Review

Bond quotation
Quoted price vs. the actual invoice price
Accrued interest
Common options/features in corporate bond
Callable, Puttable, Convertible, Floating rate, etc.
Bonding pricing and YTM calculation
Zero-coupon Bonds
Short-term: T-bills
Long-term: Treasury strips

Review: Bond Prices and Interest Rates

The decline is monotonic, but at a decreasing rate, which is

known as convexity.

Review: Bond Prices over Time

Review: Callable and Straight Debt

Yield to Call: YTC vs. YTM

Given the same bond as in the last slide, but callable in 10
years. Call price is $1,100. Current price is $1,150.
20

40
1,100
1,150

t
(1 c) 20
t 1 (1 c )
From which we obtain YTC = c = 3.32% per half year.
The YTM for this callable bond is 3.41% per half year.
Figure 14.4 shows how the call feature affects bond prices.
It truncates the upside potential to the investor. It is not a
bad deal, however, as callable bonds command higher
coupon rates than otherwise similar non-callable bonds.

Default Risk and Bond Pricing

Rating companies:
Moodys Investor Service, Standard & Poors, Fitch
Rating Categories
Highest rating is AAA or Aaa
Investment grade bonds are rated BBB or Baa and
above
Speculative grade/junk bonds have ratings below BBB
or Baa.

Yields Spreads

Promised vs. Actual Yield to Maturity

Given 9% coupon, semiannual payments, 10 years remaining
to maturity, P0 = $750
All interest payments are expected, but only 70% of par value
is expected. What are the promised and expected YTM?
20

45
700
750

t
(1 re )20
t 1 (1 re )

so re , the expected YTM, is 5.82% per half year.

20

45
1000
750

t
(1 rp ) 20
t 1 (1 rp )

so rp , the promised YTM, is 6.83% per half year.

So beware of high promised yields on junk bonds!

Vulture Investor

Bond Indentures to Protect the Bondholders

Sinking funds
Spread the payment burden over several years
Repurchase a fraction of the outstanding bonds in the open
market each year

Subordination of further debt

Restrict the amount of additional borrowing
Junior bondholders will not be paid unless the prior senior
debt is fully paid off.

Dividend restrictions
Limit the dividends firms may pay

Collateral
A particular asset bondholders receive if the firm defaults

EF3320 Security Analysis and

Portfolio Management
Chapter 16
Managing Bond Portfolios

Interest Rate Risk

As interest rates rise and fall, bondholders experience
capital looses and gains.
Therefore, the sensitivity of bond prices to changes in
market interest rates is of great concern to investors.

Interest Rate Risk

A:B - different maturity

B:C - different coupon rate
C:D - different YTM at which the bond currently is selling

Bond Pricing Relationships

Bond prices and yields are inversely related.
An increase in yield results in a smaller price decline than
the gain associated with an equal magnitude decrease in
yield (convexity).
Long-term bonds are more price sensitive to interest rate
changes than short-term bonds.
As maturity increases, price sensitivity increases, but at a
decreasing rate.
Prices of low coupon bonds are more sensitive than prices of
high coupon bonds.
The price sensitivity is higher when the current YTM is
lower.

Coupon Effect
Two bonds with the same time to maturity do not necessarily
have the same interest rate risk.
Consider the coupon rates:
Higher coupon rate means a higher fraction of value tied to
coupons rather than the final payment of par value
Heavier weights on the earlier payments
shorter effective
maturity
lower interest rate risk
For lower coupon bond, investors must wait longer to realize a
substantial return
longer effective maturity
higher interest
rate risk

Coupon Effect
Shaded area of each box is PV of cash flow
Effective maturity is similar to the distance to the fulcrum

Effective maturity

High C, Lower effective maturity

Low C, Higher effective maturity

YTM Effect
Consider the current yield to maturity:
Higher yield reduces the present value of all payments, but
more so for more-distant ones
Higher yield means a higher fraction of the bonds value is
due to its earlier payments
Heavier weights on the earlier payments
shorter
effective maturity
lower interest rate risk

YTM Effect

Effective maturity

yield, weight on earlier payments , fulcrum shifts

left
yield, weight on earlier payments , fulcrum shifts
right

Duration Macaulays Duration

Duration: A measure of the effective maturity of a bond

Macaulays Duration: the weighted average of the times to

each payment
CFt /(1 y ) t

CFt /(1 y ) t
wt T

;
t
1 CFt /(1 y ) bond price
y is the bonds YTM
D 1 t wt
T

w
T

Duration & Price Relationships

Whats the interest rate sensitivity of a bond?
T

P
t 1

CFt
(1 y ) t

CFt
dP
1 T
t

dy 1 y t 1 (1 y )t

1 T
CFt

t
P P

1 y t 1 (1 y )

dP
1

DP
dy 1 y

Therefore,

wt

dP
dy
D
P
1 y
P
y
D
P
1 y

Price change is proportional to duration and not to maturity

Duration Modified Duration

If we want a more direct measure of the relationship between changes in bond prices
and interest rates, we can use Modified Duration, defined as

