Reading 56 - Understanding Fixed-Income Risk and Return

Reading Summary
This topic is a slight advanced topic. Do not panic if you are not able to understand in first reading. Here we
introduce term structure theories and how these theories explain the various shapes that the term structure can
take. You need to understand the spread measures and how the different attributes of a bond can impact the
spread. Also understand why spread should be related to the economic environment. In examination, one sure
shot question will come on the calculation of after-tax and before-tax yield, make sure you are able to solve that.
LOS 55.a. Calculate and interpret the sources of return from investing in a fixed-rate bond
The various source of return received from bond investment are:1) Periodic coupon payments
2) Capital Gain or Loss The final payment will be the face value.
In case of Plain Vanilla Bond
1) If the bond was a premium bond then there will be capital loss
2) If the bond was a discount bond then there will be capital gain
In case of callable bond
1) If the call price is more than the purchase price then there will be capital gain
2) If the call price is less than the purchase price then there will be capital loss
3) Reinvestment income The income generated by reinvesting the coupons and withdrawing when the bond
matures.
We will assume that a bond will give all the promised coupon and principal payments on time. Also, the coupons
will be reinvested at the YTM rate.
Lets see the computation of source of return.
Concept Builder Sources of Return
1. A bond is trading at $111, the bond is semi-annual coupon paying bond. The stated coupon rate is
8% pa and the bond will mature in 5 years. Find out the various sources of return?
Explanation
Total coupon received = $4 * 5 * 2 = $40
Capital gain/loss = End Price Purchase Price = $100 - $111 = -$11
Now how do we compute the reinvestment income?
Please note that we will assume that the coupons are invested at the rate of 8% pa till maturity of the
bond. What we need to do is to find the future value of those investments and subtract the amount of
investment.
It will become clear from the following timeline

So, we need to find the FV at t=10

We also need to find the yield of the bond to compute this.
The semi-annual yield of the bond can be computed as
N = 10, PV = -111, PMT = 4, FV = 100, compute I/Y
The I/Y is the semi annual yield or YTM and it comes to 2.7283%
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The PMT = $4 and the number of payments are 10, this is the end of the period payments.
So, to compute
N=10, I/Y = 2.7283, PV =0 , PMT = 4, FV=?
FV = $45.2858
So, the reinvestment income will be $45.2858 4*2*5 = $5.2858
If we want to know the return for the investor per annum. We can compute it.
Money he is getting at the end = $100 + $45.2858 = 145.2858
He has held the bond for 5 years
Return= (FV/PV)1/N 1 => (145.2858/111)1/10 -1 = 2.72828%
This return is the same as the I/Y. So, it demonstrated that the $111 invested at a semi-annual rate of
2.72828% will give the same money if I invest in the bond and reinvest the coupon at 2.72828%
We have some outcomes from the assumptions which we have made, we will take them one by one
1. An investor who holds a fixed rate bond to maturity will earn an annualized rate of return which is equal to the
YTM (at purchase) of the bond.
This we have seen in the concept builder #1, the investor was getting the same return as the YTM of the bond.
2. An investor who sells the bond prior to maturity will earn a rate return equal to the YTM (at purchase) if the
YTM of the bond doesnt change.
Concept Builder Find the return when the bond is sold before maturity
2. A bond is trading at $111, the bond is semi-annual coupon paying bond with YTM of 5.4566%. The
stated coupon rate is 8% pa and the bond will mature in 5 years. An investor sold the bond at the
end of 2 years. Find the return that is generated by the investor, assuming that the YTM remained
constant.
Explanation
Find the price of the bond after 2 years
N=6, I/Y = 2.7283, PV =? , PMT = 4, FV=100 => PV = 106.95
Compute future value of reinvested coupon
N=4, I/Y = 2.7283, PV =0 , PMT = 4, FV=? => FV = 16.67
Total Value received = 123.62
Return= (FV/PV)1/N 1 => (123.62/111)1/4 -1 = 2.72828%
This return is the same as the I/Y.
3. If the market rate (or YTM) and hence reinvestment rate increases after bond purchase but before the 1st
coupon date, a buy and hold (till maturity) investor will get a realized rate of return MORE than the YTM (at
purchase) of bond
4. If the market rate (or YTM) and hence reinvestment rate decreases after bond purchase but before the 1st
coupon date, a buy and hold (till maturity) investor will get a realized rate of return LESS than the YTM (at
purchase) of bond
Concept Builder Find the return when the bond is held till maturity but reinvestment rate is higher
3. A bond is trading at $111, the bond is semi-annual coupon paying bond with YTM of 5.4566%. The
stated coupon rate is 8% pa and the bond will mature in 5 years. Assume that the reinvestment
rate becomes 6% pa (on BEY basis). Find the realized rate of return if the investor hold the bond till
maturity.
Explanation
Compute future value of reinvested coupon
N=10, I/Y = 3, PV =0 , PMT = 4, FV=? => FV = 45.86
At the end the investor will get $100 also.
Total value = 145.86
Return= (FV/PV)1/N 1 => (145.86/111)1/10 -1 = 2.7685%
Annual (on BEY basis) = 2.7685% *2 = 5.537%
This return is more than the YTM of 5.4566%

