2 Measuring ReturnRequired Return: the rate of return an investor must earn on an investment to be fully compensated for its riskFor bonds, the risk premium depends upon:the default, or credit, risk of the issuerthe term-to-maturityany call risk, if applicable
3 Major Bond SectorsBond market is comprised of a series of different market sectors:U.S. Treasury issuesMunicipal bond issuesCorporate bond issuesDifferences in interest rates between the various market sectors are called yield spreads
4 Factors Affecting Yield Spreads Municipal bond rates are usually 20-30% lower than corporate bonds due to tax-exempt featureTreasury bonds have lower rates than corporate bonds due to no default riskThe lower the credit rating (and higher the risk), the higher the interest rateDiscount (low-coupon) bonds yield less than premium (high-coupon) bonds
5 Factors Affecting Yield Spreads (cont’d) Revenue municiple bonds yield more than general obligation municiple bonds due to higher riskFreely callable bonds yield higher than noncallable bondsBonds with longer maturities generally yield more than shorter maturities
6 What is the single biggest factor that influences the price of bonds? Interest RatesInterest rates go G, bond prices go HInterest rates go H, bond prices go G
7 What is the single biggest factor that influences the direction of interest rates? InflationInflation goes G, interest rates go GInflation goes H, interest rates go H
8 Figure 11.1 The Impact of Inflation on the Behavior of Interest Rates
9 Term Structure of Interest Rates and Yield Curves Term Structure of Interest Rates: relationship between the interest rate or rate of return (yield) on a bond and its time to maturityYield Curve: a graph that represents the relationship between a bond’s term to maturity and its yield at a given point in time
11 Theories on Shape of Yield Curve Slope of yield curve affect by:Investors’ expectations regarding the future behavior of interest ratesLiquidity preferences of investorsMarket segmentation (supply and demand for bonds of different maturities)Risk premium and convexity
12 Theories on Shape of Yield Curve (cont’d) Expectations HypothesisShape of yield curve is based upon investor expectations of future behavior of interest ratesWhen investors expect interest rates to go up, they will only purchase long-term bonds if those bonds offer higher yields than short-term bonds; hence the yield curve will be upward slopingWhen investors expect interest rates to go down, they will only purchase short-term bonds if those bonds offer higher yields than long-term bonds; hence the yield curve will be downward sloping
13 Theories on Shape of Yield Curve (cont’d) Liquidity Preference TheoryShape of yield curve is based upon the difference in risk between short-term and long-term bondsIf investors’ view long-term bonds as being riskier than short-term bonds, then rates on long-term bonds must be higher than rates on short-term bondsInvestors may view long-term bonds as being riskier because long-term bonds are less liquid and are subject to greater interest rate risk
14 Theories on Shape of Yield Curve (cont’d) Market Segmentation TheorySuggests that the bond market consists of distinct segments (based on maturity) due to the preferences of investors and borrowersSupply and demand for funds in these distinct segments determine the level of short- and long-term interest ratesTherefore, an upward sloping yield curve is not a sign that investors expect rates to rise or a sign that investors see long-term bonds as being riskier than short-term bondsInstead, an upward sloping curve means that the supply of short-term funds is high relative to borrowers’ needs, so rates on short-term bonds are lower than rates on long-term bonds
15 Interpreting Shape of Yield Curve Upward-sloping yield curves result from:Expectation of rising interest ratesLender preference for shorter-maturity loansGreater supply of shorter-term loansFlat or downward-sloping yield curves result from:Expectation of falling interest ratesLender preference for longer-maturity loansGreater supply of longer-term loans
16 Basic Bond Investing Strategy If you expect interest rates to increase, buy short-term bondsIf you expect interest rates to decrease, buy long-term non-callable bonds
17 The Pricing of BondsBonds are priced according to the present value of their future cash flow streams
18 The Pricing of Bonds (cont’d) Bond prices are driven by market yieldsAppropriate yield at which the bond should sell is determined before price of the bondRequired rate of return is determined by market, economic and issuer characteristicsRequired rate of return becomes the bond’s market yieldMarket yield becomes the discount rate that is used to value the bond
19 The Pricing of Bonds (cont’d) Bond prices are comprised of two components:Present value of the annuity of coupon payments, plusPresent value of the single cash flow from repayment of the principal at maturityCompounding refers to frequency coupons are paidAnnual compounding: coupons paid once per yearSemi-annual compounding: coupons paid every six months
20 The Pricing of Bonds (cont’d) Bond Pricing Example:What is the market price of a $1,000 par value 20 year bond that pays 9.5 % compounded annually when the market rate is 10%?
