Bond Valuation and Interest Rates

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Bond Valuation and Interest Rates

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CORPORATE FINANCE

Laurence Booth W. Sean Cleary

Rates

Prepared by

Ken Hartviksen and Robert Ironside

CHAPTER 6

Bond Valuation and Interest

Rates

Lecture Agenda

Learning Objectives

Important Terms

Basic Structure of Bonds

Valuing Bonds

Bond Yields

Interest Rate Determinants

Other Types of Bonds/Debt Instruments

Summary and Conclusions

Appendix Bond Duration

CHAPTER 6 Bond Valuation and

Interest Rates

6-3

Learning Objectives

How to value bonds given an appropriate discount rate

How to determine the discount rate or yield given the

market value of a bond

How market interest rates or yields affect bond investors

How bond prices change over time

The factors (both domestic and global) that affect

interest rates

Interest Rates

6-4

Balloon payment

Bills

Bond indenture

Bullet payment

Call prices

Callable bonds

Canada Savings Bonds

Collateral trust bonds

Coupons

Current yield

Debentures

Debt ratings

Default free

Default risk

Discount (premium)

Duration

Equipment trust certificates

Expectations theory

Extendible bonds

Face value

Floating rate bonds

Interest payments

Interest rate parity (IRP)

theory

Interest rate risk

Issue-specific premiums

Liquidity preference theory

Maturity value

Interest Rates

6-5

Mortgage bonds

Nominal interest rates

Notes

Paper

Par value

Protective covenants

Purchase fund provisions

Real return bonds

Retractable bonds

Risk-free rate

Sinking fund provisions

Spread

Term structure of

interest rates

Term to maturity

Yield curve

Yield to maturity

Zero coupon bond

Interest Rates

6-6

Bond Valuation and Interest Rates

What is a Bond?

In its broadest sense, a bond is any debt

instrument that promises a fixed income

stream to the holder

Fixed income securities are often classified

according to maturity, as follows:

1 year < Maturity < 7 years Notes

< 7 years Bonds

Interest Rates

6-8

A typical bond has the following

characteristics:

A fixed face or par value, paid to the holder of the

bond, at maturity

A fixed coupon, which specifies the interest payable

over the life of the bond

Coupons are usually paid either annually or semi-annually

Interest Rates

6-9

Note:

The coupon rate, the maturity date, par value are all

set (fixed) at the time the bond was originally sold to

the market

The coupon rate will reflect the required rates of

interest at the time of bond issue.

After issue, interest rates, and required rates of return

will change. Because everything is fixed except the

required rate of return and the bond price, as rates

change, so too will bond prices!

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 10

Bonds may be either:

Bearer bonds

Registered bonds

issuer of the bond and the investors who hold it

The market price of a bond is equal to the

present value of the payments promised by the

bond

(See the basic pattern of cash flows from a traditional bond on the next slide)

Interest Rates

6 - 11

Cash Flow Pattern for a Traditional Coupon-Paying Bond

6-1 FIGURE

00

11

II

22

II

33

II

II

nn

II

FF

Interest Rates

6 - 12

0

Purchase Coupon

Price

Cash Outflows

to the Investor

Coupon

Coupon

Coupon

Coupon +

Face Value

Cash Inflows

to the Investor

value of the cash inflows, discounted at the bonds yield-to-maturity

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 13

Bond Valuation and Interest Rates

Bond Indenture

The bond indenture is the contract between

the issuer and the holder. It specifies:

Collateral

Positive & negative covenants

Par or face value (usually increments of $1,000)

Bond pricing usually shown as the price per $100 of

par value, which is equal to the percentage of the

bonds face value

Interest Rates

6 - 15

Term-to-maturity the time remaining to the

bonds maturity date

Coupon rate the annual percentage interest

paid on the bonds face value. To calculate

the dollar value of the annual coupon,

multiply the coupon rate times the face value.

