U U N IT
7
Analysis of Bonds
Overview
In this chapter, we will examine how to calculate the value of bonds. Bonds are publicly
issued, long-term, nonconvertible debt obligations of public and private issuers. We
will first cover some basic fundamentals about bonds, then explore the correlation
between the duration and maturity of bonds and its impact on the bond’s value.
In this chapter, we will introduce the relationship between bond prices and interest
rates, we will also discuss ways to measure the returns on bond (yields) and discuss
the options for pricing bonds.
Unit 7 Learning Objectives
At the end of this Unit students should be able to:
• Compute current yield, yield to maturity, yield to call and compound realized
yield.
• Explain and compute bond duration.
This Unit is divided into three sessions as follows:
Session 7.1: Bond Valuation
Session 7.2: Calculating Bond Yields
Session 7.3: Passive vs Active Bond Portfolio Management Strategies
12 © 2015 University of the West Indies Open Campus
Readings and Resources
Required Reading
Faure, P. D. (2013). Bond Market Instruments: In Investments: An Introduction.
bookboon.com. pg 72-75
http://bookboon.com/en/bond-market-an-introduction-ebook
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SSession 7.1
Bond Valuation
Introduction
In order to maintain a diversified portfolio, investors ought to have some level of
bond investment. Of course, this is dependent on other important factors, including
the investor’s risk appetite. The income stream from bond investments is relatively
predictable, eliminating a significant amount of risk. This session will explain the
process of determining the value of bond.
Session Objectives
At the end of this session, you will be able to:
• Determine the value of a bond based on the present value formulae.
• Explain bond yields.
Bond Fundamentals
• Coupon – the income that the investor will receive over the life of the issue.
• Term to Maturity – the date or number of years before the bond matures.
• Par Value – The original value of the bond. It is not the same as the market value
of the bond.
• Yield – the return on a bond.
Readings and Resources
Required Reading
The following article provides useful information on bond fundamentals:
Bond Basics:
http://www.syllc.com/templates/media/files/sy_bondbasics-brochure.pdf
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Bond Prices and Yields
A bond repays the investor by means of coupon payments and the repayment of the
amount invested. The current market value of a bond is the present value of cash
flows expected, i.e. the cash flows (coupon payments and par value) discounted by the
current market interest rates.
The current market interest rate represents the opportunity cost for the cash flow.
This can be represented using the following bond-pricing equation:
n
C Par
(1+Rt)t
� +
(1+Rn)n
t=1
Where;
C = Coupon Payment
n = number of periods to maturity
Par = face value of the bond (payment at maturity)
P = the current market price of the bond
Rt = the interest rate that applies for cash flows that are received after t periods
Yield to Maturity
Yield to Maturity (YTM) is the internal rate of return of the bond. It is the rate at which
the present value of the future cash flows of the bond equals the current price of the
bond.
– If a bond offers a coupon rate above YTM, it is trading at a premium
– If a bond offers a coupon rate below YTM, it is trading at a discount
Bond Pricing Principles
Bond pricing has the following basic principles:
• Bond prices change with the passage of time:
o As time to mature becomes shorter, there will be fewer coupons payments.
Premium bonds with high coupon rates experience declining prices in the
future, discount bonds with low coupon rates experience rising prices in the
future.
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• Bond prices are inversely related to YTM:
o This will be explained in the following session
• The longer the maturity, the more sensitive the bond’s price and changes to the
YTM
o The prices of longer maturity bonds are more sensitive to changes in YTM than
shorter maturity bonds
• The sensitivity of the price of a bond to changes in the YTM increases at a decreasing
rate with the length to maturity
Videos
These videos walk through the application of these bond valuation:
https://www.youtube.com/watch?v=vVT-sCI2_s4
https://www.youtube.com/watch?v=1Z7C0MbMm3s
ACTIVITY 7.1
What would be the initial offer price of the following bonds:
A. A 15 year zero coupon bond with a YTM of 12%
B. A 20 year zero coupon bond with a YTM of 10%
Session Summary
Now that we have covered the basic principles of bond valuation, we can move onto
the examination of bond yield calculation and the relationship with interest rates.
16 FINA2004 Portfolio Management – UNIT 5
SSession 7.2
Calculating Bond Yields
Introduction
The term “yield” has various meanings and serves several purposes. This session
introduces the definitions of the term, and its contributions to the investment decision.
