of
bond investments by a factor of 1/(margin
requirement).
22
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
23
What Determines the
Price Volatility for Bonds
 The maturity effect
 The coupon effect
 The yield level effect
 Some trading strategies
24
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
25
The Duration Measure
n
Ct (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
26
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
27
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
28
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
29
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
30