1

VALUATION OF FIXED
INCOME SECURITIES

Bond: A debt instrument with periodic
payments of interest and repayment of
principal at maturity

rM rM rM rM rM rM rM+M
|___|____|____|____|____|.....|___ |
0 1 2 3 4 5 n-1 n

r: coupon interest rate
M: maturity (par value)
n: term to maturity

2
Bond Valuation
V= rM(PVIF)
i,1
+rM(PVIF)
i,2
+
rM(PVIF)
i,n
+ M(PVIF)
i,n


i: market rate of interest

Coupon payments (rM) can be regarded as
an annuity,

V= rM(PVIFA)
i,n
+ M(PVIF)
i,n


or

(1+i)
n -1
1
V = rM ------------- + M ------------
(1+i)
n
(1+i)
n

3
Bond Valuation example
n=10 years, coupon rate: 8%
M= $1,000 Market rate : 10%

$80 $80 $80 $80 $80 $80 $180
|___|____|____|____|____|.....|___ |
0 1 2 3 4 5 9 10

V= $80x(PVIFA)
10%,10
+ $1,000x(PVIF)
10%,10

= $877.11

If i > r V < M (discount)
i < r V > M (premium)
i = r V = M (par)

Yield-to-maturity: the rate of return on a bond
In the example, the YTM is 10%.

A bonds YTM is the market rate of interest for
that risk group and maturity.
4
Valuation Between Interest
Payment Dates
(

+
+
+
+
+
=

=

1
1
1 /
) 1 ( ) 1 ( ) 1 (
1
n
t
n t g c
i
M
i
rM
rM
i
V
V: invoice price of the bond
c: days until first payment
g: number of days between two payment periods

P= quoted price = V - accrued interest
Accrued Interest = rM (g-c)/g


5
Valuation Example
Eg. N=5 years,semiannual coupon r=8%,
i=10%, first payment 2 months from today.
(

+
+
+
+
+
=

=
9
1
9 6 / 2
) 05 . 0 1 (
1000
) 05 . 0 1 (
40
40
) 05 . 0 1 (
1
t
t
V
V= Invoice Price = $953.29
Accrued Interest = 40 x (4/6)
= $26.67

Quoted price = $926.62
6
Risks Faced by a Bond
Investor
Default risk
Interest rate risk (price risk)
Reinvestment risk
Call risk
Inflation risk
Foreign exchange risk
Liquidity risk
7
Rating
Category Moodys S&P
------------------------------------------
High Grade Aaa AAA
Aa AA
-------------------------------------------
Investment A A
Grade Baa BBB
-------------------------------------------
Speculative Ba BB
B B
-------------------------------------------
Default Caa CCC
Ca CC
C C
D
8
Interest Rate Risk
Bond Value
Market Rate of
Interest
First Issue:
N = 1 yr
Second Issue:
N = 10 yrs
5% 100.00 100.00
6% 99.06 92.64
7% 98.13 85.95
8% 97.22 79.87
Example: Two bond issues of ABC Co.
N
1
=1 yr N
2
= 10 yrs r = 5%
As term to maturity increases, value of the
bond becomes more sensitive to movements
in market interest rate.
9
Bond Value and Coupon Rates
Example:Two issues of ABC Co.
n=20 yrs, r
1
=10%, r
2
=6%
Market
Interest Rate
Bond 1
R=10%
Percent
change
Bond 2
R=6%
Percent
change
8% 119.64 80.36
9% 109.13 -8.78% 72.61 -9.64%
10% 100.00 -8.36% 65.95 -9.17%
11% 92.04 -7.96% 60.18 -8.75%
12% 85.06 -7.58% 55.18 -8.31%
Low coupon bonds are more
sensitive to changes in market
interest rates
10
Value of a Bond in Time
Example: Market rate stays at 10%, values of
two bonds with coupon rates of 8% and 12%
as the term to maturity approaches:
Maturity Bond 1
R=8%
Bond 2
R=12%
5 92.42 107.58
4 93.66 106.34
3 95.03 104.97
2 96.53 103.47
1 98.18 101.82
0 100.00 100.00
Assuming that interest rates remain the same,
bond value approaches to par over time as
term to maturity shortens.
11
Term Structure of Interest
Rates
Relationship between yield and time to
maturity.