D
So D* measures the sensitivity of the %(1change
y ) in bond price to changes in yield
D*

P
D *y
P

Calculating the Duration of Two Bonds

Duration of Bonds with Different Features

Duration Rules
1. Duration is shorter than maturity for all bonds except zero
coupon bonds. Duration of a zero-coupon bond equals
maturity.
2. Holding time to maturity and YTM constant, duration is
higher when coupons are lower.
3. Holding coupon and YTM constant, duration generally (but
not always) increases with time to maturity.
4. Holding coupon and time to maturity constant, duration is
higher when YTM is lower.
5. Duration of a perpetuity is (1+y)/y.

Bond Durations
(Yield to Maturity = 8% APR; Semiannual Coupons)

Duration is Additive
The duration of a portfolio of securities is the weighted
average of the durations of the individual securities with
the weights reflecting the proportion invested in each.
Example: Let 25% of a portfolio be invested in a bond
with a duration of 5 and let 75% of the portfolio be
invested in a bond with a duration of 10.
Dp = (0.25 * 5) + (0.75 * 10) = 8.75 years

Why is Duration a Big Deal?

Simple summary statistic of effective average maturity
Measures sensitivity of bond price to interest rate changes
Measure of bond price volatility
Measure of interest-rate risk
Useful in the management of risk
You can match the duration of assets and liabilities
Or hedge the interest rate sensitivity of an investment

Example
Consider a 3-year 10% coupon bond selling at $1078.7 to
yield 7%. Coupon payments are made annually. Whats the
duration of this bond? If yields increase to 7.10%, how does
the bond price change (duration rule & PV formula)?
100
93.5
(1.07)
100
PV (CF2 )
87.3
2
(1.07)
1100
PV (CF3 )
897.9
3
(1.07)
Price of bond 93.5 87.3 897.9 1078.7
PV (CF1 )

93.5
87.3
897.9
Duration ( D ) 1*
2*
3*

1078.7
1078.7
1078.7
2.7458

Example
Modified duration of this bond:
D*

2.7458
2.5661
1.07

If yields increase to 7.10%, how does the bond price change?

The percentage price change of this bond is given by:
P
D* y
P
= 2.5661 .0010
= .2566 %

Example
What is the predicted change in dollar terms?
P 0.2566% P
0.2566% $1078.7
$2.768

New predicted price: $1078.7 2.768 = $1075.932

Actual dollar price (using PV formula):
N=3; PMT=100; FV=1000; I/Y =7.1; PV=$1075.966

Good
approximation!

Duration and Interest Rate Sensitivity

Example: A 30-year bond that pays an annual coupon of 8%.
The current YTM is 9%. Then the duration should be 11.37
years. The current bond price is $897.26. If YTM changes to
9.1%, we predict that the bond price should change by:
P = D P y/(1+y) = 11.37/1.09
= $9.36 (Decrease)
Whats the price change if we use the annuity formula?
The bond price with 9.1% interest equals $887.98. The
difference of $9.28 is quite close to $9.36 predicted by
duration formula.

Duration is a Local Concept

Suppose that in the last example the YTM changed to
10%. Whats the price change predicted by the duration
formula?
P = 11.37897.260.01/1.09 = $93.59.

Whats the price change predicted by the annuity formula?

P = 811.46 897.26 = $85.80.

Duration is a Local Concept

Now the divergence is more substantial. This points to an
important limitation of the duration formula.
Duration is a local concept, and its value changes as the
YTM changes.
Why?

Convexity
The relationship between bond prices and yields is not
linear.
Duration rule is a good approximation for only small
changes in bond yields.
Bonds with greater convexity have more curvature in the
price-yield relationship.

