FE 445 – Investment Analysis and Portfolio

Management
Fall 2020

Farzad Saidi

Boston University | Questrom School of Business

Chapter 17: Bond prices, yields,
and the yield curve
Overview bond markets

600

500

Equity
400
in USD bn

Treasury

300

200

100
2000 2002 2004 2006 2008 2010 2012 2014 2016

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U.S. bond market trading volume

600
Municipal
Treasury
500 Agency MBS
Non-Agency MBS
ABS
400 Corporate Debt
in USD bn

300

200

100

0
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

2
U.S. bond market issuance

3
Bond characteristics

Indenture: legal contract between borrower and lender, it specifies:

ˆ Face or par value

ˆ Maturity
ˆ Coupon rate and frequency
ˆ Jurisdiction
ˆ Provisions (embedded options)
ˆ Callable: issuer can repurchase the bond
ˆ Puttable: holder can ask for early repayment
ˆ Convertible: holder can exchange for stocks
ˆ Covenants

4
Typical covenants

ˆ Seniority: junior or senior

ˆ Collateral:
ˆ Specific asset pledged against possible default
ˆ Debenture: no collateral pledged
ˆ Dividend restrictions

All parts of the indenture affect the price of a bond

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Treasury notes and bonds

ˆ T-bill matures in one year or less

ˆ T-note maturity from 2 to 10 years
ˆ T-bond maturity from 10 to 30 years
ˆ Typical par = $1,000 with biannual coupon, T-bills do not pay a
coupon
ˆ Prices quoted in dollars and 32nds as a % of par
ˆ Quoted or flat price does not include interest accrued
⇒ Invoice price is what you have to pay

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Accrued interest

With semi-annual coupons:

annual coupon $ days since last coupon payment

accrued interest = ×
2 days between coupon payments
invoice price = flat price + accrued interest
Example:

ˆ T-bond: flat price $925.30

ˆ Annual coupon of $42.50 paid semi-annually
ˆ 160 days have passed since the last coupon payment, 182 days
separating the coupon payment

The accrued interest is . . . . . . . . . and the price you have to pay is

.........

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Corporate bonds

ˆ Most bonds are traded over-the-counter (OTC), less liquid than

equity
ˆ Large companies can have 100 separate bonds
ˆ Par usually $1,000
ˆ Provisions common: puttable / callable / convertible
ˆ Default risk might be large

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Bond prices

Use discounted cash flow model:

ˆ Semi-annual coupons:
2T
X $C $Par
P= t + 2T
t=1
(1 + r /2) (1 + r /2)

ˆ Annual coupons:
T
X $C $Par
P= t + T
t=1
(1 + r ) (1 + r )

ˆ r = expected (fair) return, assumed to be constant

Example:

ˆ Semi-annual C = 10%, r = 12%, T = 10 years, Par = $1,000

ˆ What is the price of this bond?
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Yield to maturity

YTM(y): r that makes PV of cash flows = P

ˆ Assumption: reinvest the coupon at return = YTM

ˆ In efficient markets: YTM = r

Example:

ˆ Semi-annual C = 8% coupon, T = 30 years, and P = $1,276.76

ˆ What is the yield to maturity?
60
X $40 $1, 000
$1, 276.76 = + 60
t=1
(1 + ytm/2)t (1 + ytm/2)
This holds if YTM = 6%

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Yield to maturity: example

Suppose that

ˆ 1-year spot rate is 5%

ˆ 2-year coupon bond with annual coupon of 6% trades “at par” in
the market (i.e., price = face value)

Questions:

a) Is the 2-year spot rate higher or lower than 6%?

b) Calculate the 2-year spot rate.
c) Now suppose that there is another 2-year coupon bond with an
annual coupon of 7%. What should be its price?