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5. If the market rate (or YTM) and hence reinvestment rate increases after bond purchase but before the 1st
coupon date, a short term investor will get a realized rate of return LESS than the YTM (at purchase) of bond
6. If the market rate (or YTM) and hence reinvestment rate decreases after bond purchase but before the 1st
coupon date, a short term investor will get a realized rate of return MORE than the YTM (at purchase) of bond
Concept Builder Find the return when the bond is sold before maturity
4. A bond is trading at $111, the bond is semi-annual coupon paying bond with YTM of 5.4566%. The
stated coupon rate is 8% pa and the bond will mature in 5 years. An investor sold the bond at the
end of 6 month. Find the return that is generated by the investor, assuming that the YTM increases
to 6% (on BEY basis).
Explanation
Find the price of the bond after 6 month
N=9, I/Y = 3, PV =? , PMT = 4, FV=100 => PV = 107.79
He will also get coupon of $4
Total Value received = $111.79
Return= (FV/PV)1/N 1 => (111.79/111) -1 = 0.70821%
This return is less than the initial YTM
There is a tradeoff between interest rate risk and reinvestment risk.
Interest rate risk is the risk that the price can decrease or uncertainty regarding the price of the bond due to the
changes in the interest rate.
Reinvestment risk is the uncertainty regarding the reinvestment income which will decrease when the interest
rate decreases.
An investor with short term horizon will have higher interest rate risk and lower reinvestment risk.
An investor with long term horizon will have lower interest rate risk and higher reinvestment risk.
LOS 55.b. Define, calculate, and interpret Macaulay, modified, and effective durations
LOS 55.c. Explain why effective duration is the most appropriate measure of interest rate risk for bonds with
embedded options
We know that a bonds price decreases when the interest rate increases. Duration is a measure of interest rate
sensitivity of the bond prices.
There are other different flavors of duration that you would find.
Macaulay Duration - Macaulay first introduced the concept of duration. Macaulay duration is computed as the
weighted average of the number of years for each of the cash flow of the bond, the weight is the present value of
the cash flow as a percentage of the full value of the bond.

Concept Builder Macaulay Duration Computation for Par Bond

5. A 2 year semi-annual payment bond is trading at Par, the coupon rate of the bond is 6% pa. Find
the Macaulay duration of the bond
Explanation
See the table Below
Time
PV
Weight
Weight * Time
0.5
2.91262
0.02913
0.01456
1.0
2.82779
0.02828
0.02828
1.5
2.74542
0.02745
0.04118
2.0
91.51417
0.91514
1.83028
Sum
100.00000
1.00000
1.91431
Note that the sum of PV is equal to the price. Also, the sum of weight is 1
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And the duration is 1.91431. The same process is applied for bond not trading at Par.

