Unit – 5: Valuing Bonds

Presentation by-
Jatin Tiwari 23/BMBA/09
Jatin Verma 23/BMBA/10
Bond Duration
• Duration is a measure of the sensitivity of the price of a bond or
other debt instrument to a change in interest rates.
• Duration measures how long it takes, in years, for an investor to
be repaid a bond’s price through its total cash flows.
• Duration can also be used to measure how sensitive the price of
a bond or fixed-income portfolio is to changes in interest rates.
• In general, the higher the duration, the more a bond’s price will
drop as interest rates rise. This also indicates a higher level of
interest rate risk. For example, if rates were to rise 1%, a bond or
bond fund with a five-year average duration would likely lose
about 5% of its value.
Factors affecting the duration
Time to Maturity Coupon Rate
• The longer the maturity, • A bond’s coupon rate, or
the higher the duration, yield that it pays, is a key
and the greater the factor in the calculation of
interest rate risk. duration. If two bonds are
Consider two bonds that identical except for their
each yield 5% and cost coupon rates, the bond
$1,000, but have different with the higher coupon
maturities. A bond that rate will pay back its
matures in one year original costs faster than
would repay its true cost the bond with a lower
faster than a bond that yield. The higher the
matures in 10 years. coupon rate, the lower
Therefore, the shorter- the duration, and the
maturity bond would have lower the interest rate
Bonds with uneven payments
• A bond with uneven payments, also known as a bond
with irregular or variable payments, is a type of fixed-
income security that differs from traditional bonds
because it does not pay fixed, equal coupon payments
at regular intervals. Instead, the bond’s interest
payments (or even principal repayments) can vary in
amount and/or timing.
 Why uneven
payments? Structured and
Floating Rate:
Callable Bonds: Project-Linked
Some bonds have
Bonds can have Bonds: Certain
floating rates tied to
structured features, bonds issued for
a specific benchmark
such as call or put specific projects, like
rate. When interest
options, which allow infrastructure, may
rates rise or fall, so
the issuer or holder have variable
do the bond
to redeem the bond payments based on
payments, creating
early or on specified project revenue or
an uneven payment
terms, affecting cash flow.
structure.
payment patterns.
Valuing Bonds with Uneven
Payments
• Discounted Cash Flow Analysis: The bond’s value is
determined by discounting each cash flow (both interest
and principal repayments) back to the present value.
Since payments are not uniform, each payment has to
be discounted individually.
• Yield Calculations: Calculating yield for these bonds is
complex due to the irregular payments. Methods such
as internal rate of return (IRR) can help estimate
the effective yield.
Terms Structure of Interest Rates
• The term structure of interest rates, commonly known
as the yield curve, depicts the interest rates of similar
quality bonds at different maturities. It's graphical
representation is known as Yield Curve
• Upward Sloping or Normal Yield Curve
Long-term yields are higher than short-term yields. This is considered to be the "normal"
slope of the yield curve and signals that the economy is expanding.
• Downward Sloping or Inverted Yield Curve

• Perhaps the most infamous, this indicates that short-term yields are higher than long-
term yields. Dubbed an "inverted" yield curve, it has traditionally signified that the
economy is in, or about to enter, a recession.
 Immunization Strategies
• Immunization, also known as multi-period immunization, is
a risk-mitigation strategy that matches the duration of
assets and liabilities in order to minimize the impact of
interest rates on net worth over time.
• Immunization is a form of risk management for fixed-
income portfolios, aimed at offsetting interest rate risk (the
risk that changes in rates will affect bond values).
• It seeks to achieve a balance where the portfolio’s value is
“immune” to interest rate changes, meaning that any
gains or losses in bond prices due to rate shifts are offset
by corresponding changes in reinvestment income.
 3 types of strategies
Cash Flow matching: Cash flow
matching, on the other hand, relies Duration matching: aims to Convexity matching: is an
on the availability of securities with balance the opposing effects advanced risk management
specific principals, coupons, and interest rates have on the price strategy in bond portfolio
maturities to work efficiently. return and reinvestment return of a management that complements
Assume an investor needs to pay a coupon bond. A multiple liability duration matching to better
$10,000 obligation in five years. To immunization strategy pays off protect a bond portfolio from
immunize against this definite cash better when the interest rate shifts interest rate changes. While
outflow, the investor can purchase are not too arbitrary. It requires a duration matching helps align the
a security that guarantees a lower investment than cash flow bond portfolio’s sensitivity to small
$10,000 inflow in five years. A five- matching but does carry interest rate shifts, convexity
year zero-coupon bond with a reinvestment risk in the case of matching accounts for larger,
redemption value of $10,000 would non-parallel rate shifts. To nonlinear changes in rates.
be suitable. By purchasing this immunize a bond portfolio using the Together, duration and convexity
bond, the investor matches the duration method, an investor must matching can create a more
expected inflow and outflow of match the portfolio's duration to resilient portfolio that maintains its
cash, and any change in interest the investment time horizon in value in volatile interest rate
rates would not affect their ability question. environments.
to pay the obligation in five years.
Modelling Term Structure
In finance, the term structure of interest rates
(often represented by the yield curve) refers to
the relationship between interest rates (or
yields) and the different maturities of debt
securities, typically government bonds.
Modeling the term structure helps to understand
how yields vary across time horizons, providing
insight into investor expectations, economic
conditions, and policy impacts. Here's an
overview of popular models used in term
structure modeling with an example to illustrate:
1. Pure Expectations Theory
• Concept: Suggests that the shape of the yield curve
reflects investor expectations for future interest rates. A
steep yield curve indicates expectations of rising rates,
while a downward-sloping (inverted) yield curve
suggests falling rates.

