UNDERSTANDING FIXED

INCOME RISK & RETURN

ANURAG MISHRA
SOURCE OF RETURN – (FIXED RATE BOND)

• Coupon Payments + Principal (on Scheduled Basis) – {Credit Risk}

• Reinvestment of Coupon – {Interest Risk}
• Capital Gains/Losses – {Interest Risk}
• Ex- 10 year, 8% Annual @ 85.5030,YTM – 10.40%
(it means, if we get 8 as an PMT every year, we can re invest it and get, 8*(1.104)^9 and
same for each rate at the start of every year.
Last payment would be just 8 at the year 10. it will be total to (129.9706)
BUY & HOLD

• Total Coupon - $80

• Interest On Interest – 49.9706
• Principal – 100
• Total return – 100 + 129.9706 = 229.9706 @ 10.40%
• If we will discount it by the YTM it will be equivalent to P.V of 85.5030

• It tells us if we can not reinvest at coupon rate, Interest risk rate will rise.
SELL AFTER 4 YEARS

• YTM Assumptions – 1) Held till Maturity, 2) No Default 3) Coupons can be re-invested at the
same rate
• Ex- 10 year, 8% Annual @ 85.5030, YTM – 10.40%, but now assume it will be sold after 4-
years.
• Fv(coupon) – 8(1.04)^1 + 8(1.04)^2 + 8(1.04)^2 +8 = 37.34711
• Now, PV of 6 year, 8% Annual with YTM 10.40% = 89.668770
• Total return = 127.015881 and after discounting it by some rate of return till year 4th it
should be equivalent to (85.503075)
• So this rate would be 10.40% but this will be called (HORIZON YIELD)
HORIZON YIELD

• It assumes:-
• Coupon can be reinvested at same rate
• Bond is sold on the constant yield price curve
BUY & HOLD INVESTOR

• Assumes Interest Rates rises 100 bps, (10.40% - 11.40%) (rasing interest rate)
• First Payment received can be re-inveseted for 9 years @ 11.40%
• Total coupon payment – 136.3801, Principal – 100
• Total return – 236.380195, after discounting it by (1+r)^10 = 85/5030. we will get r =
10.7%
• {A) Buy & Hold bond investor will realise higher YTM, if interest rate increases, coz they
have eliminated price risk. They are only exposed to coupon re–investment risk, since
interest rate are rising, coupon will be invested at higher risk.
SELL IT AFTER 4 YEARS

• FV at t(4) = 37.8999724
• PV of 6 year bond at t(4) = 85.7804, total return = 123.6801
• Putting it equal to 85.3030, we will get r = 0.0967
• 89.66870-85.7804 = 3.88762 (Capital Loss)
• Interest Rate Risk – lower reinvestment of coupon, but capital gain makes up for it.
• Rising interests rate good for Reinvestment and for Price volatility rising interest rates
are bad.
INTEREST RATE RISK

• Duration – measures the sensitivity of the bond’s full price to changes in bond’s own
yield or more generally in the benchmark rate.
• Assumes all other variables are held constant.
• Represents approx. time of a bond would have to be hold for the market discount rate to
be realised.
• Ex- 10 yr, 8% Annual @ 85.5030,YTM-10.4%, Duration – 7.0029
• If Interest rates goes up, reinvestment coupon (+) but Capital Loss (-).. At 7.0029 these
difference will be diminished. (Macaulay Duaration)
PRICE VOLATILITY

Option - free bond price yield curve

Price % of par

An option free bon has Price yield

curve convex towards the origin

P1
Price fall as yields increase
P2

5% 7% YTM
INTEREST RATE RISK

• Types of bond duration :- yield duration (sensitivity of price to its own yield) & Curve
duration (sensitivity of price to benchmark yield)
• Yield duration :-
• 1) Macauley
• 2) Modified
• 3) Money
• 4) Price Value of basis point
• Curve Duration:-
• 1) Govt.Yield Curve
• 2) Spot curve
• 3) forward Curve
• 4) Par Curve – used with complex bonds and also with financial assets/liabilities/ that
have interest rate risk but are not bonds.
DURATION MEASURES

• Modified duration – assumes yield changes do not change the expected cash flows

1 1∗𝑃𝑉𝐶𝐹1 + 2∗𝑃𝑉𝐶𝐹2 +⋯+(𝑛∗𝑃𝑉𝐶𝐹𝑛)

𝑚𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = [ ]
1+𝑦𝑖𝑒𝑙𝑑/𝑘 𝑘∗𝑝𝑟𝑖𝑐𝑒

k = no. of payments per year

n = no. of periods until maturity

1∗𝑃𝑉𝐶𝐹1 + 2∗𝑃𝑉𝐶𝐹2 +⋯+(𝑛∗𝑃𝑉𝐶𝐹𝑛)

• Macaulay duration = [ ]
𝑘∗𝑝𝑟𝑖𝑐𝑒
MODIFIED DURATION

• Modified duration – Mac due/(1+r)

