Topic 6: Relationship Between Bond Prices and Yields

BUS 442 Investment Theory and Portfolio Management The goal of the previous topic is to help you become more familiar with the different features of a bond the different types of bonds and the different ratings a bond can receive! "nce you have a better understanding of the basic anatomy of a bond it is time to learn more about the relationship between the price of a bond and its yield #or mar$et interest rate%! 1. Determining the Intrinsic Value of a Bond

&hen you invest in a bond you are e'pected to receive a steady stream of fi'ed interest payments from the bond! &hat do you do with the interest payments( )ou are e'pected to reinvest them in the mar$et at the mar$et interest rate! *eep in mind that we are dealing with the nominal mar$et interest rate which is made up of three parts+ #a% a real ris$,free rate of return #b% a compensation for e'pected inflation and #c% a compensation for bond,specific characteristics #such as ratings call features li-uidity etc!%! This means that there will be a different mar$et interest rate for each bond that reflects the ris$s associated with that bond #because of its characteristics%! To $eep things simple for now we will assume that there is a single nominal mar$et interest rate that applies to all bonds! To determine the intrinsic value of a bond we simply apply the concept of time value of money to determine the present values of all the cash flows #i!e! interest payments and principal% generated by the bond throughout its lifetime! In other words the intrinsic value of a bond is simply the present value of all its interest payments plus the present value of its principal which is e'pressed by the formula below+

P0 =

C/ C. C2 CT Par + + + !!!!! + + 2 / T . + r (. + r ) (. + r ) (. + r ) #. + r % T T Ct Par = + t #. + r % T t =. #. + r %

where P0 is the intrinsic value of a bond Ci is the coupon #or interest% payment from period i and r is the nominal mar$et interest rate! Refer to In class !"ample 1 #. $essons $earned from Valuing a Bond

In the previous e'ample we $now that the characteristics of a bond #e!g! coupon rate term to maturity and payment schedule% will have an impact on the intrinsic value #i!e! fair mar$et price% of the bond! &hat are some of the lessons we learned from valuing a bond( &e will loo$ at five of these lessons through a number of e'amples! Refer to In class !"ample #

$esson 1: There is an inverse relationship between the market interest rate and the price of a bond, i.e. if the market interest rate goes up (down), then the price of a bond will go down (up).

&e can easily plot the data we have collected from 1'ample . and illustrate what we have learned in 2esson . in the following graph!

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Price

Mar$et interest rate

$esson #: The price of a bond is affected by the relationship between its coupon rate and the market interest rate. Coupon rate !arket interest Price of bond Par "old at premium Coupon rate # market interest Price of bond # Par "old at par Coupon rate $ market interest Price of bond $ Par "old at discount &e have learned 2esson 2 by observing a pattern that emerges from our calculations in 1'ample 2! 5an you provide an intuitive e'planation as to why this 6pattern7 is observed(

Refer to In class !"ample %

$esson %: The lower the coupon rate of a bond (with the same term to maturity), the more sensitive it is to interest changes.

Refer to In class !"ample &

Price

Mar$et interest rate

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$esson &: %onger&term bonds are more sensitive to interest rate changes than shorter&term bonds (with the same coupon rate). 's a result, longer&term bonds are considered to be riskier than shorter&term bonds.

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So far the e'amples we loo$ed at focused on studying the impacts of interest rate changes on the fair mar$et price #i!e! intrinsic value% of a bond! &e would now turn our attention to understanding how the price of a bond changes as it gets closer to its maturity date #in a scenario where the mar$et interest rate remained the same%! Refer to In class !"ample '
Price

Time

$esson ': (f the market interest rate remains unchanged, the intrinsic values of )ero coupon bonds, discount bonds, and premium bonds all converge to their face values.

%.

The (an) Yields of a Bond

)ou have probably heard the term yield used in a financial conte't before! The term yield is generally used to represent the return of an investment! 4owever do you $now that there are different types of yield associated with a bond each representing a different way to measure the return of the bond( In this section we will loo$ at #a% normal yield #b% current yield #c% yield to maturity and #d% yield to call! #a% 8ormal yield The normal yield of a bond is simply the -uoted coupon rate of the bond! 9or e'ample a bond with an :; coupon rate has a normal yield of :;! *eep in mind that the normal yield of a bond is fi'ed #in general% and does not ta$e into consideration the current mar$et condition which means that you should nor rely on the normal yield to help you determine the return of a bond! #b% 5urrent yield The current yield of a bond does ta$e the current mar$et condition into consideration by incorporating the current mar$et price into its calculation! < bond=s current yield is determined as follows+
5urrent yield = <nnual coupon payment current bond price

#c% )ield to maturity The current yield provides the annual return of a bond based on the bond=s annual interest payments and current mar$et price! 4owever it does not ta$e into consideration the reinvestments of the interest payments! This is where the yield to maturity #)TM% comes in! It represents the average return earned by a bond if it is held until maturity! To determine the yield to maturity of a bond you need to solve the following e-uation+

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P=
t =.