• Example: If 1-year government bonds currently yield

3%, and investors expect rates to rise to 4% next year,
the yield on a 2-year bond will approximately average
out to 3.5%.
2. Liquidity Preference Theory
• Concept: Investors require a premium for holding
longer-term bonds due to the increased risk and
decreased liquidity of these investments. As a result,
the yield curve is typically upward sloping, even when
future interest rates are expected to remain constant.

• Example: If the expected 1-year interest rate is 3%, the

2-year bond might yield 3.25% to compensate for
additional holding risks.
3. Market Segmentation Theory
• Concept: Assumes that different investor groups have
specific maturity preferences based on their needs,
leading to different demand levels at different
maturities.

• Example: Pension funds prefer long-term bonds, while

corporations might prefer short-term bonds. This causes
yields to vary independently of general interest rate
expectations.
Term Structure Example with
Bonds of the Same Maturity
Suppose you are examining the yield of bonds that all
mature in 10 years (2034) but are issued by different types
of entities, each with varying credit quality. This scenario
allows you to see how bond yields align with risk factors,
forming a mini term structure for the same maturity date.
Let’s analyze three bonds with the same maturity date in
2034.
 U.S. Treasury Bond Corporate Bond (High- High-Yield Corporate Bond
(Benchmark Risk-Free Grade Investment Bond) (Junk Bond)
Bond) • Issuer: AAA-rated • Issuer: BB-rated
• Issuer: U.S. corporation, e.g., corporation, e.g., a
Government Microsoft telecommunications
• Maturity Date: 2034 • Maturity Date: 2034 company with higher debt
(10 years from now) (10 years from now) levels
• Coupon Rate: 3.5% • Coupon Rate: 4.2% • Maturity Date: 2034 (10
annually annually years from now)
• Credit Rating: AAA • Credit Rating: AA (Low • Coupon Rate: 7.0%
(Very Low Risk) Risk but slightly higher annually
• Yield to Maturity than the U.S. Treasury) • Credit Rating: BB (Higher
(YTM): 3.3% • Yield to Maturity Risk)
This high-yield corporate bond
• Price: $1,015 (slightly (YTM):
This 4.0% corporate
high-grade • Yield to Maturity (YTM):
has a significantly higher yield
above par due to high •bond
Price:
has $1,020 (slightly
a slightly higher 6.8%
The U.S. Treasury bond is (6.8%) due to its BB credit
demand and low yield) above
yield par)than the Treasury
(4.0%) • Price: $950 (trades below
used as the risk-free rating, indicating higher risk. The
benchmark for 10-year bond due to the additional par)
lower price reflects the
bonds, with a yield of credit risk, although it’s still additional yield investors require
3.3%. Investors use this as rated highly (AA). Investors to hold this riskier asset, and it
a baseline to evaluate require a small risk premium typically appeals to investors
additional risk premiums over the Treasury rate to seeking higher returns in
required for other bonds. compensate for the additional exchange for accepting greater
risk of lending to a
Key Insights:
• Credit Spread: The yield difference between bonds with the same
maturity reflects the credit spread, which increases as credit risk rises.
Here, the high-yield corporate bond yields 3.5% more than the U.S.
Treasury bond, representing compensation for its higher risk.
• Risk Premium in Term Structure: Even though all bonds mature in
2034, investors require varying premiums over the Treasury bond
(benchmark risk-free rate). The corporate bond’s yield is 0.7% higher than
the Treasury, reflecting a small premium for its high credit quality but lower
security compared to the U.S. government.
• Investor Considerations: Investors might select among these bonds
based on their risk tolerance. Conservative investors may choose the
Treasury bond with the lowest yield for maximum safety. Those seeking
higher returns with moderate risk may opt for the AA-rated corporate bond,
while aggressive investors might go for the high-yield bond, accepting its
elevated risk in exchange for a higher return.
• This example highlights how bonds with the same maturity create a mini-
term structure, allowing investors to assess credit risk and yield premiums
based on the issuer's reliability while holding the maturity date constant.
Fitting a function form to term
structure
Fitting a function to the term structure of
interest rates, or yield curve, involves
selecting a mathematical model that
describes how yields vary across different
maturities. This is essential for estimating
yields when data is limited or for forecasting
future interest rates. Common function
forms for fitting term structures include
polynomial models, exponential
models, and parametric models (e.g.,
1. Polynomial Models
• Concept: The yield curve is modeled as a polynomial
function of the bond maturity. A simple polynomial
model can be written as:

