Callable bonds

Bonds that may be repurchased by the issuer

at a specified call price during the call period
A call usually occurs after a fall in market
interest rates that allows issuers to refinance
outstanding debt with new bonds.

Generally, the call price is above the bonds

face value. The difference between the call
price and the face value is the call premium

Bonds are not usually callable during the first

few years of a bonds life. During this period
the bond is said to be call-protected. 1
 Investors are typically interested in knowing
what the yield will be if the bond is called by
the issuer at the first possible date. This is
called yield to call (YTC).
Suppose that we have a 3-year, $1,000 par
value, 6% semiannual coupon bond. We
observe that the value of the bond is $852.48.
The first call price is $1,060 in 2 years. Find
YTC.
N= 4, FV = 1060 PMT=30 PV = -852.48
I/YR = 8.85*2= 17.707%

2
More on Bond Prices

C 1 FV
Bond price 1
YTM
1 YTM
2

2M
1
YTM
2
2M

Now assume a bond has 25 years to maturity, a 9% coupon,
and the YTM is 8%. What is the price? Is the bond selling at
premium or discount?

90 1 1000
Bond price 1 $1,107.41
.08

1 .08
50

2
1 .08
2

50

Now assume the same bond has a YTM of 10%. (9% coupon &
25 years to maturity) What is the price? Is the bond selling at
premium or discount?

90 1 1000
Bond price 1 $908.72
.10

1 .10
50

2
1 .10
2

50

3
 More on Bond Prices (contd)
Now assume the same bond has 5 years to maturity (9% coupon
& YTM of 8%) What is the price? Is the bond selling at
premium or discount?

90 1 1000
Bond price 1 $1,040.55
.08

1 .08
10

2
1 .08
2
10

Now assume the same bond has a YTM of 10%. (9% coupon &
5 years to maturity) What is the price? Is the bond selling at
premium or discount?

90 1 1000
Bond price 1 $961.39
.10

1 .10
10

2
1 .10
2

10

4
More on Bond Prices (contd)
Where does this leave us? We found:
Coupon Years YTM Price
9% 25 8% $1,107
9% 25 10% $ 908
9% 5 8% $1,040
9% 5 10% $ 961
$1,150
$1,100 25 years
$1,050

$1,000 5 years
$950
$900
8% 9% 10% 11%

5
 Decreasing yields cause bond prices to
rise, but long-term bonds increase more
than short-term. Similarly, increasing
yields cause long-term bonds to
decrease in price more than short-term
bonds.

6
 Malkiels Theorems
Summarizes the relationship between bond
prices, yields, coupons, and maturity:
all theorems are ceteris paribus:

1) Bond prices move inversely with interest

rates.

2) The longer the maturity of a bond, the

more sensitive is its price to a change in
interest rates.

7
3) The price sensitivity of any bond
increases with its maturity, but the
increase occurs at a decreasing rate. A
10-year bond is much more sensitive to
changes in yield than a 1-year bond.
However, a 30-year bond is only slightly
more sensitive than a 20-year bond .

8
Bond Prices and Yields (8% bond)

Time to Maturity
Yields 5 years 10 years 20 years
7 percent $1,041.58 $1,071.06 $1,106.78
9 percent 960.44 934.96 907.99
Price Difference $81.14 $136.10 $198.79

67.7% 46.1%

9
4) The lower the coupon rate on a bond, the
more sensitive is its price to a change in
interest rates.
If two bonds with different coupon
rates have the same maturity, then the
value of the one with the lower coupon is
proportionately more dependent on the
face amount to be received at maturity.
As a result, all other things being
equal, the value of lower coupon bonds
will fluctuate more as interest rates
change.
Put another way, the bond with the
higher coupon has a larger cash flow
early in its life, so its value is less
sensitive to changes in the discount rate 10
20-Year Bond Prices and Yields

Coupon Rates
Yields 6 percent 8 percent 10 percent
6 percent $1,000.00 $1,231.15 $1,462.30
8 percent 802.07 1,000.00 1,197.93
10 percent 656.82 828.41 1,000.00

11
5) For a given absolute change in a bonds yield
to maturity, the magnitude of the price
increase caused by a decrease in yield is
greater than the price decrease caused by an
increase in yield

