Chapter 10

Bond Prices and Yields

Straight Bond
Obligates the issuer of the bond to pay the
holder of the bond:
A fixed sum of money (principal, par value, or face
value) at the bonds maturity
Constant, periodic interest payments (coupons)
during the life of the bond (Sometimes)

Special features may be attached

Convertible bonds
Callable bonds
Putable bonds
10-2

Straight Bond Basics

$1,000 face value
Semiannual coupon payments
Annual Coupon
(10.1) Coupon Rate
Par Value
Annual Coupon
(10.2) Current Yield
Bond Price

10-3

Straight Bonds
Suppose a straight bond pays a semiannual
coupon of $45 and is currently priced at $960.
What is the coupon rate?
What is the current yield?
$45 2
(10.1) Coupon Rate
9.00%
$1,000
$45 2
(10.2) Current Yield
9.375%
$960
10-4

Straight Bond Prices & Yield to

Maturity
Bond Price:
Present value of the bonds coupon
payments
+ Present value of the bonds face value

Yield to maturity (YTM):

The discount rate that equates todays bond
price with the present value of the future
cash flows of the bond
10-5

Bond Pricing Formula

C
1
(10.3) Bond Price
1
YTM
YTM
1

FV

2M
YTM
1

2M

PV of coupons
PV of FV
Where:
C = Annual coupon payment
FV = Face value
M = Maturity in years
YTM = Yield to maturity
10-6

Straight Bond Prices

Calculator Solution

C
1
(10.3) Bond Price
1
YTM
1 YTM

Where:

2M

FV
1 YTM

2M

N = 2M

C = Annual coupon payment

I/Y = YTM/2

FV = Face value

PMT = C/2

M = Maturity in years

FV = 1000

YTM = Yield to maturity

CPT PV

10-7

Straight Bond Prices

C
1
(10.3) Bond Price
1
YTM
1 YTM 2

FV

2M
1 YTM 2

PV of coupons

PV of FV

2M

For a straight bond with 12 years to maturity, a coupon

rate of 6% and a YTM of 8%, what is the current price?

60
1
$457.41
PV of Coupons
1
24
.08
.
08
1

2
1000
PV of FV
$390.12
24
1 .08 2

Price = $457.41 + $390.12 = $847.53

10-8

Calculating a Straight Bond Price Using Excel

Excel function to price straight bonds:
=PRICE(Today,Maturity,Coupon Rate,YTM,100,2,3)

Enter Today and Maturity in quotes, using mm/dd/yyyy format.

Enter the Coupon Rate and the YTM as a decimal.
The "100" tells Excel to us $100 as the par value.
The "2" tells Excel to use semi-annual coupons.
The "3" tells Excel to use an actual day count with 365 days per year.
Note: Excel returns a price per $100 face.

10-9

Spreadsheet Analysis

10-10

Par, Premium and Discount Bonds

Par bonds:

Price = par value

YTM = coupon rate

Premium bonds: Price > par value

YTM < coupon rate
The longer the term to maturity, the greater the
premium over par

Discount bonds: Price < par value

YTM > coupon rate
The longer the term to maturity,
discount from par

the greater the

10-11

Premium Bond Price

12 years to maturity
8% coupon rate, paid semiannually
YTM = 6%

80
1
PV of Coupons
1

.06
.06
1

1000
PV of FV
1 .03 2

$677.42
24

24

$491.93

Price = $457.41 + $390.12 = $1,169.36

10-12

Discount Bonds
Consider two straight bonds with a coupon rate of 6%
and a YTM of 8%.
If one bond matures in 6 years and one in 12, what
are their current prices?
60
1
Bond Price (6 yr)
1
.08
1 .08 2

1000

12

1 .08

Bond Price (12 yr)

60
1
1
.08
1 .08

12

$906.15

1000

24
1 .08

24

$847.53

10-13

Premium Bonds
Consider two straight bonds with a coupon rate of 8% and
a YTM of 6%.
If one bond matures in 6 years and one in 12, what are
their current prices?