If the coupon is paid twice a year, divide the annual

coupon by two

Example: A $1000 bond with an 8% coupon rate will

have an $80 coupon if paid annually or a $40 coupon

if paid semi-annually.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 16

Mortgage bonds secured by real assets

Debentures either unsecured or secured

with a floating charge over the firms assets

Collateral trust bonds secured by a pledge

of financial assets, such as common stock,

other bonds or treasury bills

Equipment trust certificates secured by a

pledge of equipment, such as railway rolling

stock

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 17

Covenants

Positive covenants things the firm agrees to do

Supply periodic financial statements

Maintain certain ratios

do

Restrictions on the amount of debt the firm can take on

Prevents the firm from acquiring or disposing of assets

Interest Rates

6 - 18

Call feature allows the issuer to redeem or

pay off the bond prior to maturity, usually at a

premium

Retractable bonds allows the holder to sell

the bonds back to the issuer before maturity

Extendible bonds allows the holder to

extend the maturity of the bond

Sinking funds funds set aside by the issuer

to ensure the firm is able to redeem the bond

at maturity

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 19

Convertible bonds can be converted into

common stock at a pre-determined

conversion price

Interest Rates

6 - 20

Bond Valuation

Annual Coupon Payments

Bond Valuation and Interest Rates

Bond Valuation

The value of a bond is a function of:

Term to maturity

Coupon rate

Investors required rate of return (discount rate is also

known as the bonds yield to maturity)

Interest Rates

6 - 22

Bond Value

General Formula

[ 6-1]

1

1 ( 1 k )n

b

B I

kb

1

F

n

(

1

k

)

Where:

I = interest (or coupon ) payments

kb = the bond discount rate (or market rate)

n = the term to maturity

F = Face (or par) value of the bond

Interest Rates

6 - 23

What is the market price of a ten year, $1,000 bond

with a 5% coupon, if the bonds yield-to-maturity is

6%?

1 1 kb n

F

BI

n

k

1

b

b

1 1.06 10

1, 000

50

10

0.06

1.06

Calculator Approach:

1,000

50

10

I/Y

CPT PV 926.40

FV

PMT

N

6

$926.40

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 24

Bond Valuation

Semi-Annual Coupon Payments

Bond Valuation and Interest Rates

So far, we have assumed that all bonds have annual

pay coupons. While this is true for many Eurobonds, it

is not true for most domestic bond issues, which have

coupons that are paid semi-annually

To adjust for semi-annual coupons, we must make

three changes:

Size of the coupon payment (divide the annual coupon payment

by 2 to get the cash flow paid each 6 months )

Number of periods (multiply number of years to maturity by 2 to

get number of semi-annual periods)

Yield-to-maturity (divide by 2 to get the semi-annual yield)

Once you solve for the semi-annual yield, you will want to

convert it back to an annualized rate of return (YTM).

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 26

For example, suppose you want to value a 5 year,

$10,000 Government of Canada bond with a 4%

coupon, paid twice a year, given a YTM of 6%.

kb

1

I

2

B

kb

2

400

2 n

$9,146.98

kb

1

.06

1

2

0.06

2

Calculator Approach:

10,000

FV

400 2 =

PMT

5x2=

N

6 2 = I/Y

CPT PV 926.40

2n

2 x 5

10, 000

.06

1

2 x5

Interest Rates

6 - 27

Bond Valuation and Interest Rates

There are three factors that affect the price

volatility of a bond

Yield to maturity

Time to maturity

Size of coupon

Interest Rates

6 - 29

Prices and Yields to Maturity

When interest rates (required rate of return

on the bond) increase, bond prices fall.

Interest Rates

6 - 30

Bond Price-Yield Curve

6 - 2 FIGURE

Price ($)

Interest Rates

6 - 31

Bond Convexity

The convexity of the price/YTM graph reveals

two important insights:

The price rise due to a fall in YTM is greater than the

price decline due to a rise in YTM, given an identical

change in the YTM

For a given change in YTM, bond prices will change

more when interest rates are low than when they are

high

Interest Rates

6 - 32

The relationship between the coupon rate and the

bonds yield-to-maturity (YTM) determines if the

bond will sell at a premium, at a discount or at par

If

Then

Bond Sells at a:

Discount

Coupon = YTM

Market = Face

Par

Premium

Interest Rates

6 - 33

Inverse Relationship Between Yields and Prices

Bond prices go down when the YTM goes up

Bond prices go up when the YTM goes down

Look at the graph on the next slide. It shows how

the price of a 25 year, 10% coupon bond changes

as the bonds YTM varies from 1% to 30%

Note that the graph is not linear instead it is

said to be convex to the origin

Interest Rates

6 - 34

As interest rates

increase, bond prices

fall, but fall at a

decreasing rate

Interest Rates

6 - 35

Term to Maturity and Size of Coupon

price volatility than short bonds

Size of coupon low coupon bonds have

greater price volatility than high coupon

bonds

Interest Rates

6 - 36

Time to Maturity

Time to maturity

Long bonds have greater price volatility than short

bonds

The longer the bond, the longer the period for which the

cash flows are fixed

More distant cash flows are affected more in the

discounting process (remember the exponential nature of

compoundingand that discounting is the inverse of

compounding)

