Chapter 11: Answers to Concepts in Review

1. There is no single market rate of interest applicable to all segments of the bond market.
Instead, a series of market yields exists for a variety of market instruments. In general, the
interest rate on a particular bond issue will depend on a variety of issue characteristics,
including the type of issuer, the amount of tax exposure, its call feature, coupon, and time to
maturity. The investment implications of such a market are simple: Investors can pick the
segments which have the return, risk, and other characteristics that best meet their
investment needs. For example, they can move from agency bonds with a fairly low return
(and risk) to corporate bonds and receive a higher return. In short, it opens up the investment
alternatives and investment opportunities for investors.

2. The behavior of interest rates is perhaps the single most important element in determining
the level of return from a bond investment program. Interest rates affect the level of current
income earned by conservative investors, as well as the amount of capital gains generated
by aggressive bond traders. Whereas conservative investors are primarily concerned with the
level of interest rates, aggressive investors are interested chiefly in movements in interest
rates (the amount of interest rate volatility). Some of the major determinants of interest rates
include: inflation, the money supply, the demand for loanable funds, the amount of deficit
spending by the Federal Government, and actions of the Federal Reserve (like changes in the
discount rate). Individual investors can monitor interest rates and formulate interest rate
expectations on an informal basis through the use of reports obtained from their brokers,
from investor services (e.g., S&Ps Creditweek), and/or by following columns/articles in
such business and financial publications as The Wall Street Journal or Business Week.

3. The term structure of interest rates is the relationship between the interest rate or yield and the
time to maturity for any class of similar risk securities. The yield curve is just a graphic
representation of the term structure of interest rates at a given point in time. To plot a yield
curve, you need to know the yield to maturity for different maturities of similar risk bonds. As
market conditions change, the yield curves shape and location also change.
The upward-sloping yield curve indicates that yields tend to increase with longer maturities.
The longer a bond has to go to maturity, the greater the potential for price volatility and the
risk of loss. Thus, investors require higher yields on longer maturity bonds. Flat yield curves
indicate that yields will be the same across maturities. Given that longer-term bonds have
more default and maturity rate risk, a flat yield curve implies that inflation rates are expected
to decline.

4. Analyzing the changes in yield curves over time provides investors with information about
future interest rate movements and how they can affect price behavior and comparative
returns. For example, if over a specific time period, the yield curve begins to rise sharply, it
usually means that inflation is increasing. Investors can expect that interest rates, too, will
rise. Under these conditions, most seasoned bond investors would turn to short or
intermediate (three to five year maturities). A downward-sloping yield curve would signal
that rates have peaked and are about to fall.
Differences in yields on different maturities at a particular point in time, or the steepness
of the curve, is an indication that long-term rates are likely to fall somewhat to narrow the
spread, providing an incentive to invest in longer-term securities. Steep yield curves are
generally viewed as a signs that long-term rates are near their peak.

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 Even among longer-term maturities, the spread between different longer-term maturities
should be considered before making a decision to invest. For example, if the spread between
10 and 30-year maturities is not large enough (say, less than 20 basis points), then the
investor should favor the
10-year bond, because he would not gain enough to compensate for investing in the much
riskier
30-year maturity. In any case, the investor would have to consider his or her own risk
tolerance to determine whether the risk premium was sufficient for the additional risk of
buying longer-term securities.
5. Bond prices are driven by market yields. In the marketplace, the appropriate yield at which
the bond should sell is determined first, and then that yield is used to find the price of the
bond. The yield is a function of certain market and economic forces, such as the risk-free
rate and inflation, as well as key issue and issuer characteristics, such as the maturity of the
issue and agency rating assigned to the bond.
You cannot value a bond without knowing its market yield, which functions as the discount
rate in the bond valuation process.

6. Bonds are usually priced using semiannual compounding because in practice, most bonds
pay interest every six months. Semiannual compounding makes discounting of semiannual
coupon payments more precise, resulting in more accurate valuation. However, using annual
compounding simplifies the valuation process a bit and does not make very much difference
in value. With higher coupons and longer maturities, the difference increases more. Bonds
offering semiannual payments will be priced higher.

7. Current yield is a measure of a bonds current income. It is the amount of current income a
bond provides relative to its prevailing market price. Yield-to-maturity is a more complete
measure and evaluates both interest income and price appreciation. Yield-to-maturity
indicates the fully-compounded rate of return earned by an investor, given that the bond is
held to maturity and all principal and interest payments are made in a prompt and timely
fashion.
Promised yield is the same as yield-to-maturity. Promised yield is computed assuming the
bond is held to maturity and the coupon cash flows are reinvested at the bonds computed
promised yield. Realized yield is the rate of return an investor can expect to earn by holding
a bond over a period of time that is less than the life of the issue. Realized yield is used by
bond traders who trade in and out of bonds over short holding periods.