Even though Macaulay was the first to give the idea of duration, Macaulay duration is not a good measure of
interest rate sensitivity and there are modifications which have been done. We understand Macaulay duration as
the weighted average time it takes to get the coupon and the principal.
Modified duration is given as approximate change in the bond price when the yield changes by 100 basis point
(or 1%) assuming that the cash flow of the bond does not change when the yield changes.
There is a relationship between modified duration and macaulay duration
(

So, for annual bond it will be

(

So, for semi-annual bond it will be

(
)
Approximate percentage price change = - modified duration x change in yield x 100
Concept Builder Calculating percentage change in the price
6. If the modified duration of a bond is 5, find the percentage change in the price of the bond when
the yield changes by 0.2%. Find the new price if the old price was $110.
Explanation
It is a direct application of the formula
approximate percentage price change = - modified duration x change in yield x 100
-5 * (0.2/100 )* 100 => -1%
New price = Old Price * (1 + percentage change)
New Price = $110 *(1+ -0.01) = $110*0.99 = $108.9
Approximate Modified Duration Note that the bond price increase is higher than the bond price decrease for
the same changes in the yield. So, we can approximate the modified duration, by taking the increase and the
decrease and taking average of the change. The formula is given below.
(

Concept Builder Calculating approximate modified Duration

7. Find the approximate modified duration of a bond which is trading at $100, the current market rate
is 8% and the bond matures in 5 year with Face Value of $100. Assume shift in the interest rate as
0.5%. Bond is an annual paying bond.
Explanation
Since the bond is trading at $100 (par value), the market interest rate should be equal to the coupon
rate, so the coupon rate is 8%.
We will have to find out the price of the bond when the interest rate is changing
When interest rate is increased => the new rate will be 8.5% => find the value of the bond
N = 5 , I/Y = 8.5, PV = ?, PMT = 8 , FV = 100 => Compute PV => 98.0297
When interest rate is decreased => the new rate will be 7.5% => find the value of the bond
N = 5 , I/Y = 7.5, PV = ?, PMT = 8 , FV = 100 => Compute PV => 102.0229
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Dont clear your work for the 2nd calculation, you can see that only thing you have to change is the I/Y
Also, notice that the price increase (2.0229) is more than the price decrease (1.9703) , this is because of
the positive convexity.
Now plug the values in the approximate modified duration formula
= 3.9933
So, if the YTM changes by 1%, the bond price will change by 3.9933%
Make sure that you put change in yield appropriately, here is will be 0.5%/100 or 0.005, many students
get confused over what to take as change in yield.
Many students ask, do we need so much accuracy in the calculation, it is not required for you to come
up with 4 decimal places, but remember you are using calculators, so you should be as near as possible,
in the examination, they would give you option as 3.99 I doubt that the institute would give you 4 as
another option. So, in exam, either 3.99 or 4 would be given as option for this problem.
Modified duration is a linear estimate of the Yield and price relationship. In reality the price yield relationship is
convex. So, modified duration doesnt give the correct change in the price. However, for small changes in the
yield modified duration can be relied on. For large changes in the yield, the modified duration performs poorly
due to the curvature effect. So, bottom line is if the change in the yield is small, we can use the modified
duration to find out the percentage change in the price and the new prices.
Since, we have seen that the callable bonds can be called when the interest rate decreases, modified durations
assumption of cash flow not changing is not applicable, as a result, modified duration is not useful for the bonds
with embedded option.
Effective duration is the most appropriate measure for the bonds with embedded options. Please ensure that
you choose effective duration whenever they ask you about the bonds with options like mortgage bonds,
callable, putable, bonds with sinking fund provision or any other options.
However both effective duration and modified duration can be used for option free bond.
Please note that there are issues with Macaulay duration and it should not be used.
The pricing of the embedded bonds are done using some benchmark yield curve and not with YTM. Formula for
effective duration is similar to approximate modified duration, only the change in YTM is replaced with change in
curve.

Effective duration makes a distinction between the changes in the benchmark yield and changes due to credit risk
and liquidity. Effective duration only computes the price changes due to the changes in the benchmark yield
curve. Changes in the credit spread is computed separately using credit duration
Also, unlike modified duration, it is not the necessarily the case that effective duration prodives a better estimate
of price changes for small changes in the yield. In reality the embedded options are impacted more by large
changes in the yield and hence useful for large changes.
LOS 55.d. Explain how a bonds maturity, coupon, embedded options, and yield level affect its interest rate risk
We know that the price of the bond is related to interest rate. Duration is used to measure the interest rate risk
of the bond. Higher the duration, higher is the interest rate risk.
This interest rate risk is different for different bonds and is depended on
Coupon Rate A bond whose coupon rate is higher will have lower interest rate risk. This is because a
higher coupon rate means that the bond investor is getting more part of the total money earlier and
lesser money is exposed to the interest rate fluctuation.