Bond Price Convexity:

30-Year Maturity, 8% Coupon; Initial YTM = 8%

Convexity
Measures how much a bonds price-yield curve deviates
from a straight line
Second derivative of price with respect to yield divided by
bond price
2P
1

2
y (1 y ) 2

CFt
2

(1 y ) t (t t )
t 1

1 2P
1
Convexity

2
P y P(1 y ) 2

CFt
2

(1 y )t (t t )
t 1

Allows us to improve the duration approximation for bond

price changes

Convexity
Recall approximation using only duration:
P
D * y
P
*
New bond price P P ( D ) y

The predicted percentage price change accounting for

convexity: P
1
*
2
P

D y

Convexity (y )

1
*
2

D
)

Convexity

y
)
New bond price
2

Numerical Example with Convexity

Consider the bond in Figure 16.3, with a 30-year 8% coupon bond selling at par value ($1,000), to yield
8%. We can find that the modified duration is 11.26, and the convexity is 212.4.
If the yield increases from 8% to 10%, the bond price will fall to $811.46, a decline of 18.85%.
The duration rule indicates that
After correcting for convexity

P
D * y 11.26 0.02 22.52%
P

P
1

*
D y Convexity (y ) 2
P
2

1
2

11
.
26

0
.
02

The convexity of the bond is 164.106. 212.4 (0.02)

2
0.1827 or 18.27%

Numerical Example with Convexity

What if yields fall by 2%?
If yields decrease instantaneously from 8% to 6%, whats
the percentage price change of this bond?
P
1

D* y Convexity (y ) 2
P
2

1
11.26 0.02 212.4 (0.02) 2
2
0.2676 or 26.76%

Note that predicted change is NOT SYMMETRIC.

Convexity of Two Bonds

Investors Like Convexity

Bonds with greater curvature gain more in price when
yields fall than they lose when yields rise.
The more volatile interest rates, the more attractive this
asymmetry.
Bonds with greater convexity tend to have higher prices
and/or lower yields, all else equal.

Passive Management VS. Active Management

There are two passive bond portfolio strategies. Both
strategies see market prices as being correct, but the
strategies have very different risks.
Indexing: have the same risk-reward profile as the bond
market index to which it is tied
Immunization: seek to establish a virtually zero-risk
profile
Active management
Interest rating forecasting
Identification of relative mispricing within the fixedincome market

Bond Index Funds

Major bond indexes:
Barclays Capital Aggregate Bond Index, Salomon Broad
Investment Grade Index, etc.

Bond indexes contain thousands of issues, many of which are

infrequently traded.
Difficult to purchase the securities at a fair market price

Bond indexes turn over more than stock indexes.

Bonds are continually dropped from the index as their
maturities fall below certain level (i.e. 1 year), and new bonds
are added when they are issued.

Therefore, bond index funds hold only a representative

sample of the bonds in the actual index.

Immunization
Immunization is a way to control interest rate risk.
Widely used by pension funds, insurance companies, and
banks, since these institutions often have a mismatch
between asset and liability maturity structures.
For example, banks liabilities are short-term deposits,
but their assets are long-term loans or mortgages.
When interest rate increase unexpectedly, banks can
suffer serious decreases in net worth.
Result: Value of assets will track the value of liabilities
whether rates rise or fall.

Immunization An Example
An insurance company must make a payment of $19,487
in 7 years. The market interest rate is 10%, so the present
value of the obligation is $10,000. The companys
portfolio manager wishes to fund the obligation using 3year zero-coupon bonds and perpetuities paying annual
coupons. How can the manager immunize the obligation?

Immunization: the duration of the portfolio of assets

equal the duration of the liability

Immunization An Example
1. Calculate the duration of the liability
one single payment: duration = 7 years
2. Calculate the duration of the asset portfolio
duration of the zero-coupon bond = 3 years
duration of the perpetuity is 1.1/0.1 = 11 years
assume the fraction in the zero is w, then the portfolio
duration = w * 3 + (1 - w) * 11

Immunization An Example
3. Find the asset mix that sets the duration of assets equal to
the 7-year duration of liabilities
w * 3 + (1 - w) * 11 = 7, implying w = 0.5
4. Fully fund the obligation.

The manager must purchase $5,000 of the zero and

$5,000 of the perpetuity.

Face value of zero = $5,000 * (1.1)3 = $6,655

Immunization An Example
Suppose that 1 year has passed, and the interest rate remains at
10%. The portfolio manager needs to reexamine her position.
Is the position still fully funded (i.e., value of the asset = value
of the obligation) ? Is it still immunized?
We first need to calculate the PV of the asset and the obligation.
PV of the obligation:
FV = $19,487; I/Y = 10; PMT = 0; N = 6; CPT PV = $11,000
PV of the asset:
Zero: PV = 6,655/ (1.1)2 = 5,500
Perpetuity : Get paid $500, and remain worth 5,000
Value of the asset = Value of the obligation fully funded

Immunization An Example
We next need to find the asset mix that sets the duration of
assets equal to the duration of liabilities
Immunization: w * 2 + (1 - w) * 11 = 6,
w = 5/9
The manager now must invest a total of $11,000*(5/9)=
$6,111.11 in the zero.