Session Objectives
At the end of this session, you will be able to:
• Compute current yield, yield to maturity, yield to call and compound realized
yield.
Nominal Yield
Nominal yield (aka Current Yield) measures the coupon rate. It measures the bond as
a percentage of price
C1
CY =
Pm
Yield to Call
This measures the estimated rate of return for a bond held to its first call date.
nc
�
C
+
(1+yc) t
call price
(1+yc)nc
t=1
P=
Where yc is the yield to call and nc is the number of coupon payments until the first
call date.
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Realized Yield
This measures the estimated rate of return for a bond that is likely to be sold prior
to maturity. This is the holding period rate of return actually generated form an
investment in a bond.
Example:
A 2 year bond with 8% annual coupon rate, $1000 par value, is currently trading at
$1030 and is callable at $1050.
Nominal Yield = C1 = 80/1000 = 8%
Pm
Yield to Call : P =
nc
� C
+
(1+yc) t
call price
(1+yc)nc
t=1
nc
80
1030 =
�(1+yc) t
+ 1050
(1+yc)1 = 1130/1+ yc = 9.71%
t=1
Videos
The following video explains the calculation of yield:
https://www.youtube.com/watch?v=AwDYUNlPHAM
https://www.youtube.com/watch?v=pfhjJ00IuW4
ACTIVITY 7.2
Exercise:
1. What is the nominal yield on a 25 year bond issued 4 years ago with
a 7% coupon rate?
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Session Summary
This session builds on our introduction to bond and bond valuation. Now that we
know how to determine bond value, we can apply this to making investment decisions
and diversifying an investment portfolio.
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SSession 7.3
Passive vs Active Bond Portfolio
Management Strategies
Introduction
Passive vs active bond portfolio management strategies, mirror those introduced in
Unit 6, with application to bonds.
A passive approach, invests in securities for the long term, while the active approach
seeks to take advantage of market inefficiencies.
Session Objectives
At the end of this session, you will be able to:
• Describe the two generic bond portfolio management styles.
• Explain the techniques for constructing a bond portfolio.
Bond Portfolio Performance Style and Strategy
An outline of Bond Portfolio’s performance, style and strategies are as follows
• Bond Portfolio Performance
– Fixed-income portfolios, generally produce both less return and less volatility
than found in other asset classes (e.g., domestic equity, foreign equity)
– The low historical correlation between fixed-income and equity securities, has
made bond portfolios an excellent tool for diversifying risk
• Bond Portfolio Style
– The investment style of a bond portfolio can be summarized by its two most
important characteristics: credit quality and interest rate sensitivity.
– The average credit quality of the portfolio can be classified as high, medium,
and low grades.
– The interest rate sensitivity of the bond portfolio can be separated as short-
term, intermediate-term, and long-term in terms of duration.
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• Bond Portfolio Strategies
– Passive Portfolio Strategies
– Active Management Strategies
– Core-plus Management Strategy
– Matched-funding Techniques
– Contingent Procedure (Structured Active Management)
An Overview of Passive Strategies
Buy and hold
– A manager selects a portfolio of bonds based on the objectives and constraints
of the client with the intent of holding these bonds to maturity.
– Can by modified by trading into more desirable positions.
Indexing
– The objective is to construct a portfolio of bonds that will track the performance
of a bond index.
– Performance analysis involves examining tracking error for differences between
portfolio performance and index performance.
An Overview of Active Strategies
• Active management strategies attempt to beat the market.
• Mostly the success or failure is going to come from the ability to accurately forecast
future interest rates.