The most distant cash flow from a bond investment is the

most important (it is the face value of the bond) and this

cash flow is affected the greatest in the discounting

process.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 37

Size of the Coupon Rate

Size of coupon

Low coupon bonds have greater price volatility

than high coupon bonds

High coupons act like a stabilizing device, since a

greater proportion of the bonds total cash flows occur

closer to today & are therefore less affected by a change

in YTM

The greatest price volatility is found with stripped bonds

(no coupon payments)

Interest Rates

6 - 38

The sensitivity of bond prices to changes in

interest rates is a measure of the bonds

interest rate risk

A bonds interest rate risk is affected by:

Yield to maturity

Term to maturity

Size of coupon

number called Duration

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 39

Duration

Duration is a measure of interest rate risk

The higher the duration, the more sensitive

the bond is to changes in interest rates

A bonds duration will be higher if its:

YTM is lower

Term to maturity is longer

Coupon is lower

(See the Appendix to this slide set for a complete discussion of duration)

Interest Rates

6 - 40

Bond Quotations

Bond Valuation and Interest Rates

Bond Prices

Discount and Premium Priced Bonds

priced

Bonds trading at prices < par discount

priced

Interest Rates

6 - 42

Bond Quotations

Issuer

Coupon

Maturity

Price

Yield

Canada

5.500

2009-Jun-01

103.79

4.16

The bonds maturity

date.

The

bonds price is in

to maturity (BEY) It takes on meaning

on the

dollars

assuming a par

The

coupon

rate

in

percent.

The

issuer

of

the

bond.

expressed in percent on anbond reportingvalue

pageof $100. Since this

annualized basis.

because there bond

will beprice

a is greater than

current date. The

$100, it is called a

difference betweenpremium

the two priced bond.

dates is the number of

years to maturity.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 43

The quoted price is the price reported by the

media

The cash price is the price paid by an investor

The cash price includes both the quoted price plus

any interest that has accrued since the last coupon

payment date

Interest Rates

6 - 44

bond with a 5% coupon, paid semi-annually.

Today is July 15th. The last coupon was paid

June 30th. If the quoted price is $902, how

much is the cash price?

Interest Rates

6 - 45

The cash price is equal to:

Quoted price of $902

Plus 15 days of interest

15

365

902 2.05

$904.05

Interest Rates

6 - 46

Bond Yields

Bond Valuation and Interest Rates

Bond Yields

The Yield to Maturity = Investors Required Rate of Return

used to evaluate bonds

The yield earned by a bond investor who:

Holds the bond to maturity

Reinvests all of the coupons at the YTM for the remaining

term to maturity (the reinvestment rate assumption)

Interest Rates

6 - 48

[ 6-2]

1

1

( 1 YTM)n

B I

YTM

1

F

n

(

1

YTM)

the sum of the present value of promised cash flows to

equal the current bond price.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 49

To solve for YTM, solve for YTM in the following

formula:

1 1 YTM n

F

BI

n

YTM

1 YTM

There is a Problem:

You cant solve for YTM algebraically; therefore, must either

use a financial calculator, Excel, trial & error or approximation

formula.

Interest Rates

6 - 50

Example: What is the YTM on a 10 year, 5% coupon

bond (annual pay coupons) that is selling for $980?

1 1 YTM n

F

BI

n

YTM

1 YTM

1 1 YTM 10

1, 000

980 50

10

YTM

1 YTM

Financial Calculator

1,000 FV

980 +/- PV

50

PMT

51

N

I/Y

5.26%

YTM 5.26%

Interest Rates

6 - 51

When solving for YTM with a semi-annual pay

coupon, the yield obtained must be multiplied

by two to obtain the annual YTM

Example: What is the YTM for a 20 year,

$1,000 bond with a 6% coupon, paid semiannually, given a current market price of

$1,030?

Interest Rates

6 - 52

What is the YTM for a 20 year, $1,000 bond with a 6%

coupon, paid semi-annually, given a current market price of

$1,030?