Bond Price (6 yr)

80
1
1
.06
1 .06 2

1000

$1,099.54
12
12
1 .06 2

80
1
Bond Price (12 yr)
1

.06
.06
1

1000

24
.06
1

24

$1,169.36

10-14

Bond Value ($) vs Years to Maturity

Premium

1,000

CR>YTM
8%>6%
YTM = CR

M
CR<YTM
6%<8%

Discount
12

0
10-15

Premium and Discount Bonds

In general, when the coupon rate and YTM are
held constant:
For premium bonds: the longer the term to
maturity, the greater the premium over par
value.
For discount bonds: the longer the term to
maturity, the greater the discount from par
value.
10-16

Relationships among Yield

Measures
For premium bonds:
coupon rate > current yield > YTM
For discount bonds:
coupon rate < current yield < YTM
For par value bonds:
coupon rate = current yield = YTM
10-17

A Note on Bond Quotations

If you buy a bond between coupon
dates:
You will receive the next coupon payment
You might have to pay taxes on it
You must compensate the seller for any
accrued interest.

10-18

A Note on Bond Quotations

Clean Price = Flat Price
Bond quoting convention ignores accrued interest.
Clean price = a quoted price net of accrued
interest

Dirty Price = Full Price = Invoice Price

The price the buyer actually pays
Includes accrued interest added to the clean
price.

10-19

Clean vs. Dirty Prices

Example

Today is April 1. Suppose you want to buy a

bond with a 8% annual coupon payable on
January 1 and July 1.
The bond is currently quoted at $1,020
The Clean price = the quoted price = $1,020
The Dirty or Invoice price = $1,020 plus
(3mo/6mo)*$40 = $1,040
10-20

Calculating Yields

C
1
FV

Bond Price
1

2M
2M

YTM
YTM
YTM
1
1
2
2

Trial and error

Calculator
Spreadsheet

10-21

Calculating Yields
Trial & Error
A 5% bond with 12 years to maturity is priced at
90% of par ($900).
Selling at a discount YTM > 5%
Try 6% --- price = $915.32 too high
Try 6.5% --- price = $876.34 too low
Try 6.25% --- price = $895.56 a little low
Actual = 6.1933%
10-22

Calculating Yields
Calculator
A 5% bond with 12 years to maturity is priced at
90% of par ($900).
N = 24
PV = -900
PMT = 25
FV = 1000
CPT I/Y = 3.0966 x 2 = 6.1933%

10-23

Calculating Yields
Spreadsheet
5% bond with 12 years to maturity,priced at 90% of par
=YIELD(Now,Maturity,Coupon, Price,100,2,3)
Now = 06/01/2008
Maturity = 06/01/2020
Coupon = .05
Price = 90 (entered as a % of par)
100 redemption value as a % of face value
2 semiannual coupon payments
3 actual day count (365)
=YIELD(06/01/2008,06/01/2020,0.05,90,100,2,3) = 0.06193276

10-24

Spreadsheet Analysis

10-25

Callable Bonds
Gives the issuer the option to:
Buy back the bond
At a specified call price
Anytime after an initial call protection
period.
Most bonds are callable Yield-to-call may
be more relevant

10-26

Yield to Call

C
1
Callable Bond Price
1
2T
YTC
YTC
1

CP
1 YTC

2T

Where:
C = constant annual coupon
CP = Call price of bond
T = Time in years to earliest call date
YTC = Yield to call
10-27

Yield to Call
Suppose a 5% bond, priced at 104% of par with 12
years to maturity is callable in 2 years with a $20
call premium. What is its yield to call?
N=4

# periods to first call date

PV = -1040
PMT = 25
FV = 1,020

Face value + call premium

CPT I/Y = 1.9368 x 2 = 3.874%

Remember: resulting rate = 6 month rate
10-28

Interest Rate Risk

Interest Rate Risk = possibility that changes
in interest rates will result in losses in the
bonds value
Realized Yield = yield actually earned or
realized on a bond
Realized yield is almost never exactly equal
to the yield to maturity, or promised yield
10-29

Interest Rate Risk and Maturity

10-30

Malkiels Theorems
1. Bond prices and bond yields move in
opposite directions.
2. For a given change in a bonds YTM, the
longer the term to maturity, the greater the
magnitude of the change in the bonds
price.
3. For a given change in a bonds YTM, the size
of the change in the bonds price increases at
a diminishing rate as the bonds term ot
maturity lengthens.
10-31

Malkiels Theorems
4. For a given change in a bonds YTM, the
absolute magnitude of the resulting
change in the bonds price is inversely
related to the bonds coupon rate.
5. For a given absolute change in a bonds
YTM, the magnitude of the price increase
caused by a decrease in yield is greater than
the price decrease caused by an increase in
yield.
10-32