Ct Par + t #. + *T! % #. + *T! % T

Basically the yield to maturity is simply the discount rate that ma$es the present values of a bond=s coupon payments and principal the same as its current mar$et price! )ou can solve for the )TM using a financial calculator or estimate it with the following formula+

<nnual cooupon payment > *T!

9ace value Mar$et price )ears until maturity

. [ +ace value > #2 Mar$et price%] /

It is important to understand that the yield to maturity of a bond is computed with the assumption that the coupon payments received are reinvested at the )TM rate! In situations when the mar$et interest rates are fluctuating you will not get the promised yield to maturity because each coupon payment is reinvested at a different rate! <n investor that does not understand the yield to maturity=s reinvestment assumption and e'pect the stated yield to maturity will suffer from yield illusion! <nother thing you need to understand is that the yield to maturity of a bond is generally treated as the same as the mar$et interest rate of that bond! In other words the )TM is generally used as the measurement of a bond=s return! #d% )ield to call The yield to maturity measures the annual return of a bond if it is held until maturity! 4owever this is not always possible for a bond with an embedded call feature! 5allable bonds have the potential to be recalled #or retired% prior to their maturities especially when the interest rate is falling! <s a result it is important for holders for such bonds to determine the bonds= yields to call #in addition to their yields to maturity%! 5alculating the yield to call is very similar to calculating the yield to maturity+ you simply #a% replace the original term to maturity with the time until first call and #b% replace the principal with the call price! 4ow do the price of a callable bond and the price of a straight bond differ for different mar$et interest rates( &hy is this the case(
Price

Mar$et interest rate

Refer to In class !"ample 6

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Term *tructure of Interest Rates and the Yield +ur,e

To ma$e li$e simple it was assumed earlier that there is a single mar$et interest rate #or yield to maturity% for all the e'isting bonds! &e $now this not true because the yield to maturity of a bond is affected by the bond=s characteristics such as its term to maturity coupon rate call provisions li-uidity default ris$ and ta' status! In this section we will focus solely on how the yield of a bond is affected by its term to maturity! The relationship between the yield to maturity of a bond and its term to maturity is $nown as the terms structure of interest rates and it is represented graphically by the yield curve! )ou can loo$ up the yield curve daily in the 5redit section of the ,all "treet -ournal! It is important to $now that the yield curve assumes all the bonds have the same ris$ li-uidity and ta' status! The yield curve can ta$e on any of the following four shapes+ .! .ormal yield curve+ The short,term yield is lower than the long,term yield i!e! it is cheaper to borrow short,term than it is to borrow long,term!

)TM

Time to maturity
2! (nverted yield curve+ The short,term yield is higher than the long,term yield i!e! it is more e'pensive to borrow short, term than it is to borrow long,term!

)TM

Time to maturity
/! +lat yield curve+ The short,term yield is the same as the long,term yield i!e! the short,term cost of borrowing is the same as the long,term cost of borrowing!

)TM

Time to maturity
4! /umped yield curve+ The intermediate yield is higher than both the short,term and long,term yields!

)TM

Time to maturity
There are three ma@or theories that attempt to e'plain the shape of a yield curve+ #a% pure e'pectation theory #b% li-uidity preference theory and #c% mar$et segmentation theory! Since you will be learning more each of these three theories in your financial institution course #BUS 444% and money and ban$ing course #15" 4.0% this will simply be a brief overview of the three theories!

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#a% Pure e'pectation theory This theory claims that the term structure of the interest rate is based on the current e'pectations of future short,term interest rates! In other words long,term interest rates are simply the #geometric% mean of the short,term interest rate in the same time period! This relationship is represented by the following formula+

0n = #. + 0. % #. + r. . % #. + r2 . % !!! #. + rn. . %

. n

<ccording to the pure e'pectation theory the yield curve+ &ill slope upward if investors e'pect short,term interest rate to rise in the future! &ill be flat if investors e'pect short,term interest rate to remain the same! &ill slope downward if investors e'pect short,term interest rate to fall in the future! #b% 2i-uidity preference theory This theory claims that long,term yield should be higher than short,term yield for the following reasons+ Savers have to be compensated for giving up cash #i!e! li-uidity%! <nd the longer the period of time they have to give up the more they need to be compensated! 2ong,term bonds are more sensitive to interest rate changes than short,term bonds! 4ence the return for a longer,term bond needs to be higher than a shorter,term bond! In other words returns of long,term bonds need to include a li-uidity premium to induce investors to buy them! #c% Mar$et segmentation theory <ccording to this theory the yield curve is composed of a series of different maturities! Bifferent institutions dominate different maturity groups! The shape of the yield curve thus depends on the demand and supply of the funds in each group!

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