Straight Bond
Obligates the issuer of the bond to pay the
holder of the bond:
A fixed sum of money (principal, par value, or face
value) at the bonds maturity
Constant, periodic interest payments (coupons)
during the life of the bond (Sometimes)
10-3
Straight Bonds
Suppose a straight bond pays a semiannual
coupon of $45 and is currently priced at $960.
What is the coupon rate?
What is the current yield?
$45 2
(10.1) Coupon Rate
9.00%
$1,000
$45 2
(10.2) Current Yield
9.375%
$960
10-4
C
1
(10.3) Bond Price
1
YTM
YTM
1
FV
2M
YTM
1
2M
PV of coupons
PV of FV
Where:
C = Annual coupon payment
FV = Face value
M = Maturity in years
YTM = Yield to maturity
10-6
C
1
(10.3) Bond Price
1
YTM
1 YTM
Where:
2M
FV
1 YTM
2M
N = 2M
I/Y = YTM/2
FV = Face value
PMT = C/2
M = Maturity in years
FV = 1000
CPT PV
10-7
C
1
(10.3) Bond Price
1
YTM
1 YTM 2
FV
2M
1 YTM 2
PV of coupons
PV of FV
2M
60
1
$457.41
PV of Coupons
1
24
.08
.
08
1
2
1000
PV of FV
$390.12
24
1 .08 2
10-9
Spreadsheet Analysis
10-10
10-11
80
1
PV of Coupons
1
.06
.06
1
1000
PV of FV
1 .03 2
$677.42
24
24
$491.93
Discount Bonds
Consider two straight bonds with a coupon rate of 6%
and a YTM of 8%.
If one bond matures in 6 years and one in 12, what
are their current prices?
60
1
Bond Price (6 yr)
1
.08
1 .08 2
1000
12
1 .08
60
1
1
.08
1 .08
12
$906.15
1000
24
1 .08
24
$847.53
10-13
Premium Bonds
Consider two straight bonds with a coupon rate of 8% and
a YTM of 6%.
If one bond matures in 6 years and one in 12, what are
their current prices?
80
1
1
.06
1 .06 2
1000
$1,099.54
12
12
1 .06 2
80
1
Bond Price (12 yr)
1
.06
.06
1
1000
24
.06
1
24
$1,169.36
10-14
Premium
1,000
CR>YTM
8%>6%
YTM = CR
M
CR<YTM
6%<8%
Discount
12
0
10-15
10-18
10-19
Calculating Yields
C
1
FV
Bond Price
1
2M
2M
YTM
YTM
YTM
1
1
2
2
10-21
Calculating Yields
Trial & Error
A 5% bond with 12 years to maturity is priced at
90% of par ($900).
Selling at a discount YTM > 5%
Try 6% --- price = $915.32 too high
Try 6.5% --- price = $876.34 too low
Try 6.25% --- price = $895.56 a little low
Actual = 6.1933%
10-22
Calculating Yields
Calculator
A 5% bond with 12 years to maturity is priced at
90% of par ($900).
N = 24
PV = -900
PMT = 25
FV = 1000
CPT I/Y = 3.0966 x 2 = 6.1933%
10-23
Calculating Yields
Spreadsheet
5% bond with 12 years to maturity,priced at 90% of par
=YIELD(Now,Maturity,Coupon, Price,100,2,3)
Now = 06/01/2008
Maturity = 06/01/2020
Coupon = .05
Price = 90 (entered as a % of par)
100 redemption value as a % of face value
2 semiannual coupon payments
3 actual day count (365)
=YIELD(06/01/2008,06/01/2020,0.05,90,100,2,3) = 0.06193276
10-24
Spreadsheet Analysis
10-25
Callable Bonds
Gives the issuer the option to:
Buy back the bond
At a specified call price
Anytime after an initial call protection
period.