• Provides an estimate of %age price change for a bond given a change in its YTM (Linear
estimates)
• %change in PV (full) = -Annualised Modified Duration * change In yield
• Ex – if, r – 11.4% instead of 10.4%
• %change in price of bond = -6.342 * .0100 = -6.3432% (if market interest rate goes up
after buying this bond, full price of bond will drop 6%)
• If r = 9.4%, instead of 10.4%. = 6.3432%
• If, Mac Duration is known, Modified = Mac Dur/(1+r)
• If mac dur is not known, we can approximate it.
• Approximately Modified = { (Present Value of a bond, when interest rates goes down,
PV_) – (Present value for a bond, when Interest rate go up, PV+)/ 2* change in yield *
Current Present Value} = {rise of risk over run}
• Approx. Mac duration = Aprrox. modified duration * (1+r)
• Ex – 10 year, 8% Annual @ 85.5030,YTM – 10.4%
• Up 25 bps – N – 10, Pmt – 8, Fv – 100, I/Y – 10.65, so PV + = 84.161819
• Down 25 bps – N – 10, Pmt – 8, Fv – 100, I/Y – 10.15, so PV - = 86.87388
• Approx. Mod Dur = (86.87388 - 84.161819)/ 2* (0.0025)* 85.5030 = (6.34377)
• %change in PV FULL = -approx. mod dur * Change in yield = -6.34377 * .005(if
interest rates goes down by 50 BPS) = -3.17%
 EFFECTIVE DURATION
Price yield relation of a callable bond

Price % of par

Call option
Negative
value convexity

Callable Bond

Negative Positive Yield

convexity Convexity
EFFECTIVE DURATION

• Effective Duration - { (Present Value of a bond, when interest rates goes down, PV_) –
(Present value for a bond, when Interest rate go up, PV+)/ 2* change in curve * Current
Present Value}
• Used for complex bonds with embedded options.
• It may be called if, Credit Spread decreases (change in credit duration) or Benchmark
Yield decreases (change in curve duration)
• Effective also used for FRN’s, MBS (home owner’s have a call option), Defined benefit
pension plans (Include interest rate risk)
KEY RATE DURATION

• Define & Use of Key rate Durations

• Eff. Dur assumes a parallel shift in the yield curve.
• Key rate duration is the duration at a specific maturity on an yield curve.
• In case of portfolio, which have multiple maturities.
• Key Rate - - { (Present Value of a bond, when interest rates goes down, PV_) – (Present
value for a bond, when Interest rate go up, PV+)/ 2* change in rate * Current Present
Value}
• At each maturity, key note rate can be calculated, and if we sum all of it, it will be equal to
Effective Duration.
• %change in Portfolio Level = Key Rate Duration (1)*(maturity 1/portfolio value) + Key
Rate Duration (2)*(maturity 2/portfolio value)……….. Key Rate Duration (n)*(maturity
n/portfolio value)
PROPERTIES OF A BOND DURATION

• Duration of a coupon paying bond is always less than its maturity. For a non-coupon paying bond, the
duration is the same as its maturity.
• Bonds with longer maturities have longer durations. This is because the coupon payments will be spread
over longer periods and will be more affected by inflation.
• The bond with higher coupon rates have lower duration, and vice versa.
• When the coupon rate is lower than the yield, the duration first increases with maturity to some
maximum value then decreases to the asymptotic limit value. As the time to maturity increases to infinity,
the duration does not increase to infinity but tends to a finite limit independent of the coupon rate.
• The duration of a bond increases immediately on the day a coupon is paid. However, throughout the life
of the bond, the duration is continually decreasing as time to the bond’s maturity decreases.
CONVEXITY

Convexity is a measure of the curvature of the price-yield curve. The more curved the price-yield relation is, the
greater the convexity.
A straight line has a convexity of zero.

Effective duration underestimates or overestimates the value of the bond.

Convexity adjustment to percentage price change = C * change in yield squared * 100

Total price change = (-duration * change in yield * 100) + (C * change in yield squared * 100)
MONEY DURATION

• Measure the price change in currency terms, per 100 of face value versus actual face
value.
• Money Dur = Ann Mod. Dur * PV Full
• Change in PV full = - Money duration * change In yield
• Ex- PV Full = 100.940243, Ann Mod Dur = 6.1268, so Money Dur = 6.1268* (100.94023)
= 618. 44178
• If ytm rises by 100 bps, change in PV full = (-6.18.4478 *0.06) = 6.1844
• Price Value of a Basis Point (PVBP)
• PVBP = (PV-) – (PV+)/2
• Money dur = Annual Duration * PV full
• Change in PV full = -Money Dur * Change in Yield (approx.)
• Change in PV full = {-Money Duration * change in Yield} + {money Convexity * Change in
yield}
• Aprox. Convexity = {(PV-) + (PV+) – (2PV.)/ change in yield * (PV.)} – When bond’s cash
flow does not change.
• Effective Convexity = {(PV-) + (PV+) – (2PV.)/ change in curve * (PV.)}
YIELD VOLATILITY

• %age in Pv full = Duration + Convexity

• = (-Ann Mod Duration * change in yield) + (1/2 Ann Convexity * (change in yield)^2)
• Yield volaitility = Number of basis point change
• Duration Gap = Mac Dur – Investment horizon
• If dur gap <0 => Coupon re investment risk dominates market price risk {risk is to lower
interest rates}
• dur gap >0 => Coupon re investment gets dominated by market price risk {risk is to
higher interest rates}
CREDIT & LIQUIDITY RISK

• Corporate bonds :- 1) Benchmark Rate + Spread

• 1) – Inflation expectations (Inflation Duration) + real Rate ( real rate duration)
• 2) – Credit Risk (Credit Duration) + Liquidity (Liquidity Duration)
• Ex- conditions leading to a change in benchmark rate are typically the same conditions
that may also affect the change in credit quality & Liquidity