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Bond prices and yields

1000

900
bond price

800

700

600
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
yield

ˆ Inverse relationship: if interest rate goes up ⇒ bond price goes

down because you want higher YTM
ˆ Bonds have different curvatures or convexities

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Premium and discount bonds

Premium bond:

ˆ C > YTM
ˆ Bond price declines over time to par by maturity ⇒ otherwise would
receive too high yields

Discount bond:

ˆ YTM > C
ˆ Bond price increases over time to par by maturity ⇒ otherwise
would receive too low yields

Note: Usually bonds sell with coupons near YTM, so P ≡ Par

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Premium and discount bonds

14
Zero coupon bonds

ˆ Trades at discount, so you earn return r every period

ˆ Example: STRIP, a Treasury “stripped” of its coupons
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Innovation in the bond market

Catastrophe bonds:

ˆ In the event of a pre-specified disaster (e.g., earthquake) the bond

issuer’s required payments are reduced or eliminated

Asset-backed bonds (MBS, CDO, CDO2 ):

ˆ Income from a pool of credit card loans, mortgages, etc. used to

service the bonds

Indexed bonds:

ˆ TIPS: principal indexed to CPI (inflation)

Contingent convertible bonds (CoCo bonds):

ˆ Converts to equity in a recession

ˆ Automatically boosts a bank’s capital

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Term structure of interest rates

Yield curve: yields on bonds relative to the number of years to maturity

(usually for Treasuries)

Yield Humped

Normal

Flat

Inverted
Maturity

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Theories of the term structure

Expectations theory:

ˆ The key assumption behind this theory is that buyers of bonds do not
prefer bonds of one maturity over another, so they will not hold any
quantity of a bond if its expected return is less than that of another bond
with a different maturity
ˆ Note that what makes long-term bonds different from the short-term
bonds are the inflation and interest rate risks. Therefore, this theory
essentially assumes away inflation and interest rate risks

r1 = 8% E (r2 ) = 10%

t=0 t=1 t=2

2-year investment: y2 = 8.995%

Two-year cumulative expected returns = 1.08 × 1.10 = 1.188 or

1.089952 = 1.188 leads to the same. 18
Theories of the term structure

Liquidity preference theory:

ˆ The liquidity premium theory views bonds of different maturities as

substitutes, but not perfect substitutes. Investors prefer short rather than
long bonds because they are free of inflation and interest rate risks.
Therefore, they must be paid a positive liquidity (term) premium
ˆ The yield, therefore, has two parts:
1. One that is risk free and
2. ... another that is a premium for holding a longer-term bond

Segmented markets theory:

ˆ This theory assumes that markets for different-maturity bonds are

completely segmented. The interest rate for each bond with a different
maturity is then determined by the supply of and demand for the bond
with no effects from the expected returns on other bonds with other
maturities
ˆ In other words, longer bonds that have associated with them inflation and
interest rate risks are completely different assets than the shorter bonds
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Implied forward rate

One period-ahead forward rate:

(1 + yn )n = (1 + yn−1 )n−1 × (1 + fn )

ˆ Break-even rate between n period investment and rolling

(reinvesting) after n − 1 years (derived from compounding)
ˆ Under the expectations hypothesis: fn = E (rn )

E (rn ) ∼ expected short-term interest rate at time n

Example:

ˆ Assume that 2yr spot rate: y2 = 4% and 3yr spot rate: y3 = 5%

ˆ What is the forward rate in year 2?

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Example

Given the following term structure, what are the implied forward rates?

maturity yield to maturity forward

1 10%
2 11%
3 12%

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Term or yield spread

Term spread = (10yr Treasury yield) − (3m T-bill yield)

3
in percent

-1
1980 1985 1990 1995 2000 2005 2010 2015 2020

What is special about the term spread?

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Yield curve and discounting

In the simple version:

2T
X $C $Par
P= t + 2T
t=1
(1 + r /2) (1 + r /2)

⇒ r is a constant: assumes a flat term structure

However, in reality:
2T
X $C $Par
P= t + 2T
t=1
(1 + rt /2) (1 + r2T /2)
or for annual coupons:
T
X $C $Par
P= t + T
t=1
(1 + rt ) (1 + rT )

⇒ rt depends on the horizon: should use the yield curve

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Using the yield curve

maturity yield to maturity forward

1 10%
2 11%
3 12%

ˆ Under the assumption that the annual coupon is $100, the par value
is $1,000, and the maturity is 3 years, what is the price of the
coupon bond?
ˆ What if we assume that the term structure is flat at 10%?

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Summary

This class:

ˆ Inverse relationship between y and bond P

ˆ Using yield curve to price bonds

Next class:

ˆ Duration
ˆ Bond portfolios

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