8. When we are dealing with semi-annual cash flows, to be technically correct, we should find
the bonds effective annual yield. But the market convention for finding the annual yield
is to double the semiannual yield. This practice produces what the market refers to as the
bond-equivalent yield. Thus, given a semi-annual yield of 4%, according to the bond-
equivalent yield convention, the annual rate of return of this bond if held to maturity is 8%.
This is also the same as the bonds promised yield or yield-to-maturity.

9. The reinvestment of interest income is an important consideration, because it is this rate that
an investor must earn on each of the interim cash throw-offs in order to realize a return equal
to or greater than the promised yield on a bond. As cash is received from interest income,
the equation for promised yield implicitly assumes this cash payment will be reinvested at a
rate of return equal to the issues promised yield; failure to do so means the investor will
generate a realized yield that is less than promised.

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10. Duration is a measure of bond price volatility. It captures both price and reinvestment risks
in a single measure and indicates how a bonds price will react to different interest rate
environments. It is the effective maturity of a fixed-income security. On the other hand, the
bonds actual maturity does not consider all of the bonds cash flows nor does it consider the
time value of money. Duration is a far superior measure of the effective timing of a bonds
cash flows, because it explicitly considers both the time value of money and the bonds
coupon and principal payments.
When the market undergoes a big change in yield, duration will understate price
appreciation when rates fall and overstate the price decline when rates increase. Modified
duration is used to overcome this problem by linking interest rate changes to changes in
bond price. First, you can compute the modified duration using the bonds computed
duration and the computed yield-to-maturity. Then, the change in bond price based upon a
change in interest rates can be computed as follows:
Percent change in bond price = 1 Modified duration Change in interest rates
11. Market interest rate changes have two effects: the price effect and the reinvestment effect,
which occur in opposite directions. When a bond portfolio is immunized, these two effects
exactly offset each other and leave the value of the portfolio unchanged. This happens when
the weighted average duration of the bond portfolio is exactly equal to the desired
investment horizon. If a portfolio is constructed and continuously rebalanced such that the
weighted average duration is equal to the desired investment horizon at any particular point
in time, then the portfolio is said to be immunized from the effects of interest rate changes.
Bond immunization allows an investor to derive a specified rate of return from bond
investments regardless of what happens to market interest rates over the course of the
holding period. That is, the investors bond portfolio is immunized from the effects of
changes in market interest rates over a given investment horizon.
Portfolio immunization is not a passive investment strategy; it requires continual portfolio
rebalancing on the part of the investor in order to maintain a fully-immunized portfolio. The
composition of the portfolio should change every time interest rates change, and also with
the passage of time.

12. Bond ladders are a passive investment strategy whereby an equal amount of money is
invested in a series of bonds with staggered maturities. Suppose an investor wants to
confine her investing to fixed income securities with maturities of 10 years or less. She
could set up the ladder by investing in roughly equal amounts of 3-, 5-, 7-, and 10-year
issues. When the 3-year issue matures, the proceeds would be reinvested in a new 10-year
note. Similar rollovers would occur whenever a bond matures. Eventually, the investor
would hold a full ladder of staggered 10-year notes. Rolling into new 10-year issues every
two or three years allows the investor to do a kind of dollar cost averaging and thereby
lessen the impact of swings in market rates.
Tax swaps involve replacement of a bond with a capital loss with a similar security. By
selling the bond with the capital loss, an investor can offset a capital gain generated in
another part of the portfolio and thereby reduce the overall tax liability. Identical issues
cannot be used for this kind of swap; the IRS will rule such swaps as wash sales and
therefore disallow the capital loss.

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13. An aggressive bond investor would employ the highly risky forecasted interest rate behavior
strategy. The intent of this strategy is to take advantage of interest rate swings by timing the
market. Usually these swings are short-lived, so aggressive bond traders will try to magnify
their returns by trading on margin. These investors try to generate capital gains when interest
rates are expected to decline and to preserve capital when an increase in interest rates is
expected.

14. The interest sensitivity of a bond determines how much the bonds price will fluctuate for a
given change in interest rates. Obviously, when rates drop, bond traders want to capitalize
on this and as such, require issues that will respond to these interest rate changes. Bonds
with longer maturities and/or lower coupons respond more vigorously to changes in market
rates; therefore, they undergo greater price swings. High-grade issues are widely used by
active bond traders since these issues are generally more interest-sensitive than lower-rated
bondsfor example, market behavior is such that a triple A corporate will generally be far
more responsive to interest rates than a triple B issue. A deteriorating economy will result in
a decline in the demand for money and hence interest rates, but it might cause more default
risk to the holder of the triple B bond issue.

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