2. Exponential Models
• Concept: Exponential models provide a smoother fit by
exponentially weighting maturities. One common form
is:
 Nelson-Siegel Model (Parametric Approach)
• Concept: The Nelson-Siegel model is a popular choice
because it offers flexibility while preventing overfitting.
The model’s functional form is:

where:
•β0​represents the long-term level of the yield curve,
•β1​controls the slope,
•β2​adjusts the curvature, and
•τ is a decay factor that determines how quickly the effect of β1 and β2 dissipates
over time.
Selecting a Model
• Simple Polynomial: Works best for local fit but may
have issues with oscillations and lack of long-term
stability.
• Exponential Models: Good for capturing short-term
interest rate dynamics.
• Nelson-Siegel: Excellent balance between flexibility
and stability, capturing level, slope, and curvature.
• Svensson: Ideal for complex curves with multiple
humps, useful in volatile market conditions.
Properties of Nelson-siegel term
stucture
1. Parsimonious and Flexible Model
• The Nelson-Siegel model captures the yield curve with just four parameters (β0 , β1 , β2 ,
and τ). This makes it parsimonious, providing a good fit without over-complicating the
model.
• The parameters effectively capture the level, slope, and curvature of the yield curve,
making it flexible enough to adapt to various shapes of yield curves (upward sloping,
downward sloping, humped, etc.).
2. Level, Slope, and Curvature Components
• Level (β0 ): Represents the long-term yield level, approximating where long-term rates
might settle over time. This component has a constant effect across all maturities.
• Slope (β1 ): Adjusts the steepness of the yield curve at short maturities. A positive slope
typically corresponds to an upward-sloping yield curve (normal curve), where short-term
yields are lower than long-term yields.
• Curvature (β2 ): Captures the "hump" or concavity in the middle of the yield curve. This is
crucial for reflecting yield curve behaviors where mid-term rates differ from short- and
long-term rates, often observed in a normal yield curve.
3. Decay Parameter (τ)
• The decay factor τ controls the rate at which the slope and curvature
components decay over time. It influences how quickly the effects of β1 and
β2 diminish as maturity increases, allowing the yield curve to transition from
short-term to long-term rates smoothly.
• A smaller τ produces a steeper curve with more emphasis on short-term
variations, while a larger τ\tauτ allows the curve to stay flatter for longer, better
capturing changes at medium to long maturities.
4. Ability to Capture Common Yield Curve Shapes
• Upward Slope (Normal Curve): When β1 is positive and larger than β2 , the
yield curve typically slopes upward, representing higher long-term yields
compared to short-term yields.
• Inverted Curve: When β1 is negative, the yield curve can slope downward,
often reflecting an inversion, which may signal economic recession expectations.
• Humped Curve: With the right combination of β2 and τ, the model can capture
a "hump" where medium-term yields are higher than short- and long-term yields,
which may occur in volatile or uncertain economic conditions.
5. Smoothness and Stability
• The model’s exponential decay function ensures smooth transitions across
maturities, creating a smooth and continuous yield curve.
• This smoothness is essential for reliable interpolation between observed
maturities and for applications such as bond pricing, risk management, and
macroeconomic analysis.

6. Empirical Consistency
• The Nelson-Siegel model has been shown to fit observed yield curves in various
market conditions, which is why it’s widely used by central banks and financial
institutions.
• It’s particularly useful for capturing dynamic movements in yield curves,
enabling central banks to estimate and analyze how the yield curve changes
over time.
Term structure of treasury notes
• The term structure of Treasury notes represents the relationship
between yields and maturities (usually 2 to 10 years). It’s visualized
by the yield curve, which can be:
• Upward-sloping (normal): Indicates confidence in future growth.
• Inverted: Signals possible recession if short-term yields are higher
than long-term.
• Flat or humped: Shows uncertainty or mid-term instability
expectations.
• Treasury yields act as a risk-free benchmark for other rates, and the
shape of the curve reflects economic expectations—influenced by
growth, inflation, Federal Reserve policy, and market sentiment.
Investors and policymakers use the term structure to gauge financing
costs, manage risks, and forecast economic conditions.