Bond Prices and Yields

10-33

Duration
Duration measure the sensitivity of a bond
price to changes in bond yields.
Change in YTM
% Bond Price Duration
1 YTM
2

Two bonds with the same duration, but not

necessarily the same maturity, will have
approximately the same price sensitivity
to a (small) change in bond yields.
10-34

Macaulay Duration
(10.5)

YTM
% Bond Price -Duration x 1 YTM 2

A bond has a Macaulay Duration = 10 years, its yield

increases from 7% to 7.5%.
How much will its price change?
Duration = 10
Change in YTM = .075-.070 = .005
YTM/2 = .035
%Price -10 x (.005/1.035) = -4.83%

10-35

Modified Duration
Some analysts prefer a variation of Macaulays
Duration, known as Modified Duration.
Macaulay Duration
Modified Duration
YTM

The relationship between percentage changes in

bond prices and changes in bond yields is
approximately:
Pct. Change in Bond Price - Modified Duration Change in YTM
10-36

Modified Duration
(10.6)

Macaulay Duration
Modified Duration
1 YTM 2

(10.7)

%Bond Price -Modified Duration x YTM

A bond has a Macaulay duration of 9.2

years and a YTM of 7%. What is its
modified duration?
Modified duration = 9.2/1.035 = 8.89 years

10-37

Modified Duration
(10.6)

Macaulay Duration
Modified Duration
1 YTM 2

(10.7)

%Bond Price -Modified Duration x YTM

A bond has a Modified duration of 7.2 years

and a YTM of 7%. If the yield increases to
7.5%, what happens to the price?
%Price -7.2 x .005 = -3.6%

10-38

Calculating Macaulays Duration

Macaulays duration values stated in years
Often called a bonds effective maturity
For a zero-coupon bond:
Duration = maturity

For a coupon bond:

Duration = a weighted average of individual maturities
of all the bonds separate cash flows, where the
weights are proportionate to the present values of each
cash flow.

10-39

Calculating Macaulay Duration

1
(10.8) Par Value bond duration 1 YTM 2 1

2M
YTM
1 YTM 2

Suppose a par value bond has 12 years to

maturity and an 8% coupon. What is its
duration?
Par Value bond duration

1 .08 2
.08

1
10.47 years
1
24
1 .08 2

10-40

General Macaulay Duration Formula

(10.9)

1 YTM 2 1 YTM 2 M(CPR YTM)

Duration

2M
YTM
YTM CPR 1 YTM 2 1

Where:
CPR = Constant annual coupon rate
M = Bond maturity in years
YTM = Yield to maturity assuming semiannual coupons

10-41

Calculating Macaulays Duration

In general, for a bond paying constant semiannual
coupons, the formula for Macaulays Duration is:
Duration

1 YTM 2
YTM

1 YTM 2 M C YTM

YTM C 1 YTM 2

2M

In the formula, C is the annual coupon rate, M is the

bond maturity (in years), and YTM is the yield to
maturity, assuming semiannual coupons.

10-42

Using the General Macaulay Duration

Formula

What is the modified duration for a bond that

matures in 15 years, has a coupon rate of
5% and a yield to maturity of 6.5%?

Steps:
1. Calculate Macaulay duration using 10.9
2. Convert to Modified duration using 10.6

10-43

Using the General Macaulay Duration

Formula
Bond matures in 15 years
Coupon rate = 5%
Yield to maturity = 6.5%

1. Calculate Macaulay duration using 10.9

1 YTM 2 1 YTM 2 M(CPR YTM)
Duration

2M
YTM
YTM CPR 1 YTM 2 1

1 .065 2 1 .065 2 15(.05 .065)

Duration

30
.065
.065 .05 1 .065 2 1
Duration 10.34 years

10-44

Using the General Macaulay Duration

Formula
Bond matures in 15 years
Coupon rate = 5%
Yield to maturity = 6.5%
Macaulay Duration = 10.34 years

2. Convert to Modified duration using 10.6

Modified Duration

Macaulay Duration
1 YTM 2

Modified Duration

10.34
10.01 years
1 .065 2
10-45

Calculating Duration Using Excel

Macaulay Duration -- DURATION function
Modified Duration -- MDURATION function
=DURATION(Today,Maturity,Coupon Rate,YTM,2,3)

10-46

Calculating Macaulay and

Modified Duration

10-47

Duration Properties: All Else Equal

1.
2.
3.
4.