1 1 YTM n

F

BI

n

YTM

1

YTM

1 1 YTM 40

1, 000

1, 030 30

40

YTM

1 YTM

Financial Calculator

1,000

FV

1,030 +/- PV

30

PMT

40

N

I/Y

2.87 x 2

= 5.746%

Interest Rates

6 - 53

Solve for Yield to Maturity

Bond Valuation and Interest Rates

This formula gives you a quick estimate of the

yield to maturity

It is an estimate because it is based on a linear

approximation (again you will remember the

exponential nature of compound interest)

inherent in the approximated YTM?

NO

Remember a YTM is an ex ante calculation as a

forecast, it is based on assumptions which may or

may not hold in this case, therefore as a forecast or

estimate, the approximation approach should be fine.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 55

F = Face Value = Par Value = $1,000

B = Bond Price

I = the semi annual coupon interest

N = number of semi-annual periods left to maturity

F-B

I

Semi - annual Yield to Maturity n

FB

2

YTM 2 semi - annual YTM

YTM (1 semi - annual YTM) 2 1

Interest Rates

6 - 56

Example

Find the yield-to-maturity of a 5 year 6%

coupon bond that is currently priced at $850.

(Always assume the coupon interest is paid

semi-annually.)

Therefore there is coupon interest of $30 paid semi-annually

There are 10 semi-annual periods left until maturity

Interest Rates

6 - 57

Find the yield-to-maturity of a 5 year 6% coupon bond

that is currently priced at $850. (Always assume the

coupon interest is paid semi-annually.)

$1,000 $850

F-B

$30

I

$15 $30

10

Semi - annual Yield to Maturity n

0.0486

FB

$1,850

$925

2

2

YTM 2 semi - annual YTM 0.0486 2 0.09273 9.3%

YTM (1 semi - annual YTM) 2 1 (1.0486) 2 1 9.97%

The

Theactual

actualanswer

answerisis9.87%...so

9.87%...soofofcourse,

course,the

the

approximation

approximationapproach

approachonly

onlygives

givesus

usan

anapproximate

approximate

answerbut

answerbutthat

thatisisjust

justfine

finefor

fortests

testsand

andexams.

exams.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 58

Approximation Formula for YTM

returns on the investmentit is made up of two

components:

The first component is the average capital gain (if it is a discount bond)

or capital loss (if it is a premium priced bond) per semi-annual period.

The second component is the semi-annual coupon interest received.

Therefore the formula is basically, average semi-annual

return on average investment.

Of course, we annualize the semi-annual return so that we

can compare this return to other returns on other

investments for comparison purposes.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 59

Yield To Call

Bond Valuation and Interest Rates

Yield to Call

If a bond has a call feature, the issuer can call

the bond prior to its stated maturity

To calculate the yield to call, simply replace

the maturity date with the first call date

Interest Rates

6 - 61

Yield to Call

[ 6-3]

1

1

( 1 YTC)n

B I

YTC

1

CP

n

(

1

YTC)

present value of all promised cash flows including the

call price (CP) to equal the current bond price.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 62

YTC on a 20-year 6 percent bond that is callable in five years at a call price of

$1,050. The bond pays semi-annual coupons and is selling for $1,030.

Financial Calculator

1,050

FV

1,030 +/- PV

30

PMT

10

N

I/Y

3.081 x 2

= 6.16%

1

( 1 YTC)n

B I

CP

YTC

( 1 YTC)n

$1,050

( 1 YTC)10

$1,030 $30

10

YTC

( 1 YTC)

YTC 3.081% 2 6.16%

Interest Rates

6 - 63

Current Yield

Bond Valuation and Interest Rates

Current Yield

The current yield is the yield on the bonds current

market price provided by the annual coupon

It is not a true measure of the return to the bondholder because

it does not consider potential capital gain or capital losses based

on the relationship between the purchase price of the bond and

its par value.

