Chapter 10: Bond Prices and Yields

Learning Objectives

• Bonds are an important component in investment portfolios.

• Key topics to learn:

  • Calculation of bond prices and yields.

  • Understanding yield to maturity (YTM).

  • Exploring interest rate risk and Malkiel's theorems.

  • Measuring the impact of interest rate changes on bond prices.

Bond Basics

• Straight Bonds: A bond where:

  • The issuer pays a fixed sum (principal, par value, or face value) at maturity.

  • The issuer pays constant, periodic interest payments (coupons) during the bond's life.

• Types of bonds:

  • Convertible Bonds: Can be converted to a predetermined number of the issuer's equity shares.

  • Callable Bonds: Can be redeemed by the issuer before maturity.

  • Putable Bonds: Allow the bondholder to sell the bond back to the issuer at a defined price before maturity.

Yield Measures

• Coupon Rate: The annual interest payment divided by the face value of the bond.

• Current Yield: Annual coupon payment divided by the current market price of the bond.

Relationships Among Yield Measures

• For premium bonds: Coupon rate > currently yield > YTM

  • the longer the term to maturity, the greater the premium over par value.

• For discount bonds: Coupon rate < current yield < YTM

  • the longer the term to maturity, the greater the discount from par value.

• For par value bonds: Coupon rate = current yield = YTM

  • all on exam

Bond Pricing Formula

• USING TI-84 EXAMPLES

Yield to Call

• yield measure that assumes a bond will be called at its earliest possible call date.

• Formula to price a callable bond:

  • 

Interest Rate Risk

• possibility that changes in interest rates will result in losses in the bonds value.

  • price risk portion: negative relationship

  • reinvestment risk portion: positive relationship

Dedicated Portfolio:

• bond portfolio created to prepare for a future cash payment

  • Ex: pension funds

Reinvestment Risk

• uncertainty about the value of the portfolio on the target date.

  • simple solution: purchase zero coupon bonds.

Malkiel’s Theorems - On Exam

Immunization definition - On Exam

• constructing a dedicated portfolio such that the uncertainty surrounding the target date value is minimized.

• Dynamic Immunization - periodic rebalancing of a dedicated bond portfolio for the purpose of maintaining a duration that matches the target maturity date