Chapter 6
Chapter 6
Chapter 6
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Chapter 6 Bond analysis and evaluation
Chapter Overview
Bond valuation
Bond portfolio
Immunization
Learning objectives:
To value a bond, we discount its expected cash flows by the appropriate discount rate. The cash
flow from a bond consists of coupon payments until maturity plus the final payment of par value.
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Chapter 6 Bond analysis and evaluation
Example
Compute the price of a 9% coupon bond with 20 years to maturity and a par value of $1000 if the
required yield is 12% and coupon payment (i) pay annually and, (ii) pay semiannually.
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Chapter 6 Bond analysis and evaluation
If we graph the price relationship for any noncallable bond, we will find it has the “bowed”
shape. This shape is referred to as convex.
Price/Yield Relationship
Price
Required Yield
When the coupon rate is less than the required yield, then the price is less than the par value.
When the coupon rate is higher than the required yield, then the price is higher than the par
value.
See Exhibit 1.
For a bond selling at par value, the coupon rate is equal to the required yield. Thus, the price of a
bond selling at par will remain at par as the bond moves toward the maturity date.
When a bond selling at discount; as the bond moves toward maturity, its price will increase if
required yield does not change.
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Chapter 6 Bond analysis and evaluation
Price
Par Value
Market
Price
For a bond selling at premium, the price of bond declines as it moves toward maturity.
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Chapter 6 Bond analysis and evaluation
Price
Market
Price
Par Value
VB = PV/ (1 + i)n
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Chapter 6 Bond analysis and evaluation
Example.
Compute the price of a zero-coupon bond that matures 10 years from now if the maturity value is
$1000 and the required yield is 8%.
VB = 1000/ (1 + 0.08)10
= $ 463.19
Current Yield
The current yield relates the annual coupon interest to the market price.
Example.
Compute the current yield for an 18-year, 6% coupon bond selling for $750.
CY = 6% X 1000
750
= 0.08 @ 8%
Yield To Maturity
The yield (YTM) is the interest rate that will make the present value of the cash flows equal to the
price (initial investment). To compute the YTM for a bond, we solve the rate i in the formula of
bond valuation.
The easy way to calculate the YTM for a bond using formula Average YTM:
AYTM = Ct + [ ( PV - MPB) /n ]
(PV + MPB) /2
Example.
Compute YTM for an 18-year , 6% coupon bond selling for $700 if the coupon paid i) annually
and, ii) semiannually. The par value for this bond is $1000.
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Chapter 6 Bond analysis and evaluation
Semiannually
Yield To Call
For a callable bond, investor also compute another yield (or internal rate of return) measure, the
yield to call (YTC). The cash flows for computing the YTC are those that would result if the issue
were called on its first call date. The YTC is the interest rate that will make the present value of
the cash flows if the bond is held to the first call date equal to the price of the bond (or dirty
price).
where;
CP = the call price
nc = number of years to the first call date
Example.
Suppose a 20-year, 12 % coupon bond that is trading at 110 ($1100) with 5 years remaining to its
first call and a call price at 102 ($1020). Compute AYTC for this bond.
Fund manager needs to have a way to measure a bond’s price volatility in managing the fund
strategies. The measures are commonly employed are:
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Chapter 6 Bond analysis and evaluation
Price value of basis point is the change in the price of the bond if the required yield changes
by 1 basis point (note: 100 basis point = 1%). It is express as the absolute value of the change
in price. Price value of basis point can be measure by dividing between the change in price
after changes in required yield over the changes in required yield.
Higher ratio of price value of basis point indicate that the bond is very volatile and sensitive
to the required yield and lower ratio indicate that the bond price is less sensitive to the
changes in required yield.
Yield value of a price change measure the changes in the yield for a specified changes in
bond value. This is estimated by first calculating the bond’s yield to maturity if the bond’s is
decreased by, say, $X . Then the difference between the initial yield and the new yield is the
yield value of an X ringgit price change.
The smaller this value, the greater the dollar price volatility, because it would take a smaller
change in yield to produce a price change of $ X.Bond duration is a period for investor to get
back the principal of his investment. It also known as a effective maturity term of the bond.
Duration is calculated by finding the weighted of a bond’s life where the various time periods in
which the bond generate cash flows are weighted according to the relative sizes of the present
value of these cash flows.
In most cases, the coupon bond duration is less than bond maturity term. Also, the lower the
coupon, generally the greater the duration of the bond. There is a consistency between the
properties of bond price volatility. That is the longer the maturity term, the greater the bond
price volatility. And the lower the coupon rate, the greater the bond price volatility. As we seen
before, the lower the coupon, generally the greater the duration of the bond. Thus we can
concluded that the greater the bond duration, the greater the price volatility.
