Investments: Analysis

and Behavior

Chapter 15- Bond Valuation

2008 McGraw-Hill/Irwin
Learning Objectives
Calculate the value of a bond
Compute the yield offered by various bonds
Measure the interest rate risk of bonds using duration
and convexity
Learn the characteristics of convertible bonds
Implement bond investment strategy

15-2
Characteristics of Bonds
Bonds: debt securities that pay a rate of interest based upon
the face amount or par value of the bond.

Price changes as market interest

changes

Interest payments are commonly

semiannual

Bond investors receive full face

amount when bonds mature

Zero coupon bonds no periodic

payment (no interest reinvestment
rate)
Originally sold at a discount

15-3
Bond Pricing
Present of the Bond = Present value of interest payments +
Present Value of Principal

PV of Annuity (pmt, I, N) + PV (FV, I, N)

N
PMT FV
PV
t 1 (1 i) t
(1 i) N

Where N = time to maturity

i= market interest rate
PMT = semiannual interest payment
FV = face value

15-4
When the market interest rate is less than the bonds coupon rate, price is greater
than the face value (Sold at premium, bonds 2,4).
When the market interest rate greater than coupon rate, bond is sold at discount
(bonds 1, 3, 5).
15-5
Bond price calculation
The bond pays $25 semiannual coupon payment
Maturity: three years and one month
Market interest rate: 6% (APR)
Solution:

Using financial calculator

N = 2 x 3 1/12 = 6.167 yrs
I/Y = 6% /2 = 3%
PMT = 25
FV = $1,000
PV = $972.23

15-6
Callable Bonds
Call provision allows the issuer to repay the
investors principal early.

Issuers call the bond when they want to

refinance their debt at the lower interest rate

Call price is commonly the face value plus one

year of interest payments.

Call protection: amount of the time before the

bond becomes callable.
15-7
Expected yield Calculation

Yield to maturity (or yield to call): expected total

rate of return if investor were to buy and hold the
bond until maturity or until call date.
Internalrate of return of the bond that equates the
present value of the cash flow with the price of the
bond.

Solve for I in
Bond price = PV of Annuity (pmt, I, N) + PV (FV , I, N)

15-8
 Example:
The bond pays $25 every six months.
The bond matures in 3 years and one month.
Price of the bond is $972.23.
What is the bonds yield to maturity?

Solution:

Using financial calculator

N= 6.167 PV = -972.23 PMT= 25 FV=1,000
i 3% (or 6% annually)

15-9
Interest rate risk
Bond prices are sensitive to the market
interest rate

If interest rates rise, the market value

of bonds fall in order to compete with
newly issued bonds with higher coupon
rates.

Sensitivity to the interest rate chance

become more severe for longer term
bonds

Percentage rise in price is not

symmetric with percentage decline.

15-10
 An Illustration of Interest-rate Risk for Treasury Securities With a 6% Coupon Selling at
Table 15.3 Par of $1,000

Term to Decline in bond value following Rise in bond value following

Maturity an increase in rates a decrease in rates

Bond Type (years) 1% 2% 3% -1% -2% -3%

Treasury bill Six months 0% 0% 0% 0% 0% 0%

Treasury note 2 -1.84% -3.63% -5.38% 1.88% 3.81% 5.78%

Treasury note 5 -4.16% -8.11% -11.87% 4.38% 8.98% 13.83%

Treasury bond 10 -7.11% -13.59% -19.51% 7.79% 16.35% 25.75%

Treasury bond 20 -10.68% -19.79% -27.60% 12.55% 27.36% 44.87%

Treasury bond 30 -12.47% -22.62% -30.96% 15.45% 34.76% 59.07%

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15-12
Term structure of interest rate

Yield curve: line describing the relationship between yield to

maturity and term to maturity

Liquidity preference hypothesis: long term yield is greater because

investors prefer the liquidity in short term issues.
Segmented market hypothesis: yield curve reflects the hedging and
maturity needs of institutional investors