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Maturity A bond with higher maturity will have more interest rate risk, this is because the bullet
payment (the final payment at maturity) is exposed to the interest rate fluctuation for more time period.
Presence of the embedded Options Embedded options decrease the interest rate risk. For a putable
option if the interest rate increases the bond holder is not at loss because he can sell the bond to the
issuer at a fixed price. However in case of callable option, you need to think of the same from the
perspective of the bond issuer.

Please memorize the below table - The impact of the various features on the interest rate risk.
Attribute

Measure

Interest Rate Risk/Duration

Coupon

Increases

Decreases

Maturity

Increases

Increases

Callable Option

Presence of option

Decreases

Putable Option

Presence of option

Decreases

LOS 55.e. Calculate the duration of a portfolio and explain the limitations of portfolio duration
Like bonds, the portfolios of bonds also have a duration measure; this is just the weighted average of durations.
So, the portfolio duration is given by
Where n is the number of bonds in the portfolio, Wi is the weight of the bond and Di is the duration
Always the weights are calculated on the basis of the market value (or full value of bond) and not the face value
Concept Builder Calculating Portfolio Duration
8. Find the duration of a portfolio which has the following structure
Bond
Duration
Market Value
Face Value
A
10
$10 Mn
$8 Mn
B
5
$20 Mn
$22 Mn
C
12
$5 Mn
$5 Mn
Explanation
We have to apply the formula directly, noting that the weights have to be calculated on the market
value and not the face value
Please see the below table
You dont need to compute the weight and then find the value, note that the weight has the constant
term (35).
Bond
Duration
Market Value Weight
Weight * Duration
A
10
$10 Mn
=10/35
= (10/35)*10
B
5
$20 Mn
=20/35
= (20/35)*5
C
12
$5 Mn
=5/35
= (5/35)*12
Summation =(100+100+60)/35
The portfolio duration will be given as (100+100+60)/35 = 7.4286
The limitations of portfolio duration are: The duration measure indicates that regardless of whether interest rates increase or decrease, the
approximate percentage price change is the same, however that is not true as we have seen that the
price increase is more than the price decrease
The portfolio duration is good measure for small changes in the yield, however for large changes in the
yield the performance is not good
It also assumes that the yield curve shift is parallel for all the maturity. In reality the yield curve may not
change parallel.
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LOS 55.f. Calculate and interpret the money duration of a bond and price value of a basis point (PVBP)
Price Value of Basis Point (PVBP) is the dollar change in the price of the bond with a one basis point change in
the yield. PVBP uses the duration concept to find out the change.
However there is a slight difference as it is measured in dollars. It doesnt measure in percentage change but in
dollar terms.
The formula for PVBP is
Price value of a basis point = duration * 0.0001 * bond value
Money Duration (or Dollar duration) is a concept similar to PVBP. Money duration measures the change in the
portfolio value when the yield changes by 100 bp (or 1%).
Money duration = annual modified duration * full price of bond
Money duration can also be expressed as money duration per 100 of bonds par value
Money duration per 100 units of par value = annual modified duration * full price of bond per 100 of par value
If change in YTM is given, the change in value of the bond will be
Change in value = money duration * change in yield
Since PVBP measures the change for 1 basis point, the PVBP is simply dollar duration divided by 100.
PVBP = Dollar Duration / 100
Concept Builder Calculating PVBP
9. Find the PVBP) of the portfolio in concept builder 8
Explanation
It is a direct application of the PVBP formula
Price value of a basis point = duration * 0.0001 * portfolio value
PVBP = 7.4286 * 0.0001 * $35 million = $0.026 Million or $26,000
LOS 55.g. Calculate and interpret approximate convexity and distinguish between approximate and effective
convexity
Duration is approximate percentage change in the price of the bond when the yield changes. Duration gives large
amount of error in calculating the percentage change when the yield change is higher. Duration is also known as
first order change.
We have another concept known as convexity which tries to measure the change with more accuracy; it is trying
to capture the curve. So, if we include the changes due to convexity (known as convexity adjustment) , the result
is more accurate as compared to the measure that we get from duration. Convexity is also known as 2 nd order
change.
(