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Chapter 6 Bond analysis and evaluation
Macaulay showed that the duration of a bond was a more appropriate measure of time
characteristics than the term to maturity of the bond because duration considers both the
repayment of capital at maturity and the size and timing of coupon payment prior to final
maturity. Using annual compounding, Duration (D) is
D = ∑ Ct (t) / (1 + i )t
∑ Ct / (1 + i )t
DMOD = D/ (1+ i )
Exhibit 4 : Calculation of Macaulay Duration and Modified Duration for a 4%, 10 year
selling to yield 8%.
An estimate of the percentage change in bond price equals the change in yield times
modified duration:
% P = - DMOD X i
where,
i = the yield change in basis points divided by 100
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Chapter 6 Bond analysis and evaluation
Example.
Consider a semiannual payment bond with Macaulay D = 10 years and yield = 8%. Assume that
the bond’s YTM to decline by 70 basis point.
DMOD = D/ (1+ i )
= 10/ (1+ 0.04 )
= 9.62
% P = - DMOD X i
= - 9.62 X - 0.70
= 6.73
It indicate that the bond price should increase by approximately 6.73 percent in respond to 70
basis-point decline in YTM. If the price of the bond before the decline in interest was $750, the
price after the decline in interest rate should be approximately:
Bond price have an indirect relationship with the yield. That means when yield is increase the
bond price will decrease and vise versa. But the actual relationship is not in the same proportion.
The price changes is greater when the yield decline, and the price changes is small when the yield
increase. These happen because bond price have a convexity relation with the yield. By refer to
the curve below, the bond price will move along the actual line if there is any changes in yield
either increase or decrease. The tangent to the actual line is the estimated bond price given
changes in yield. This estimation derives by using the Macaulay duration. We can see that, the
estimation is good when there is only a small changes in yield from the initial point. But when the
yield changes is greater, the price dispersion from actual line is higher. So its not suitable to make
the estimation.
As a solution, the estimation should included the convexity effect of the bond price and yield
relationship. Bond convexity is discussed below.
Graph to show the relationship between bond price and yield of the bond.
Price
Actual price line
Yield
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Chapter 6 Bond analysis and evaluation
WAPY method
It is found by calculating the weighted average of the yield for all the bonds in the portfolio. The
yield is weighted by proportion of the portfolio that the security makes up. In general, the bond
portfolio yield is:
k
Bp = ∑ wi . yi
1
Example
For example consider the bond portfolio below.
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Chapter 6 Bond analysis and evaluation
Solution:
Under this method the yield calculated only rely on the market value of the bond and the bond yield
to maturity. Its do not take into consideration the investment horizon and the expected coupon to be
received during the investment period.
IRR method
IRR method is to estimate the portfolio yield based on expected cash flow for each bond. The cash
flow are in the form of coupon payment and the maturity amount. It is assumed that the cash flows
received are on the same date of payment and can be invested at the same rate of the bond yield.
Moreover, the portfolio also assumed to be held till the maturity of the longest-maturity bond in the
portfolio. From the assumption above, we can proceed with practice.
Example: Study the two-bonds portfolio which pays twice coupon per annum below.
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Chapter 6 Bond analysis and evaluation
The portfolio’s IRR is the interest rate that will make the present value of the portfolio’s cash flow is
equal to the portfolio’s initial investment at par value of RM 30 mil. Where the equation is
5
PV of cash flow = ∑ CFn. PVIF i,n
n=1
30 = 0.7 PVIFi,1 + 0.7 PVIFi,2 + 0.7 PVIFi,3 + 10.7 PVIFi,4 + 20.5 PVIFi,5
The portfolio’s internal rate of return then can be obtained through trial and error method.
Since the average coupon is 2.5%, to simplify the problem let say i=2%.
So to reduce the present value, we need to increase the i. Let say i=3%.
To do interpolation:
i – 2% = 30 – 30.47
3% - 2% 29.17 – 30.47
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Chapter 6 Bond analysis and evaluation
Activity
Study Questions
1. Two bonds, bond A and bond B are being examined by an investor. Both bonds have face
values of RM10,000, yield-to-maturity of 9%, and four years to maturity. Bond A has
10% coupon rate and bond B has a coupon rate of 7.5%. Coupon are paid annually.
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Chapter 6 Bond analysis and evaluation
2. a) You are considering investing in two bonds, both with 10 years to maturity. Bond A ia
a zero-coupon with 8% yield to maturity. Bond B pays RM20 annually, and its yield to
maturity is 10%.
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