[ 6-4]

Annual interest

CY

B

Interest Rates

6 - 65

Current Yield

Example

market price provided by the annual coupon

Example: If a bond has a 5.5% annual pay coupon and

the current market price of the bond is $1,050, the

current yield is:

Annual Coupon

Current Market Price

55

1, 050

5.24%

Current Yield =

Interest Rates

6 - 66

Bond Valuation and Interest Rates

Interest is the price of money

Interest rate changes are often measured in Basis

points 1/100 of 1%

Up when the demand for loanable funds rises

Down when the demand for loanable funds falls

Interest Rates

6 - 68

Usually use the yield on short federal

government Treasury bills as a proxy for the

risk-free rate (RF)

The risk-free rate is comprised of two

components:

Real rate compensation for deferring consumption

Expected inflation compensation for the expected

loss in purchasing power

(See Figure 6 3 to see rates of inflation and yields on long Canada bonds since

1961)

Interest Rates

6 - 69

6 - 3 FIGURE

Interest Rates

6 - 70

Fisher Equation

If we call the risk-free rate the nominal rate, then

the relationship between the real rate, the

nominal rate and expected inflation is usually

referred to as the Fisher Equation (after Irving

Fisher)

[ 6-5]

Interest Rates

6 - 71

Fisher Equation

When inflation is low, can safely use the

approximation formula:

When inflation is high, use the exact form of the

Fisher Equation:

Interest Rates

Inflation

6 - 72

Fisher Equation

Example

what is the approximate expected future inflation

rate?

5.5 3 Expected Inflation

Expected Inflation 2.5%

Interest Rates

6 - 73

Canadian domestic interest rates are heavily

influenced by global interest rates

Interest rate parity (IRP) theory states that FX

forward rates will be established that equalize

the yield an investor can earn, whether

investing domestically or in a foreign

jurisdiction

A country with high inflation and high interest rates will

have a depreciating currency

Interest Rates

6 - 74

(Long-term Interest Rates)

Bond Valuation and Interest Rates

Is that set of rates (YTM) for a given risk-class

of debt securities (for example, Government

of Canada Bonds) at a given point in time.

When plotted on a graph, the line is called a

Yield Curve

Interest Rates

6 - 76

The Yield Curve is the graph created by putting term

to maturity on the X axis, YTM on the Y axis and then

plotting the yield at each maturity.

The four typical shapes of yield curves:

Upward sloping (the most common and persistent shape historically

when short-term interest rates and inflation are low)

Downward sloping (occurs at peaks in the short-term interest rate

cycle, when inflation is expected to decrease in the future)

Flat (occurs when rates are transitioning)

Humped (occurs when rates are transitioning or perhaps market

participants are attracted in large numbers to particular maturity

segment of the market)

(See Figure 6-4 for Yield curves that existed at various times in Canada)

Interest Rates

6 - 77

1990, 1994, 1998, 2004

6 - 4 FIGURE

16

14

12

Percent

10

8

6

4

2

0

1 mth

3 mths

6 mths

1 yr

2yrs

5 yrs

7 yrs

10 yrs

30 yrs

1990

1994

1998

Interest Rates

2004

6 - 78

Three theories are used to explain the shape

of the term structure

Liquidity preference theory

Investors must be paid a liquidity premium to hold less

liquid, long-term debt

Expectations theory

The long rate is the average of expected future short interest

rates

Distinct markets exist for securities of different maturities

Interest Rates

6 - 79

Risk Premiums

have their own yield curve and it will plot at higher

YTM at every term to maturity because of the default

risk that BBBs carry

The difference between the YTM on a 10-year BBB

corporate bond and a 10-year Government of Canada

bond is called a yield spread and represents a defaultrisk premium investors demand for investing in more

risky securities.

Spreads will increase when pessimism increases in the

economy

Spreads will narrow during times of economic

expansion (confidence)

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 80

Risk Premiums (Yield Spreads)

16

14

12

Yield

Spread

Percent

10

8

6

4

2

0

1 mth

3 mths

6 mths

1 yr

2yrs

5 yrs

7 yrs

10 yrs

30 yrs

BBB Corporates

Interest Rates

6 - 81

Risk Premiums

The YTM on a corporate bond is comprised of:

[ 6-6]

structure

Spread is the additional yield due to default risk

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 82

Debt Ratings

All publicly traded bonds are assigned a risk

rating by a rating agency, such as Dominion

Bond Rating Service (DBRS), Standard &

Poors (S&P), Moodys, Fitch, etc.

