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INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones

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Chapter 11 Bond Yields and Prices

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Calculate the price of a bond. Explain the bond valuation process. Calculate major bond yield measures, including yield to maturity, yield to call, and horizon return. Account for changes in bond prices. Explain and apply the concept of duration. Learning Objectives

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Intrinsic value Is an estimated value Present value of the expected future cash flows Required to compute intrinsic value Expected future cash flows Timing of expected cash flows Discount rate, or required rate of return by investors Bond Valuation Principle

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Value of a coupon bond with semi-annual payments: Bond Valuation Biggest problem is determining the discount rate or required yield Required yield is the current market rate earned on comparable bonds with same maturity and credit risk

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Rates and basis points 100 basis points are equal to one percentage point Short-term riskless rate Provides foundation for other rates Approximated by rate on Treasury Bills Other rates differ because of Maturity differentials Security risk premiums Interest Rates

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Maturity differentials Term structure of interest rates Accounts for the relationship between time and yield for bonds the same in every other respect Risk premium Yield spread or yield differential Associated with issuer’s particular situation Interest Rates

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Real rate of interest Rate that must be offered to persuade individuals to save rather than consume Rate at which real capital physically reproduces itself Nominal interest rate Function of the real rate of interest and expected inflation premium Determinants of Interest Rates

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Market interest rates on riskless debt (nominal rate) real rate + expected inflation Fisher Hypothesis Real rate estimates obtained by subtracting the expected inflation rate from the observed nominal rate Determinants of Interest Rates

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Defined as the ratio of the coupon interest to the current market price Uses the current market price instead of the face amount of a bond ($1,000) Not a true measure of the return – does not account for the difference between bond’s purchase piece and eventual redemption at par value Current Yield

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Yield to maturity (YTM) Rate of return on bonds most often quoted for investors Promised compound rate of return received from a bond purchased at the current market price and held to maturity Equates the present value of the expected future cash flows to the initial investment Similar to internal rate of return Yield to Maturity

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Solve for YTM (semi-annual coupons): Investors earn the YTM if the bond is held to maturity and all coupons are reinvested at YTM Yield to Maturity

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Yield to a specified call date and call price Substitute number of periods until first call date for and call price for face value (semi- annual coupons) Applies to callable bonds Yield to Call

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For:(1) longer-term bonds (2) bonds with higher coupon rates (i.e., have more money to reinvest) NO reinvestment risk for “Zeroes” Reinvestment Risk

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Rate of return actually earned on a bond given the reinvestment of the coupons at varying rates Can only be calculated after investment period is over Horizon return analysis Bond returns based on assumptions about reinvestment rates Realized Yield

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Over time, bond prices that differ from face value must change Bond prices move inversely to market yields The change in bond prices due to a yield change is directly related to time to maturity and inversely related to coupon rate Bond Price Changes

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Holding maturity constant, a rate decrease will raise prices a greater percent than a corresponding increase in rates will lower prices Price Market yield Bond Price Changes

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Important considerations Different effects of yield changes on the prices and rates of return for different bonds Maturity inadequate measure of a bond’s economic lifetime A measure is needed that accounts for both size and timing of cash flows Measuring Bond Price Volatility: Duration

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A measure of a bond’s lifetime, stated in years, that accounts for the entire pattern (both size and timing) of the cash flows over the life of the bond The weighted average maturity of a bond’s cash flows Weights determined by present value of cash flows Duration

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Need to time-weight present value of cash flows from bond Duration depends on three factors Maturity of the bond Coupon payments Yield to maturity Calculating Duration

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Duration increases with time to maturity, but at a decreasing rate For coupon paying bonds, duration is always less than maturity For zero coupon-bonds, duration equals time to maturity Duration increases with lower coupons Duration increases with lower yield to maturity Duration Relationships

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Allows comparison of effective lives of bonds that differ in maturity, coupon Used in bond management strategies, particularly immunization Measures bond price sensitivity to interest rate movements, which is very important in any bond analysis Why is Duration Important?

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Refers to the degree to which duration changes as the yield to maturity changes Price-yield relationship is convex Duration equation assumes a linear relationship between price and yield Convexity largest for low coupon, long-maturity bonds, and low yield to maturity Convexity

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To obtain maximum price volatility, investors should choose bonds with the longest duration Duration is additive Portfolio duration is just a weighted average Duration measures volatility, which is not the only aspect of risk in bonds Duration Conclusions

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Appendix 11-A Treasury Bill Yields and Prices T-bill are sold in Canada on a discount basis

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Appendix 11-C Convertible Bonds Convertible Bonds Bonds that are convertible into a specified number of C/S Terminology Iie. How many shares per bond

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Where “r” is the required rate of return on identical (similar) non-convertible bonds. Appendix 11-C Convertible Bonds

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Conversion Premium = Market price of convertible – Conversion value Minimum (Floor) Value = Maximum (straight bond value; conversion value) Appendix 11-C Convertible Bonds

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Why Issue/Buy Convertibles? Investors income (interest) but at lower rate participate in share price appreciation Firm “lower” coupons delayed equity financing (when share price rises) usually have call feature attached

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Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright

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INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones.

INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones.

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