The Valuation of Bonds

Bond Values
Bond values are discussed in one of two ways:
The price
The yield to maturity
These two methods are equivalent since a price
implies a yield, and vice-versa
Bond Price Relations
Bond Relation 1: Relation between coupon rate,
required rate (discount rate or YIELD), bond value
(price), and face value (principal):

bond premium F V R C If
bond par F V R C If
bond discount F V R C If
F / C rate coupon C Let
R
R
R
R
> >
= =
< <
= =
Bond Price Relations (2)
Bond Relation 2: Inverse relation between bond price
(value) and rate of return (YIELD).
| +
+ |
V R If
V R If
Bond Price Relations
Bond Relation 2: Price-Yield Curve depicts the
inverse relation between V and R. The Price-Yield
curve for the 10-year, 9% coupon bond:
B
V
R
8550 . 93
100
9% 10%
-
-
Bond Price Relations
Bond Relation 3: The greater a bonds maturity, the
greater its price sensitivity to interest rate changes.
Symbolically:
c
A
A
= c
Greater M Greater
R %
V %
Let
Bond Price Relations
Bond Relation 4: The smaller a bonds coupon rate, the
greater its price sensitivity to interest rate changes.
Symbolically:
c
A
A
= c
Greater C Lower
R %
V %
Let
R
Bond risks
interest rate risk -- The major risk facing all bondholders
is interest rate risk. This is the effect on bond prices when
interest rates change. The prices of outstanding bonds move
inversely with changes in interest rates.
default risk -- the possibility that the issuing firm will not
be able to pay, on a timely basis, the interest and/or
principal. Measured by bond ratings.
reinvestment rate risk -- a major risk factor for bond
investors holding longer term bonds. Since standard yield
calculations assume reinvestment at a certain rate, actual
returns will be lower if rates fall and investors are not able
to reinvest at the assumed rate.

Bond risks
inflation risk -- The possibility of unexpected changes in
price levels.
maturity risk -- the longer the term of the security, the
more risk there is in the investment. The source of this risk
is twofold: (a) harder to forecast farther in the future, and
(b) longer term bonds are more volatile than shorter bonds.
call risk -- the possibility of a bond being called in.
Liquidity (marketability) risk -- many bonds trade less
frequently than stocks. A liquid security is liquid if it can be
sold easily without significant price effects
US market - Fractions
The fractions of points differ among bonds.

Fractions are either in thirds, eighths, quarters, halves,
or 64ths.

On a 100 basis, a 1/2 point is 0.50 and a 1/32 point is
0.03125.

A price quote of 97-4/32 (97-4) is 97.125 for a bond
with a 100 face value.