Fundamental Strategies
• Interest-rate anticipation
– Risky strategy relying on uncertain forecasts
– Ladder strategy staggers maturities
– Barbell strategy splits funds between short duration and long duration
securities
• Valuation analysis
– The portfolio manager attempts to select bonds based on their intrinsic value
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• Credit analysis
– Involves detailed analysis of the bond issuer to determine expected changes in
its default risk
• Yield spread analysis
– Assumes normal relationships exist between the yields for bonds in alternative
sectors
– When abnormal relationship occurs, a bond manager could execute various
sector swaps
– The spread widens during economic recession
– Interest rate volatility also affects the spread
• Bond swaps
– Involve liquidating a current position and simultaneously buying a different
issue in its place with similar attributes but having a chance for improved
return
• Bond Swaps Types
– Pure yield pickup swap
• Swapping low-coupon bonds into higher coupon bonds
– Substitution swap
Active Global Bond Investing
An active approach to global fixed-income management must consider the following
three interrelated factors
• The local economy in each country including the effects of domestic and
international demand
• The impact of total demand and domestic monetary policy on inflation and interest
rates
• The effect of the economy, inflation, and interest rates on the exchange rates among
countries
Core-Plus Management Strategies
• A combination of passive and active styles ( a form of enhanced indexing)
• A large, significant part of the portfolio is passively managed in one of two sectors:
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– The U.S. aggregate sector, which includes mortgage-backed and asset-backed
securities
– The U.S. Government/Corporate sector alone
• The rest of the portfolio is actively managed
– Often focused on high yield bonds, foreign bonds, emerging market debt
– Diversification effects help to manage risks
Matched-Funding Strategies
• Dedicated Portfolios
– Designing portfolios that will service liabilities
– Exact cash match
° Conservative strategy, matching portfolio cash flows to needs for cash
° Useful for sinking funds and maturing principal payments
– Dedication with reinvestment
° Does not require exact cash flow match with liability stream
° Great choices, flexibility can aid in generating higher returns with lower
costs
° Immunization Strategies
– The process is intended to eliminate interest rate risk that includes:
° Price Risk
° Coupon Reinvestment Risk
– A portfolio manager (after client consultation) may decide that the optimal
strategy is to immunize the portfolio from interest rate changes
– The immunization techniques attempt to derive a specified rate of return during
a given investment horizon regardless of what happens to market interest rates
• Classical Immunization
– Immunize a portfolio from interest rate risk by keeping the portfolio duration
equal to the investment horizon
– Duration strategy superior to a strategy based only a maturity since duration
considers both sources of interest rate risk
– An immunized portfolio requires frequent rebalancing because the modified
duration of the portfolio always should be equal to the remaining time horizon
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• Difficulties in Maintaining Immunization Strategy
– Rebalancing required as duration declines more slowly than term to maturity
– Modified duration changes with a change in market interest rates
– Yield curves shift
• Horizon matching
– Combination of cash-matching dedication and immunization
– Important decision is the length of the horizon period
– With multiple cash needs over specified time periods, can duration-match for
the time periods, while cash-matching within each time period
A comparison of active vs. passive portfolio management is outlined in the
following text file.
Active vs Passive Portfolio Management: http://tinyurl.com/ncga8fh
ACTIVITY 7.3
How would you explain these management strategies to a casual
observer?
Unit 7 Summary
Unit 7 has provided students with the information needed to make bond investments.
This now leads us to evaluation of portfolio performance.
24 FINA2004 Portfolio Management – UNIT 5
References
Education Unlocked. (2015, April 13). Calculating the Yield of a Coupon Bond . [Video
File]. Retrieved from https://www.youtube.com/watch?v=AwDYUNlPHAM
Faure, P. D. (2013). Bond Market Instruments: In Investments: bookboon.com. pg 72-
75 http://bookboon.com/en/bond-market-an-introduction-ebook
FinCampus Lecture Hall. (2013, May 25). Bond Pricing . [Video File]. Retrieved from
https://www.youtube.com/watch?v=vVT-sCI2_s4
Horn, J. (2011, April 20). Khan Academy - Bond Prices and Interest Rates . [Video File].
Retrieved from https://www.youtube.com/watch?v=1Z7C0MbMm3s
Levy, H., & Port, T. (2005). Investments. Essex: Pearson Educational Limited.
Preston Pysh (2012, April 26). 8. Value a Bond and Calculate Yield to Maturity (YTM)
. [Video File]. Retrieved from https://www.youtube.com/watch?v=pfhjJ00IuW4
Reilly, F. K., & Brown, K. C. (2012). Investment Analysis and Portfolio Management. South-
Western Cengage Learning.
Securities Industry and Finance Marker Association (2009). Bond Basics. [PDF].
Retrieved from http://www.syllc.com/templates/media/files/sy_bondbasics-
brochure.pdf
Vanguard Research (2013). The Active/passive Decision in Global Bond Funds. [PDF].
Retrieved from https://pressroom.vanguard.com/content/nonindexed/The_
activepassive_decision_in_global_bond_funds_11.26.2013.pdf
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