BOND LECTURE I. FIVE Bond Characteristics: A. Face value or par value, FV = $1,000 B.

Coupon rate, CR = 7% Annual coupon or interest payment = CR x FV .07 x $1,000 = $70 Semi-annual coupon payment = annual payment/2 = $70/2 = $35 C. Term to maturity, T = 10 years D. Market yield (or interest rate), r E. Bond price, Pb Bond price, Pb = semi-ann payment[P/A, r/2, Tx2] + $1,000[P/F,r/2,Tx2] Pb = $35 [P/A,10%/2, 10x2] + $1,000[P/F,10%/2 , 10x2] = $813.10 Yield to Maturity is the return on a bond investment if bond is held to maturity. A. Find r in the equation below. Through trial-n-error just like the Internal Rate of Return (IRR). $813.10 = $35 [P/A, r, 10x2] + $1,000[P/F, r , 10x2] B. RELATIONSHIP BETWEEN YTM and CR. 1. If Pb < $1,000 (Face value), then the YTM > CR. 2. If Pb = $1,000 (Face value), then YTM = CR. 3. If Pb < $1,000 (Face value), then YTM < CR. C. So for the example in PART B, we know $813.10 < $1,000, so r must be greater than 7%/2 or 3.5%. D. In fact r = 5%, so YTM = 2 x r or 2 x 5% = 10% E. ASSUMPTION of YTM:

II.

III.

IV.

FIVE BOND THEOREMS. 1. Bond price move inversely to changes in interest rates. 2. rates. 3. Longer maturity makes a bond price more sensitive to interest

Price sensitivity increases with maturity at a decreasing rate.

4.

Lower coupon rates increase price sensitivity.

5. A price increse caused by a yield decrease exceeds a price decrease caused by a similar yield increase.

V.

Using the BOND THEOREMS choose the bond with the greater price sensitivity. YTM COUPON RATE MATURITY BOND A: 8% 10% 20 years BOND B: 8% 6% 19 years

V. The relationship above can be seen more directly by using duration. A. What is duration, D? B. D is the number of years it takes to recover the average cash flow from investing in a bond, Pb. t= T (CFt )(t) t C. Equation for duration D = t=1 (1+ r) Pb

D. Example: Duration of a 5 year 9% coupon bond with market yield of 9% Year 1 2 3 4 5 Cash flow $ 90 $ 90 $ 90 $ 90 $1090 PV factor .9174 .8417 .7722 .7084 .6499 Pb = PV of CF $ 82.57 $ 75.75 $ 69.50 $ 63.76 $708.42 $1000 % of Pb 8.257% 7.575% 6.950% 6.376% 70.842% 100% D= Yr x % 0.0826 0.1515 0.2085 0.2550 3.5421 years

E.

Relationship between Bond price and interest rate. %Pb = - D [%(1+r)] (P1-Po)/Po = - D [(1+r1) (1+ro)] / (1+ro) also $(P1-Po) = - D {[(1+r1)-(1+ro)]/(1+ro) x Po F. Example above, if interest rates decline by 1/2% then the bond price will increase by: %Pb = = 1.945% = - 4.24 [(1+.085) (1+ .09)] / (1+.09) Or $19.45 = - 4.24 {[(1+.085)-(1.09)]/ (1+.09)} x $1000

G. Generally to invest in bond funds you must speculate on interest rate changes, then: If you expect int rates to decline buy long D bonds If you expect int rates to increase buy short D bonds

V. Hedging with Bonds. A. Bond Risk = Market Int rate Risk + Default Risk 1. Default Risk is rated by Financial Services Companies such as Moodys and Standard & Poors. Generally AAA is premier bonds almost riskfree and it declines from there, AA, A, BBB, BB, B, CCC, CC, C, DDD, DD, D If you are hedging we can avoid risky bonds by investing in AAA or government bonds. B. Market Int rate Risk = Price Risk + Reinvestment Rate Risk C. One form of hedging is Target Immunization where Price risk and Reinvestment rate Risk offset each other; hence Market Int rate Risk is virtually = 0. Assuming Default Risk is virtually = 0 (by investing in AAA or gov bonds), BOND RISK can be virtually zero when you TARGET IMMUNIZE. D. TO TARGET IMMUNIZE procedure: 1. Determine the subjective horizon date, HD, for liquidating bond investment. 2. Determine bond durations. 3. Choose bonds with duration = HD. 4. You are immunized from market int rate risk for the first change in int rate. 5. NOTE that: IF int rate increases Duration decreases and IF int rate decreases Duration increases. 6. Rebalance bond investment by: Buying shorter Duration bonds if INT RATE decreases Buying longer Duration bonds if INT RATE increases E. Example: BOND Coupon Rate Term to Maturity A 0% 4.24 yrs B 9% 2.0 yrs C 9% 20 yrs D 9% 5 yrs

Yield to Mat Duration, D 9% 4.24 yrs 9% 9% 9% 4.24yrs

BOND D
Int rate 7% 9% 11% Price at HD + Total Coupons + Reinvest Coupon $1,035 + $360 + $ 46 $1,021 + $360 + $ 60 $1,006 + $360 + $ 75

Actual = Total CF Rate of = $1,441 = $1,441 = $1,441

Ret 9% 9% 9%

BOND B
Int rate 7% 9% 11% Price at HD + Total Coupons + Reinvest Coupon =Total CF $1,016 + $320 + $ 44 = $1,380 $1,021 + $360 + $ 60 = $1,441 $1,025 + $400 + $ 78 = $1,503

Actual Rate of Ret 7.39% 9.00% 10.09%

BOND C
Int rate 7% 9% 11%

Actual Price at HD + Total Coupons + Reinvest Coupon =Total CF Rate of Ret $1,208 + $360 + $ 46 = $1,614 11.95% $1,021 + $360 + $ 60 = $1,441 9.00% $ 874 + $360 + $ 75 = $1,309 6.56%