Most bonds are callable Yield-to-call may
be more relevant
10-26
Yield to Call
C
1
Callable Bond Price
1
2T
YTC
YTC
1
CP
1 YTC
2T
Where:
C = constant annual coupon
CP = Call price of bond
T = Time in years to earliest call date
YTC = Yield to call
10-27
Yield to Call
Suppose a 5% bond, priced at 104% of par with 12
years to maturity is callable in 2 years with a $20
call premium. What is its yield to call?
N=4
PV = -1040
PMT = 25
FV = 1,020
10-30
Malkiels Theorems
1. Bond prices and bond yields move in
opposite directions.
2. For a given change in a bonds YTM, the
longer the term to maturity, the greater the
magnitude of the change in the bonds
price.
3. For a given change in a bonds YTM, the size
of the change in the bonds price increases at
a diminishing rate as the bonds term ot
maturity lengthens.
10-31
Malkiels Theorems
4. For a given change in a bonds YTM, the
absolute magnitude of the resulting
change in the bonds price is inversely
related to the bonds coupon rate.
5. For a given absolute change in a bonds
YTM, the magnitude of the price increase
caused by a decrease in yield is greater than
the price decrease caused by an increase in
yield.
10-32
10-33
Duration
Duration measure the sensitivity of a bond
price to changes in bond yields.
Change in YTM
% Bond Price Duration
1 YTM
2
Macaulay Duration
(10.5)
YTM
% Bond Price -Duration x 1 YTM 2
10-35
Modified Duration
Some analysts prefer a variation of Macaulays
Duration, known as Modified Duration.
Macaulay Duration
Modified Duration
YTM
Modified Duration
(10.6)
Macaulay Duration
Modified Duration
1 YTM 2
(10.7)
10-37
Modified Duration
(10.6)
Macaulay Duration
Modified Duration
1 YTM 2
(10.7)
10-38
10-39
1
(10.8) Par Value bond duration 1 YTM 2 1
2M
YTM
1 YTM 2
1 .08 2
.08
1
10.47 years
1
24
1 .08 2
10-40
2M
YTM
YTM CPR 1 YTM 2 1
Where:
CPR = Constant annual coupon rate
M = Bond maturity in years
YTM = Yield to maturity assuming semiannual coupons
10-41
1 YTM 2
YTM
1 YTM 2 M C YTM
YTM C 1 YTM 2
2M
10-42
Steps:
1. Calculate Macaulay duration using 10.9
2. Convert to Modified duration using 10.6
10-43
2M
YTM
YTM CPR 1 YTM 2 1
30
.065
.065 .05 1 .065 2 1
Duration 10.34 years
10-44
Macaulay Duration
1 YTM 2
Modified Duration
10.34
10.01 years
1 .065 2
10-45
10-46
10-47
Properties of Duration
10-49
(10.11)
1
32 Dollar Value of an 01
In both cases, the bond price is per $100 face value.
10-50
C
1
(10.3) Bond Price
1
YTM
1 YTM
50
1
Bond Price
1
.065
1 .065 2
2M
FV
1 YTM
1000
30
1 .065 2
30
2M
$857.64
10-51
(10.10)
10-52
(10.11)
1
1
0.364
32 Dollar Value of an 01 32 0.0859
10-53
Dedicated Portfolios
Bond portfolio created to prepare for a
future cash payment, e.g. pension funds
Target Date = date the payment is due
10-54
Price Risk:
Risk that bond prices will decrease
Arises in dedicated portfolios when the target date
value of a bond is not known with certainty
10-55
Immunization
Immunization = constructing a dedicated
portfolio that minimizes uncertainty
surrounding the target date value
Engineer a portfolio so that price risk and
reinvestment rate risk offset each other
(just about entirely).
Duration matching = matching the
duration of the portfolio to its target date
10-57
10-58
Dynamic Immunization
Periodic rebalancing of a dedicated
bond portfolio for the purpose of
maintaining a duration that matches the
target maturity date
Advantage = reinvestment risk greatly
reduced
Drawback = each rebalancing incurs
management and transaction costs
10-59
P(1 YTM 2) 2M
10.13
Face Value
C
1 YTM 2 2M 1 Face value
YTM
10-62
10-63