Bonds are categorized as:

Investment grade top four rating categories (AAA,

AA, A & BBB)

Junk or high yield everything below investment

grade (BB, B, CCC, CC, D, Suspended)

Interest Rates

6 - 83

higher the required YTM

Liquidity the less liquid the bond, the higher

the required YTM

Call features increase required YTM

Extendible feature reduce required YTM

Retractable feature reduce required YTM

Interest Rates

6 - 84

Bond Valuation and Interest Rates

Treasury Bills

Short-term obligations of government with an initial

term to maturity of one year or less

Issued at a discount & mature at face value

The difference between the issue price and the face

value is treated as interest income

To calculate the price of a T bill, use the following

formula:

PT Bill

F

n

1 BEY

B

Where:

P = market price of the T Bill

F = face value of the T Bill

BEY = the bond equivalent yield

n = the number of days until maturity

B = the annual basis (365 days in Canada)

Interest Rates

6 - 86

What is the price of a $1,000,000 Canadian T bill with

80 days to maturity and a BEY of 4.5%?

PT Bill

B

1, 000, 000

80

1 .045

365

$990, 233.32

1 BEY

Interest Rates

6 - 87

To solve for the yield on a T bill, rearrange the previous

formula and solve for BEY.

Example: What is the yield on a $100,000 T bill with

180 days to maturity and a market price of $98,200?

F P B

P n

100, 000 98, 200 365

98, 200

180

3.72%

BEY

Interest Rates

6 - 88

A zero coupon bond is a bond issued at a

discount that matures at par or face value

A zero coupon bond has no reinvestment rate

risk, since there are no coupons to be

reinvested

To calculate the price of a zero coupon bond,

solve for the PV of the face amount

Interest Rates

6 - 89

Example: What is the market price of a $50,000

zero coupon bond with 25 years to maturity that is

currently yielding 6%?

1 kb

50, 000

1.06

25

$11, 649.93

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 90

Floating rate bonds have a coupon that floats

with some reference rate, such as the yield on

T bills

Because the coupon floats, the market price will

typically be close to the bonds face value

Government of Canada to protect investors

against unexpected inflation

Each period, the face value of the bond is grossed up

by the inflation rate. The coupon is then paid on the

grossed up face value.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 91

A Canada Savings Bond (CSB) is a special type of bond

issued by the Government of Canada

It is issued in two forms:

Regular interest interest is paid annually

Compound interest interest compounds over the life of the

bond

at their face value plus accrued interest (after the first

three months after issue)

There is no secondary market for CSBs (they are nonnegotiable meaning that they cannot be traded in a

market between investors.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 92

In this chapter you have learned:

About the nature of bonds as an investment

How to value a bond using discounted cash flow

concepts

About the determinants of interest rates and theories

used to explain the term structure of interest rates

Interest Rates

6 - 93

Bond Valuation and Interest Rates

Bonds and Mortgages

mortgages?

Interest Rates

6 - 95

Bond Valuation and Interest Rates

Duration

An alternative measure of bond price sensitivity is the bonds

duration.

Duration measures the life of the bond on a present value

basis.

Duration can also be thought of as the average time to receipt

of the bonds cash flows.

The longer the bonds duration, the greater is its sensitivity to

interest rate changes.

Interest Rates

6 - 97

Duration Rules-of-Thumb

Duration of zero-coupon bond (strip bond) = the term left until

maturity.

Duration of a consol bond (ie. a perpetual bond) = 1 + (1/k)

where: k = required yield to maturity

Interest Rates

6 - 98

Duration and Maturity

rate.

The higher the coupon or promised interest payment on the security, the lower

its duration.

Interest Rates

6 - 99

duration is a direct measure of the interest rate sensitivity

or elasticity of an asset or liability. (ie. what impact will a

change in YTM have on the price of the particular fixedincome security?)

interest rate sensitivity is equal to:

dP

P

= - D [ dk/(1+k)]

Where:

P=

C = Coupon (annual)

k = YTM

N = Number of periods

F = Face value of bond

Price of bond

Interest Rates

6 - 100

the percent change in the bonds price

caused by a given change in interest rates

(change in YTM)

(The following slide illustrates how bond price sensitivity can be graphed

against changing discount rates)

Interest Rates

6 - 101

30 year stripped bond price given different YTM.

Interest Rates

6 - 102

Take our previous example where a $20,000 30-year stripped

bond has a required rate of return of 12%:

P0

= $20,000(PVIFn=30, k = 12%)

= $20,000 (.0334)

= $668.00

Assume now that interest rates fall by 16.7% from 12% to 10%.

What is the percentage change in price of the bond?

P0

= $20,000(PVIFn=30, k = 10%)

= $20,000 (.0573)

= $1,146.00

=71.6%

(200 bp) decrease in required rate of return.

