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Investment Analysis & Portfolio Management (FIN630) VU

Lesson # 29


Bond Yields:

Bond yields and interest rates are the same concept. Therefore, we begin our discussion of
bond yields with a brief consideration of interest rates.

Interest rates measure the price paid by a borrower to a lender for the use of resources over
some time period—that is, interest rates are the price for loanable funds. The price differs
from case to case, based on the demand and supply for these funds, resulting in a wide
variety of interest rates. The spread between the lowest and highest rates at any point in time
could be as much 10 to 15 percentage points. In bond parlance, this would be equivalent to
1,000 to 1,500 basis points, since 1 percentage point of a bond yield consists of 100 basis
It is convenient to focus on the one interest rate that provides the foundation for other rates.
This rate is referred to as the short-term riskless rate (designated RF in this 'text) and is
typically proxied by the rate on Treasury bills. All other rates differ from RF because of two

1. Maturity differentials
2. Risk premiums

The Basic Components of Interest Rates:

Explaining interest rates is a complex task that involves substantial economics reasoning
and study. Such a task is not feasible in this text. However, we can analyze the basic
determinants of nominal (current) interest rates with an eye toward recognizing the factors
that affect such rates and cause them to fluctuate. The bond investor who understands the
foundations of market rates can then rely on expert help for more details, and be in a better
position to interpret and evaluate such help.

The basic foundation of market interest rates is the opportunity cost of foregoing
consumption; representing the rate that must be offered to individuals to persuade them to
save rather than consume. This rate is sometimes called the-real risk-free rate of interest
because it is not affected by price changes or risk factors. We will refer to it simply as the
real rate and designate it RR in this discussion.

Thus, for short-term risk-free securities, such as three-month Treasury bills, the nominal
interest rate is a function of the real rate of interest and the expected inflationary premium.
This is expressed as, which is an approximation:

RF ≈ RR + EI

RF = short term Treasury bill rate
RR = the real risk-free rate of interest
El = the expected rate of inflation over the term of the instrument

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Measuring Bond Yields:

Several measures of the yield on a bond are used by investors. It is very important for
bond investors to understand which yield measure is being discussed, and what the
underlying assumptions of any particular measure are. To illustrate these measures, we will
use as an example a three-year, IC-percent coupon, AAA-rated corporate bond, with interest
payments occurring exactly six months from now, one year from now, and so forth.

Current Yield:

The ratio of the coupon interest to the current market price is the current yield, and, this is
the measure reported daily In The Wall Street Journal for those corporate bonds shown
under the sections "New York Exchange Bonds" and "AMEX Bonds." The current yield is
clearly superior to simply citing the coupon rate on a bond, because it uses the current
market price as opposed to the face amount of a bond (almost always $1,000). However,
current yield is not a true measure of the return to a bond purchaser, because it does not
account for the difference between the bond's purchase price and its eventual redemption at
par value.

Yield to Maturity:

The rate of return on bonds most often quoted for investors is the yield to maturity (YTM),
a promised rate of return that will occur only under certain assumptions. It is the compound
rate of return, an investor will receive from a bond purchased at the current market price if:

1. The bond is held to maturity, and

2. The coupons received while the bond is held are reinvested at the calculated yield to

Barring default, investors will actually cam this promised rate if, and only if, these two
conditions are met. As we shall see, however, the likelihood of the second condition
actually being met is extremely small.

The yield to maturity, is the periodic interest rate that equates the present value of the
expected future cash flows (both coupons and maturity value) to be received on the bond to
the initial investment in the bond, which is its current price. This means that the yield to
maturity is the internal rate of return (IRR) on-the bond investment, similar to the IRR used
in capital budgeting analysis.
Yield to Call:

Most corporate bonds, as well as some government bonds, are callable by the issuers,
typically after some deferred call period. For bonds likely to be called the yield to maturity
calculation is unrealistic. A better calculation is the yield to call. The end of the deferred
call period, when a bond can first be called, is often used for the yield to call calculation.
This is particularly appropriate for bonds selling at a premium (i.e. high-coupon bonds with
market prices above par value).
Realized Compound Yield:

After the investment period for a bond is over, an investor can calculate the realized,
compound yield (RCY). This rate measures the compound yield on the bond investment
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actually earned over the investment period, taking into account all intermediate cash flows
and reinvestment rates. Defined in this manners it cannot be determined until the investment
is concluded and all of the cash flows are known. Thus, if you invest $1,000 in a bond for
five years, reinvesting the coupons as they are received, you will have X dollars at the
conclusion of the five years, consisting of the coupons received, the amount earned from
reinvesting the coupons, and the $1,000 par value of the bond payable at, maturity. You can
then calculate your actual realized rate of return on the investment.

The RCY for a bond can be calculated by dividing the total ending wealth (including the
purchase price) at the bond's maturity by the amount invested; and raising the result to the
1/n power, where n is the number of compounding periods. Next, subtract 1.0 from the
result. Finally, because of the semiannual basis for bonds, multiply by 2 to obtain the bond
equivalent rate.