12
Malkiels Theorems (#5)
8% coupon, 20 year bond

Percentage price
Price when yield
change
Yield Price Falls 2% Rises 2% Increase Decrease
6% $1,231 $1,547 $1,000 25.70% 18.80%
8% $1,000 $1,231 $828 23.10% 17.20%
10% $828 $1,000 $699 20.80% 15.60%

13
Duration
Price sensitivity tends to increase with time to
maturity
Need to deal with the ambiguity of the
maturity of a bond making many payments.
Duration measures a bonds sensitivity to
interest rate changes.
More specifically, duration is a weighted
average of individual maturities of all the
bonds separate cash flows.
The weight is the present value of the
payment divided by the bond price.

14
 Calculate a duration for a bond with
three years until maturity. 8% of
Coupon rate and yield.

15
Figure 10.3: Calculating bond duration

Discount Present Years x Present value

Years Cash flow factor value / Bond price

0.5 40 0.96154 38.4615 0.0192

1 40 0.92456 36.9822 0.0370
1.5 40 0.88900 35.5599 0.0533
2 40 0.85480 34.1922 0.0684
2.5 40 0.82193 32.8771 0.0822
3 1040 0.79031 821.9271 2.4658
$1,000.00 2.7259
Bond price Bond duration

16
 Calculating Par Value Bond Duration
Calculating Macaulays Duration for a par value bond is a
special case, as follows:

YTM
1
Par value bond duration 1
2 1
YTM YTM
2M

1
2

Mac. duration
1 .09
2 1 1

8.51 years
.09

1 .09
30

17
To calculating Macaulays Duration for any other bond:

YTM 1 YTM MC YTM

1
MD 2 2
YTM YTM 2M
YTM C 1 1
2

C = annual coupon rate

M = maturity (years) 18
 Assume you have a bond with 9% coupon, 8% YTM,
and 15 years to maturity. Calculate Macaulays
Duration.

Mac. Dur.
1 .08
2
1 .08 15.09 .08
2 8.78 years
.08 .09 1 .08 1
30
.08
2

19
 Price Change & Duration
To compute the percentage change in a bonds price
using Macaulay Duration:
Change in YTM
% in bond price MD
YTM
1
2
To compute the Modified Duration:
Macaulay duration
Modified duration
YTM
1
2
To compute the percentage change in a bonds price
using Modified Duration:
% in bond price Modified Duration Change in YTM
20
Calculating Price Change
Assume a bond with Macaulays duration of 8.5 years,
with the YTM at 9%, but estimated the YTM will go to 11%,
calculate the percentage change in bond price and the
new bond price.
.09 .11
% in bond price 8.5 16.27%
.09
1
2
Change in bond price, assuming bond was originally at par:

Approx. new price = $1,000 + (-16.27% x $1,000) = $837.30

21
 Price Change & Duration
Assume you have a bond with Macaulays duration of
8.5 years and YTM of 9%, calculate the modified duration.
8.5
Modified duration 8.134 years
.09
1
2
Using the bond above with modified duration of 8.134
years and a change in yields from 9% to 11%, calculate
the percentage change in bond price.

% in bond price 8.134 .09 .11 16.27%

Note this is the same percentage change as computed previously.

22
 Figure 10.3: Bond duration and maturity
12

10 5% Coupon 10% Coupon

0% Coupon
Bond duration (years)

8 15% Coupon

0
0 5 10 15 20 25 30
Bond maturity (years)

23
 Zero coupon bond: duration =
maturity
Duration Properties
Longer maturity, longer duration
Duration increases at a decreasing rate
as maturity lengthens
Lower coupon, longer duration
Higher yield, shorter duration
24
What is the Macaulay duration of an 8% coupon bond with 3
years to maturity and a current price of $937.10? What is the
modified duration?
Solution:
First calculate the yield:

80 1 1000
$937 1
YTM
1
YTM
6

2

1
YTM
2
6

YTM = 10.498%

25
 Now calculate the Macaulays duration.
Solution:
.10498
3.08 .10498
.10498
1 1
Mac. Dur. 2 2
.10498 .10498 6
.10498 .08 1 1
2

Mac. Duration = 2.715 years

Modified duration
= 2.715 / (1 + .10498/2) = 2.58 years

26