15-13
Duration
Term to maturity is an imperfect measure of bond
risk because it ignores the valuation effects of
differences in coupon rate and principal payment
schedule
Duration: an estimate of economic life of a bond
measured by the weighted average time to
receipt of cash flows
The shorter the duration, the less sensitive is a bonds
price to fluctuations

15-14
 Duration (or Maculay duration) calculation
T
t Cash Payment t T
t Cash Payment t
1 Yield
t 1
tj 1 Yield
t 1
tj
Duration
Cash Payment
T
Bond Price
1 Yield
t 1
tj
t

Example: Calculate duration for a 7.5% bond with 5

years to maturity and a yield of 6.75%.

0.5 $37.50 1 $37.50 1.5 $37.50 4.5 $37.50 5 ($37.50 $1,000)

Duration 0.5
$1,031.40 4.3 years
1.0675 1.06751 1.06751.5 1.06754.5 1.06755

15-15
 Duration
Modified duration
Yield
1
Coupon Payments per Year

Direct estimate of the percentage change in bond

price for each percentage point change in the market
interest rate.

% change in bond price = 1 % Yield change modified duration

Example: given that duration is 4.3 yrs, if interest rates

fall by 0.5% what is the change in the bond price?
Modified duration = 4.3 / (1.0337) = 4.16

% change in price= -1 (0.5%)4.16 = 2.08%

15-16
Convexity
Convexity measures the sensitivity of modified duration
to changes in interest rate (the rate of acceleration in
bond price changes)
The degree of bend in the priceyield curve

15-17
Bond pricing using convexity and
duration
T
t 2
t Cash Payment t

t 1 1 Yield tj
Convexity
Bond Price 1 Yield
2

% bond price change = 1 % Yield change modified

duration + convexity (Yield change) 2
Using both duration and convexity allows for a more accurate
estimation

15-18
 Example:

Compute the convexity for the 7.5% bond with 5 years to maturity
and a yield of 6.75%.

0.52 0.5 $37.50 12 1 $37.50 4.52 4.5 $37.50 52 5 ($37.50 $1,000)

0. 5
1
4.5
5

1.0675 1.0675 1.0675 1.0675
Convexity 21.49
$1,031.40 1.0675
2

% change in bond price :

(0.005)4.16 + 21.49(0.005)2 = 2.11%.
(% change approximation using only duration was 2.08%)

15-19
Convertible bonds
A special type of bond that can be exchanged into some
more junior grade of securities (usually into common
stock)

Conversion value = # of equivalent common shares

multiplied by the current share price

Premium to conversion = % over conversion value at

which the convertible trades

Break even time = # of years needed to recover the

conversion premium with the convertibles higher income

15-20
Example:
A common stock pays a 35 dividend and has a price of $55/share.
The company also has 6% convertible bond selling at 118% of the par
value, convertible into common at $50/share.

What is the conversion ratio, conversion value, and premium to convert?

Solution:
The conversion ratio is $1,000/$50 = 20:1.
The conversion value is 20$55 = $1,100.
The premium to convert is $1,180 - $1,100 = $80.

Interest from convertible bond: $60

Dividend from stocks when converted: $7
Therefore, holding convertible yields higher income.

15-21
Bond Investment Strategies
Why invest in bonds?
Stable income and diversification

Asset allocation: the process of diversifying an

investment portfolio across various asset
categories, like stocks and bonds and cash to
balance the risk/reward tradeoff.

Prime benefit: the risk reduction

Even modest amount of diversification can sharply
dampen portfolio risk

15-22
15-23
15-24
Maturity-Based Strategies

Laddering: for an investor who seeks

greater interest income with minimum price
volatility
Construct a portfolio using bonds with a
series of targeted maturities,
resembling a bond maturity ladder

Barbell strategy: concentrates on both very

short term and very long term bonds (six
month T-bill and 30 year T-bonds)

Bond swap: the simultaneous sale and

purchase of fixed income securities

15-25