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1 Callable bonds n Bonds that may be repurchased by the issuer at a specified call price during the call period n A call usually occurs after a fall in market interest rates that allows issuers to refinance outstanding debt with new bonds. n Generally, the call price is above the bonds face value. The difference between the call price and the face value is the call premium n Bonds are not usually callable during the first few years of a bonds life. During this period the bond is said to be call-protected.

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2 n Investors are typically interested in knowing what the yield will be if the bond is called by the issuer at the first possible date. This is called yield to call (YTC). n Suppose that we have a 3-year, $1,000 par value, 6% semiannual coupon bond. We observe that the value of the bond is $ The first call price is $1,060 in 2 years. Find YTC. n N= 4, FV = 1060 PMT=30 PV = n I/YR = 8.85*2= %

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3 More on Bond Prices Now assume a bond has 25 years to maturity, a 9% coupon, and the YTM is 8%. What is the price? Is the bond selling at premium or discount? Now assume the same bond has a YTM of 10%. (9% coupon & 25 years to maturity) What is the price? Is the bond selling at premium or discount?

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4 More on Bond Prices (contd) Now assume the same bond has a YTM of 10%. (9% coupon & 5 years to maturity) What is the price? Is the bond selling at premium or discount? Now assume the same bond has 5 years to maturity (9% coupon & YTM of 8%) What is the price? Is the bond selling at premium or discount?

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5 More on Bond Prices (contd) Where does this leave us? We found: CouponYearsYTMPrice 9%25 8%$1,107 9%2510%$ 908 9% 5 8%$1,040 9% 510%$ years 5 years

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6 n Decreasing yields cause bond prices to rise, but long-term bonds increase more than short-term. Similarly, increasing yields cause long-term bonds to decrease in price more than short-term bonds.

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7 Malkiels Theorems Summarizes the relationship between bond prices, yields, coupons, and maturity: all theorems are ceteris paribus: 1) Bond prices move inversely with interest rates. 2) The longer the maturity of a bond, the more sensitive is its price to a change in interest rates.

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8 3) The price sensitivity of any bond increases with its maturity, but the increase occurs at a decreasing rate. A 10-year bond is much more sensitive to changes in yield than a 1-year bond. However, a 30-year bond is only slightly more sensitive than a 20-year bond.

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9 Bond Prices and Yields (8% bond) Time to Maturity Yields5 years10 years20 years 7 percent $1,041.58$1,071.06$1, percent Price Difference $81.14 $ % $ %

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10 4)The lower the coupon rate on a bond, the more sensitive is its price to a change in interest rates. n If two bonds with different coupon rates have the same maturity, then the value of the one with the lower coupon is proportionately more dependent on the face amount to be received at maturity. n As a result, all other things being equal, the value of lower coupon bonds will fluctuate more as interest rates change. n Put another way, the bond with the higher coupon has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate

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11 20-Year Bond Prices and Yields Coupon Rates Yields6 percent8 percent10 percent 6 percent$1,000.00$1,231.15$1, percent , , percent ,000.00

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12 5) For a given absolute change in a bonds yield to maturity, the magnitude of the price increase caused by a decrease in yield is greater than the price decrease caused by an increase in yield

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13 Malkiels Theorems (#5) 8% coupon, 20 year bond

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14 Duration –Price sensitivity tends to increase with time to maturity –Need to deal with the ambiguity of the maturity of a bond making many payments. –Duration measures a bonds sensitivity to interest rate changes. –More specifically, duration is a weighted average of individual maturities of all the bonds separate cash flows. –The weight is the present value of the payment divided by the bond price.

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15 n Calculate a duration for a bond with three years until maturity. 8% of Coupon rate and yield.

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17 Calculating Par Value Bond Duration Calculating Macaulays Duration for a par value bond is a special case, as follows:

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18 To calculating Macaulays Duration for any other bond: C = annual coupon rate M = maturity (years)

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19 Assume you have a bond with 9% coupon, 8% YTM, and 15 years to maturity. Calculate Macaulays Duration.

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20 Price Change & Duration To compute the percentage change in a bonds price using Macaulay Duration: To compute the Modified Duration: To compute the percentage change in a bonds price using Modified Duration:

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21 Calculating Price Change Assume a bond with Macaulays duration of 8.5 years, with the YTM at 9%, but estimated the YTM will go to 11%, calculate the percentage change in bond price and the new bond price. Change in bond price, assuming bond was originally at par: Approx. new price = $1,000 + (-16.27% x $1,000) = $837.30

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22 Price Change & Duration Assume you have a bond with Macaulays duration of 8.5 years and YTM of 9%, calculate the modified duration. Using the bond above with modified duration of years and a change in yields from 9% to 11%, calculate the percentage change in bond price. Note this is the same percentage change as computed previously.

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24 n Zero coupon bond: duration = maturity n Duration Properties –Longer maturity, longer duration –Duration increases at a decreasing rate as maturity lengthens –Lower coupon, longer duration –Higher yield, shorter duration

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25 YTM = % What is the Macaulay duration of an 8% coupon bond with 3 years to maturity and a current price of $937.10? What is the modified duration? Solution: First calculate the yield:

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26 Now calculate the Macaulays duration. Solution: Mac. Duration = years Modified duration = / ( /2) = 2.58 years

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