The longer a bonds maturity, the longer its

duration.
A bonds duration increases at a decreasing
rate as maturity lengthens.
The higher a bonds coupon, the shorter is
its duration.
A higher yield to maturity implies a shorter
duration, and a lower yield to maturity
implies a longer duration.
10-48

Properties of Duration

10-49

Bond Risk Measures based on

Duration
Dollar Value of an 01:
(10.10)
Modified Duration x Bond Price x 0.0001
= Value of a basis point change
Yield Value of a 32nd:

(10.11)

1
32 Dollar Value of an 01
In both cases, the bond price is per $100 face value.
10-50

Calculating Bond Risk Mesures

Bond matures in 15 years M = 15
Coupon rate = 5% C = $50
Yield to maturity = 6.5% YTM = .065
Macaulay Duration = 10.34 years
Modified Duration = 10.01 years

First we have to find the price of the bond:

C
1
(10.3) Bond Price
1
YTM
1 YTM

50
1
Bond Price
1
.065
1 .065 2

2M

FV
1 YTM

1000

30

1 .065 2

30

2M

$857.64

10-51

Bond Risk Measures based on Duration

Bond matures in 15 years
M = 15
Coupon rate = 5%
C = $50
Yield to maturity = 6.5%
YTM = .065
Macaulay Duration = 10.34 years
Modified Duration = 10.01 years
Price = 85.764
Dollar Value of an 01:
Modified Duration x Bond Price x 0.0001
10.01 x 85.764 x 0.0001 = 0.0859

(10.10)

10-52

Bond Risk Measures based on Duration

Bond matures in 15 years
M = 15
Coupon rate = 5%
C = $50
Yield to maturity = 6.5%
YTM = .065
Macaulay Duration = 10.34 years
Modified Duration = 10.01 years
Price = 85.764

Yield Value of a 32nd:

(10.11)

1
1

0.364
32 Dollar Value of an 01 32 0.0859

10-53

Dedicated Portfolios
Bond portfolio created to prepare for a
future cash payment, e.g. pension funds
Target Date = date the payment is due

10-54

Reinvestment Risk & Price Risk

Reinvestment Rate Risk:
Uncertainty about the value of the portfolio on the
target date
Stems from the need to reinvest bond coupons at
yields not known in advance

Price Risk:
Risk that bond prices will decrease
Arises in dedicated portfolios when the target date
value of a bond is not known with certainty
10-55

Price Risk vs. Reinvestment Rate

Risk For a Dedicated Portfolio
Interest rate increases have two effects:
in interest rates decrease bond prices, but
in interest rates increase the future value of
reinvested coupons

Interest rate decreases have two effects:

in interest rates increase bond prices, but
Decreases in interest rates decrease the future
value of reinvested coupons
10-56

Immunization
Immunization = constructing a dedicated
portfolio that minimizes uncertainty
surrounding the target date value
Engineer a portfolio so that price risk and
reinvestment rate risk offset each other
(just about entirely).
Duration matching = matching the
duration of the portfolio to its target date

10-57

Immunization by Duration Matching

10-58

Dynamic Immunization
Periodic rebalancing of a dedicated
bond portfolio for the purpose of
maintaining a duration that matches the
target maturity date
Advantage = reinvestment risk greatly
reduced
Drawback = each rebalancing incurs
management and transaction costs
10-59

Constructing a Dedicated Portfolio

Suppose a Pension Fund estimates it will
need to pay out about $50 million in 4 years.
The fund decides to buy coupon bonds
paying 6%, maturing in 4 years and selling at
par.
Assuming interest rates do not change over
the next four years, how much should the
fund invest to have $50 million in 4 years?
10-60

Constructing a Dedicated Portfolio

10.12

P(1 YTM 2) 2M

10.13

Face Value

C
1 YTM 2 2M 1 Face value
YTM

Future Value Required

(1 YTM 2) 2M

Future Value required = $50 million

Time = 4 years (M=8)
Par value bonds paying 6%
$50,000,00 0
Face Value
$39,470,462
8
(1.03)
10-61

Constructing a Dedicated Portfolio

10-62

Useful Internet Sites

www.sifma.org (check out the bonds section)

www.jamesbaker.com (a practical view of bond
portfolio management)
www.bondsonline.com (bond basics and current
market data)
www.investinginbonds.com (bond basics and
current market data)
www.bloomberg.com (for information on
government bonds)

10-63