Effective convexity Like effective duration, we use effective convexity to measure the changes in the bonds with
embedded option
(

A bond will have higher convexity when

Maturities are longer
Coupons are lower
Yield to maturity is lower
Cash flows are more dispersed over time
Impact of change in Interest rate change on the price of the bonds
Straight bond exhibit positive convexity, that is, the price increase is more than the price decrease.
Bonds with embedded options exhibit certain deviations.
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Callable bond prices are capped as a result the price increase doesnt happen that much like the
option free bond. Callable bond shows negative convexity.

For a callable bond

The price volatility is similar to that of the comparable option free bond when the yields are higher
beyond a certain point
However, the price volatility is lesser (negative convexity) when the yields are lower. You can see this in
the above diagram.
Putable bond has less convexity than an option free bond.
LOS 55.h. Estimate the percentage price change of a bond for a specified change in yield, given the bonds
approximate duration and convexity
Convexity is always positive value for normal bonds and it will always increase the percentage change of the
bond, it is an add on measure on the percentage change calculated from duration. The more the convexity is the
more adjustment is required to estimate the price changes.
The formula of the percentage change in the price of the bond when convexity is present is given as
( )
( )
( )
( )
Please make sure that you remember the formula and note that 100 is multiplied at the end. We have seen that
students get confused in this relatively easy calculation because of the presence of square factor in convexity.
Make sure that you use
terms in decimal, so if 1% change, it implies that
is 0.01. We will see a problem
Concept Builder Calculating percentage change in the price due to duration and convexity
10. Calculate the percentage change in the price of a bond when the market rate increases by 0.5%. The
bond has duration of 5 and convexity of 70.
Explanation
Apply the formula, note that
is 0.5% or 0.005
( )
( )
2
= { - 5 * 0.005 +0.5* 70 * 0.005 } = -0.024125 = 2.4125%
Most of the time students forget minus sign as a result answer is wrong.
Dont worry if your calculator shows 0 when you are computing 0.0052, the calculator internally stores
the value

LOS 55.i. Describe how the term structure of yield volatility affects the interest rate risk of a bond
Term structure of yield volatility is relationship of volatility of bond yields and time to maturity. The volatility of
bonds price is a concern to the investor. There are 2 components of volatility of bond prices, first is the
sensitivity of the bond price to a given change in the yield and second is the volatility of the bonds yield.

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When we computed the bond price change using duration and convexity, we assumed that the yield curve shifts
in a parallel manner. In reality this is not the case. It may happen that short term rate may increase more than the
long term rate. Short term bond may have more price volatility than longer term due to the greater yield volatility
in the short term, even though we know that a long term bond has higher duration.
LOS 55.j. Describe the relationships among a bonds holding period return, its duration, and the investment
horizon
Understanding of macaulay duration can help us in matching the bond to an investment horizon. When the
investment horizon and the bonds Macaulay duration is matched, then a parallel shift in the interest rate before
the first coupon date will not have any impact on the investors return.
When the investment horizon matches the macaulay duration, if the interest rate decreases then the decrease in
the reinvestment income is exactly offsetted by increase in the bond price (capital gain). So the market price risk
is offsetted by the reinvestment risk.
LOS 55.k. Explain how changes in credit spread and liquid affect yield-to- maturity of a bond and how duration
and convexity can be used to estimate the price effect of the changes
A bonds spread relative to the benchmark has 2 component.
One component is premium for credit risk
Another component is premium for lack of liquidity
An increase in any of the component will increase the YTM by the same amount.
We can find out percentage change in the bond value when there is a change in the spread and is given by
(
)
(
)
Concept Builder Calculating percentage change in the price due to spread changes
11. Calculate the percentage change in the price of a bond when the spread increases by 0.5%. The
bond has duration of 10 and convexity of 200. Bond Value is $100
Explanation
Apply the formula, note that
is 0.5% or 0.005
( )
( )
2
= { - 10 * 0.005 +0.5* 200 * 0.005 } = -0.0475 * 100 = 4.75%

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