Bonds expressed in 64ths usually are denoted in the
financial pages with a plus sign (+); for example,
100.2+ would indicate a price of 100 3/64.
Bond Yields
There are several ways that we can describe the
rate of return on a bond:
Coupon rate
Current yield
Yield to maturity
Modified yield to maturity
Yield to call
Realized Yield
The Coupon Rate
The coupon rate of a bond is the stated rate of
interest that the bond will pay
The coupon rate does not normally change
during the life of the bond, instead the price of
the bond changes as the coupon rate becomes
more or less attractive relative to other interest
rates
The coupon rate determines the amount of the
annual interest payment:
Annual Pmt Coupon Rate Face Value =
The Current Yield
The current yield is a measure of the current
income from owning the bond
If the current yield is less than the coupon rate,
the bond would be purchased at a premium
Roughly you can think of holding cost
It is calculated as:
Value
Pmt Annual
CY =
Value
Pmt Annual
CY =
The Yield to Maturity
The yield to maturity is the average annual rate of
return that a bondholder will earn under the
following assumptions:
The bond is held to maturity
The interest payments are reinvested at the YTM
The yield to maturity is the same as the bonds
internal rate of return (IRR)
The Modified Yield to Maturity
The assumptions behind the calculation of the YTM
are often not met in practice
This is particularly true of the reinvestment
assumption
To more accurately calculate the yield, we can change
the assumed reinvestment rate to the actual rate at
which we expect to reinvest
The resulting yield measure is referred to as the
modified YTM, and is the same as the MIRR for the
bond
The Yield to Call
Most corporate bonds, and some government bonds,
have provisions which allow them to be called if
interest rates should drop during the life of the bond
Normally, if a bond is called, the bondholder is paid a
premium over the face value (known as the call
premium)
The YTC is calculated exactly the same as YTM,
except:
The call premium is added to the face value, and
The first call date is used instead of the maturity date
The Realized Yield
The realized yield is an ex-post measure of the
bonds returns
The realized yield is simply the average annual
rate of return that was actually earned on the
investment
If you know the future selling price, reinvestment
rate, and the holding period, you can calculate an
ex-ante realized yield which can be used in place
of the YTM (this might be called the expected
yield)
Valuing Bonds Between Coupon Dates
Imagine that we are halfway between coupon dates.
We know how to value the bond as of the previous (or
next even) coupon date, but what about accrued
interest?
Accrued interest is assumed to be earned equally
throughout the period, so that if we bought the bond
today, wed have to pay the seller one-half of the
periods interest.
Bonds are generally quoted flat, that is, without the
accrued interest. So, the total price youll pay is the
quoted price plus the accrued interest (unless the
bond is in default, in which case you do not pay
accrued interest, but you will receive the interest if it is
ever paid).
The Term Structure of Interest Rates
Interest rates for bonds vary by term to maturity,
among other factors
The yield curve provides describes the yield
differential among treasury issues of differing
maturities
Thus, the yield curve can be useful in determining
the required rates of return for loans of varying
maturity
Bond Price Volatility
Bond prices change as any of the variables
change:
Prices vary inversely with yields
The longer the term to maturity, the larger the
change in price for a given change in yield
The lower the coupon, the larger the percentage
change in price for a given change in yield
Price changes are greater (in absolute value) when
rates fall than when rates rise
Duration
Duration is calculated as:




So, Macaulays duration is a weighted average of
the time to receive the present value of the cash
flows
The weights are the present values of the bonds
cash flows as a proportion of the bond price

( )
( )
D
Pmt t
i
Bond ice
t
t
t
N
=
+
=

1
1
Pr
Modified Duration
A measure of the volatility of bond prices is the
modified duration (higher DMod = higher volatility)
Modified duration is equal to Macaulays duration
divided by 1 + per period YTM



Note that this is the first partial derivative of the
bond valuation equation wrt the yield

( )
D
D
i
Mod
=
+ 1
Convexity
Convexity is a measure of the curvature of the
price/yield relationship





Note that this is the second partial derivative of
the bond valuation equation wrt the yield
Yield
D = Slope of Tangent Line
Mod
Convexity
Convexity and Bond Price
Convexity can be calculated with the following
formula:




We can approximate the change in a bonds price
for a given change in yield by using duration and
convexity:


( ) ( )
( )
C
i
CF
i
t t
V
t
t
t
N
B
=
+ +
+

(
(
=

1
1 1
2
2
1
( ) ( )
( )
A A A V D i V C V i
B Mod B B
= + 05
2
.
Observations on duration
When bond has coupons, dur is < time to maturity
Holding maturity and YTM constant, there is inverse
relation between coupons and dur
A bond without coupons, e.g., zero coupon bond has
duration = time to maturity
Generally a positive relation exists between dur and
time to maturity; duration expands with time to
maturity but at a decreasing rate, especially beyond
15 years.
Observations on convexity
The longer the maturity, usually the greater will be the
convexity, all else equal.
Holding yield and duration constant, the higher the
coupon rate, the greater the convexity.
As interest rates decrease, the convexity of a bond
increases, and vice versa.
Two bonds with the same duration but different
convexities will experience different price changes
when there is a significant change in interest rates. As
a result, convexity is said to be desirable when
interest rates are volatile. Note on prior slide that
Bond 1(with the greater convexity) has greater upside
potential when interest rates fall and less downside
movement when rates rise.