21 Ways to Measure Bond Yield Current yieldYield-to-MaturityYield-to-CallExpected Return
22 Current YieldSimplest yield calculationOnly looks at current income
23 Yield-to-Maturity Most important and widely used yield calculation True yield received if the bond is held to maturityAssumes all interest income is reinvested at rate equal to market rate at time of YTM calculation—no reinvestment riskCalculates value based upon PV of interest received and the appreciation of the bond if held until maturityDifficult to calculate without a financial calculator
24 Yield-to-Maturity (cont’d) Yield-to-Maturity Example:Find the yield-to-maturity on a 7.5 % ($1,000 par value) bond that has 15 years remaining to maturity and is currently trading in the market at $809.50?
25 Yield-to-Call Similar to yield-to-maturity Assumes bond will be called on the first call dateUses bonds call price (premium) instead of the par valueTrue yield received if the bond is held to call
26 Yield-to-Call (cont’d) Yield-to-Call Example:Find the yield-to-call of a 20-year, 10.5 % bond that is currently trading at $1,204, but can be called in 5 years at a call price of $1,085?
27 Expected ReturnUsed by investors who expect to actively trade in and out of bonds rather than hold until maturity dateSimilar to yield-to-maturityUses estimated market price of bond at expected sale date instead of the par value
28 Expected Return (cont’d) Expected Return Example:Find the expected return on a 7.5% bond that is currently priced in the market at $ but is expected to rise to $960 within a 3-year holding period?
29 Bond DurationBond Duration: A measure of bond price sensitivity to interest rate changes.Macauley duration: Weighted average maturity of all cash flows, with the weight given by the present value of the cash flow, divided by the current bond price.
30 Bond DurationModified duration: Macauley duration/(1+y), measures the percentage change in bond value per change in interest rateExample: A bond as a Macauley duration of 7.00 and is priced to yield 5%. If the market interest rate goes up so that the yield goes up to 5.5%, the percentage change in the bond price is:-7*(5.5%-5%)/(1+5%)=-3.33%The bond price will go down by 3.33%.
31 The Concept of Duration Generally speaking, bond duration possesses the following properties:Bonds with higher coupon rates have shorter durationsBonds with longer maturities have longer durationsBonds with higher YTM lead to shorter durationsThe bond duration as a sensitivity measure works better for small rate moves, but may not work well for large moves due to convexity effects.
32 Measuring Duration Steps in calculating Macauley duration Step 1: Find present value of each coupon or principal paymentStep 2: Divide this present value by current market price of bondStep 3: Multiple this ratio by the year in which the bond makes each cash paymentStep 4: Repeat steps 1 through 3 for each year in the life of the bond then add up the values computed in Step 3
33 Table 11. 1 Duration Calculation for a 7 Table Duration Calculation for a 7.5%, 15-Year Bond Priced to Yield 8%
34 Bond ImmunizationStrategy to derive a specified rate of return regardless of what happens to market interest rates over holding periodSeeks to offset the opposite changes in bond valuation caused by price effect and reinvestment effectPrice effect: change in bond value caused by interest rate changesReinvestment effect: as coupon payments are received, they are reinvested at higher or lower rates than original coupon rateBond immunization occurs when the average duration of the bond portfolio just equals the investment time horizon.
35 Bond Investment Strategies Conservative ApproachMain focus is high current incomeHigh credit quality bonds are usedUsually longer holding periodsAggressive ApproachMain focus is capital gainsUsually shorter holding periods with frequent bond tradingUse forecasted interest rate strategy to time bond trading
36 Bond Investment Strategies (cont’d) Buy-and-hold strategyReplace bonds as they mature or quality declinesBond ladder strategySet up “ladder” by investing equal amounts into varying maturity dates (i.e. 3-, 5-, 7- and 10-year)As bonds mature, purchase new bonds with 10-year maturity to keep ladder growingProvides higher yields of longer-term bonds and dollar-cost averaging benefits
37 Bond Investment Strategies (cont’d) Bond SwapsOccur when investor sells one bond and simultaneously buys another bond in its placeYield pickup swap strategySell a lower yielding bond and replace it with a comparable credit quality bond with higher yieldOften done between different bond sectors (i.e. industrial bonds vs. utility bonds)
38 Bond Investment Strategies (cont’d) Tax swap strategySell a bond that has declined in value, use the capital loss to offset other capital gains, and repurchase another bond of comparable credit qualityWatch out for wash sales—new bond cannot be an identical issue to old bond