CHAPTER 6 Bond Valuation and

Interest Rates

6 - 103

A bonds duration is affected by the size of the coupon rate

offered by the bond.

The duration of a zero coupon bond is equal to the bonds term to

maturity. Therefore, the longest durations are found in stripped bonds or

zero coupon bonds. These are bonds with the greatest interest rate

elasticity.

The higher the coupon rate, the shorter the bonds duration. Hence the

greater the coupon rate, the shorter the duration, and the lower the

interest rate elasticity of the bond price.

Interest Rates

6 - 104

Duration

The numerator of the duration formula represents the present value of

future payments, weighted by the time interval until the payments

occur. The longer the intervals until payments are made, the larger will

be the numerator, and the larger will be the duration. The

denominator represents the discounted future cash flows resulting

from the bond, which is the bonds present value.

n

Ct (t )

t

t 1 (1 k )

DUR n

Ct

t

t 1 (1 k )

where : Ct the coupon or principal payment generated by the bond

t the time at which the payments are provided

k the bond ' s yield to maturity

Interest Rates

6 - 105

Duration Example

As an example, the duration of a bond with $1,000 par value and a 7

percent coupon rate, three years remaining to maturity, and a 9

percent yield to maturity is:

$70

$70(2) $1070(3)

1

2

(1.09) (1.09)

(1.09) 3

DUR

$70

$70

$1070

1

2

(1.09) (1.09) (1.09) 3

2.80 years

Interest Rates

6 - 106

Duration Example

A Formula-based Duration Calculation for a Zero Coupon Bond

As an example, the duration of a zero-coupon bond with $1,000 par

value and three years remaining to maturity, and a 9 percent yield to

maturity is:

$1000(3)

(1.09) 3

DUR

$1000

(1.09) 3

3.0 years

Interest Rates

6 - 107

Using a Spreadsheet Model

Interest Rates

6 - 108

Duration of a Portfolio

portfolio, or insulate their portfolio from the effects of interest

rate movements.

This is a common challenge when the investment portfolio is

dedicated to funding a future liability.

Interest Rates

6 - 109

Duration of a Portfolio

Insurance Company Example

A life insurance company knows that they need $100 million 30 years from

now cover actuarially-determined claims against a group of life insurance

policies just no sold to a group of 30 year olds.

The insurance company has invested the premiums into 30-year government

bonds. Therefore there is no default risk to worry about. The company

expects that if the realized rate of return on this bond portfolio equals the

yield-to-maturity of the bond portfolio, there wont be a problem growing that

portfolio to $100 million. The problem is, that the coupon interest payments

must be reinvested and there is a chance that rates will fall over the life of the

portfolio.

If this happens the portfolios terminal value will be less than the liability the

insurance company needs to finance. This shortfall in investment returns will

have to be borne at the expense of the Insurance companys shareholders.

Interest Rates

6 - 110

Interest Rate Risk

fixed-income portfolio management - interest rate risk.

The portfolio manager, before-the-fact calculates the bond

portfolios yield-to-maturity. This is an ex ante calculation.

As such, a nave assumption assumption is made that the

coupon interest received each year is reinvested at the yieldto-maturity for the remaining years until the bond matures.

Over time, however, interest rates will vary and reinvestment

opportunities will vary from that which was forecast.

Interest Rates

6 - 111

Duration of a Portfolio

Immunization

from this reinvestment risk.

The simplest way to do this is to convert the entire bond

portfolio to zero-coupon/stripped bonds. Then the ex ante

yield-to-maturity will equal ex post (realized) rate of return.

(ie. the ex ante YTM is locked in since there are no

intermediate cash flows the require reinvestment).

If the bond portfolio manager matches the duration of the bond

portfolio with the expected time when they will require the

$100 m, then interest rate risk will be largely eliminated.

Interest Rates

6 - 112

Copyright

Copyright 2007 John Wiley & Sons

Canada, Ltd. All rights reserved.

Reproduction or translation of this

work beyond that permitted by

Access Copyright (the Canadian

copyright licensing agency) is

unlawful. Requests for further

information should be addressed to

the Permissions Department, John

Wiley & Sons Canada, Ltd. The

purchaser may make back-up copies

for his or her own use only and not

for distribution or resale. The author

and the publisher assume no

responsibility for errors, omissions,

or damages caused by the use of

these files or programs or from the

use of the information contained

herein.

Interest Rates

6 - 113

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