The semi-annual realized compound yield can be calculated using the following formula:

RCY = [total ending wealth / purchase price of bond] 1/ n – 1.0


The Valuation Principle:

A security's intrinsic value, or estimated value, is the present value of the expected cash
flows from that asset. Any security purchased is expected to provide one or more cash flows
some time in the future. These cash flows could be periodic, such as interest or dividends, or
simply a terminal price or redemption value, or a combination of these. Since these cash
flows occur in the future, they must be discounted at an appropriate rate to determine their
present value. The sum of these discounted cash flows is the estimated intrinsic, value of the
asset. Calculating intrinsic value, therefore, requires the use of present value techniques.

Value t = 0 = ∑ cash flows / (1 + k) t



Value t = 0 = the estimated value of the asset now (time period 0)

Cash flows = the future cash flows resulting from ownership of the asset
k = the appropriate discount rate or rate of return required by an investor for an
investment of this type
n = number of periods over which the cash flows are expected

To solve and derive the “intrinsic value of a security”, it is necessary to determine the

1. The expected cash flows from the security. This includes the size and type of cash
flows, such as dividends, Interest, face value expected to be received at maturity, or
the expected price of the security at some point in the future.
2. The riming of the expected cash flows. Since the returns to be generated from a
security occur at various times in the future, they must be properly documented far
discounting back to time period 0 (today). Money has a time value, and the timing of
future cash flows significantly affects the value of the asset today.
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3. The discount rate, required rate of return demanded by investors. The discount rate
used will reflect the time value of the money and the risk of the security. It is an
opportunity cost, representing the rate foregone by an investor in the next best
alternative with comparable risk.

Bond Valuation:

The price of a bond should equal the present value of its expected cash flows. The coupons
and the principal repayment of $1,000 are known, and the present value, or price, can be
determined by discounting these future payments from the issuer at an appropriate required
yield, r, for the issue. To solve for the value of an option-free coupon bond.

P = ∑ ct / (1 + r) t + FV / (1 + r) n


P = the present Value or price of the bond today (time period 0)

c = the semiannual coupons or interest payments
FV = the face value (or par value) of the bond
n = the number of semiannual periods until the bond matures
r = the appropriate semiannual discount rate or market yield

In order to conform with the existing payment practice on bonds of paying interest annually
rather than annually, the discount rate being used (r), the coupon (ct on the bond, and the
number of periods are all on a semiannual basis.

For expositional purposes, we will illustrate the calculation of bond prices by referring to
the present value tables at the end of the text; in actuality, a calculator or computer is used.
The present value process for a typical coupon-bearing bond involves three steps, given the
dollar coupon on the bond, the face value, and the current market yield applicable to a
particular bond:

1. Using the present value of an annuity table, determine the present value of the
coupons (interest payments).
2. Using the present value table, determine the present value of the maturity (par) value
of the bond; for our purposes, the maturity value will always be $1,000.
3. Add the present values determined in steps 1 and 2 together.


Bond Price Changes Over Time:

We now know how to calculate, the price of a bond, using the cash flows to be received and
the YTM as the discount rate. Assume that we calculate the price of a 20-year bond issued
five years ago and determine that it is $910. The bond still has 15 years to maturity. What
can we say about its price over the next 15 years?

When everything else is held constant, including market interest rates, bond prices that
differ from the bond's face value (assumed to be $1,000) must change over time. Why? On a
bond's specified maturity date, it must be worth its face value or maturity value. Therefore,
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over time, holding all other factors constant, a bond's price must converge to $1,000 on the
maturity date because that is the amount the issuer will repay on the maturity date.

After bonds are issued, they sell at discounts (prices less than $1,000) and premiums (prices
greater than $1,000) during their lifetimes. Therefore, a bond selling at a discount will
experience a rise in price over time, holding all other factors constant, and a bond selling at
a premium will experience a decline in price over time, holding all other factors constant, as
the bond's remaining life approaches the maturity date.

Bond Price Changes As a Result of Interest Rate Changes:

Bond prices change because interest rates and required yields change. Understanding how
bond prices change given a change in interest rates is critical to successful bond
management. The basics of bond price movements as a result of interest rate changes have
been known for many years. For example, over 40 years ago, Burton Malkiel derived five
theorems about the relationship between, bond prices and yields. Using the bond valuation
model, he showed the changes that occur in the price of a bond (i.e., its volatility), given a
change in yields, as a result of bond variables such as time to maturity and coupon. We will
use Malkiel's bond theorems to illustrate how bond prices change as a result of changes in
interest rates.

Bond Prices Move Inversely to Interest Rates:

Investors must always keep in mind the fundamental fact about the relationship between
bond prices and bond yields. Bond prices, move inversely to market yields. When the level
of required yields demanded by investors on new issue changes, the required yields on all
bonds already outstanding will also change. For-these yields to change, the prices of these
bonds must change. This inverse relationship is the basis for understanding, valuing, and
managing bonds.
Effects of Maturity:

The effect of a change in yields on bond prices depends on the maturity of the bond. An
important principle is that for a given change in market yields, changes in bond prices are
directly related to time to maturity: Therefore, as interest rates change, the prices of longer
term bonds will change more than the prices of shorter term bonds, everything else being

The Effects of Coupon:

In addition to the maturity effect, the change in the price of a bond as a result of a change in
interest rates depends on the coupon rate of the bond. We can state this principle as (other,
things equal): Bond price fluctuations (volatility) and bond coupon rates are inversely
related. Note that we are talking, about percentage-price fluctuations; this relationship does
not necessarily hold if we measure volatility in terms of dollar price changes rather than
percentage-price changes..

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