Example: n=1 i=6%
n=5 i=8%
n=20 i=9%

Maturity
i
Yield Curve
12
Possible Explanations of
the Term Structure
1. Expectations Hypothesis

1 + i
n
=[(1+ i
1
)(1+
1
i
2
).(1+
n-1
i
n
)]
1/n


Example: i
2
=8% i
1
=6%
1
i
2
=?

1 + 0.08 = [(1+ 0.06)(1+
1
i
2
)]
1/2


1
i
2
= 0.1004 or 10%

2. Liquidity Preference Hypothesis

Slope of the yield curve is higher than
specified in expectations hypothesis

3. Segmented Markets Hypothesis
13
Duration
Volatility in bond price is directly proportional
to term to maturity but inversely proportional
to coupon payments. Duration of a bond is a
measure that incorporates both factors that
affect volatility.

=
+
=
n
t
t
t
V
i
C t
D
1
) 1 (
) (
14
Duration Example
n=5 yrs, r=8%, i=10%
(1)
Year
(2)
PMT
(3)
PVIF
(4)
(2)x(3)
(5)
(4)/V
(6)
(1)x(5)
1 8 0.9091 7.27 0.0787 0.0787
2 8 0.8264 6.61 0.0715 0.1430
3 8 0.7513 6.01 0.0650 0.1950
4 8 0.6830 5.46 0.0591 0.2364
5 108 0.6209 67.06 72.57 3.6284
Total 92.41 4.28
Bond Value = $92.41
Macaulay Duration = 4.28 years
15
Hedging Interest Rate Risk

$12 $12 $12 $12 $12 $12 $112
|___|____|____|____|____|.....|___ |
0 1 2 3 4 5 9 10

V
0
=$84.94 when i=15%

After i declines to 12%, V = $100
V when term to maturity is 4 years:
V
6
= $100

Future value of the first 6 coupon payments
reinvested at 12%:
12 x PVIFA
12%,6
= $97.38
Total savings = $100 + $97.38 = $197.38

$84.94 in 6 years grows to $197.38
Annual growth of 15%.
16
Immunization Example

$1,000 $2,000 $2,500 $2,000 $1650
|_____|______|______|______|______|
0 1 2 3 4 5

Total Premiums = Assets = $6,830.82
Market rate = 10% Flat yield curve

Strategy 1: Invest in 1-yr bills with 10% interest

6830.82 -> 7513.90
(1000.00)
6513.90 --> 7165.29
(2000.00)
5165.29 --> 5681.82
(2500.00)
3181.82 ->3500
(2000)
1500 ->1650
(1650)
17
Immunization Example
(Contd)
However, if interest rates fall, assets will
be short of liabilities

Strategy 2: Invest in 3-yr zero coupon bonds
yielding 10%

Duration of Liabilities:

1 1000 909.09 0.133 0.133
2 2000 1652.89 0.242 0.484
3 2500 1878.29 0.275 0.825
4 2000 1366.03 0.200 0.800
5 1650 1024.52 0.150 0.750
2.990

Duration = 2.99 years
18
Immunization Example
(Contd)
Market rate 10%, V = $6,830.82
M = $9,091.82 Duration = 3 years

If interest rates fall from 10% to 8%,
V= $9,091.82 x PVIF
8%,3
= $7,217.38

7217.38 ->7794.77
(1000.00)
6794.77 ->7338.35
(2000.00)
5338.35->5765.42
(2500.00)
3265.42->3526.66
(2000.00)
1526.66->1650
(1650)
19
Modified Duration

D
MD = -----------
(1 + i)

In the example above, MD = 4.28/1.10 = 3.89

Approximate Change in V = -MD x Change in
yield

Example:
If the yield decreases from 10% to 8%

% Change in V= -4.28 x (-2) = 8.56%

In fact when i=10% V = $92.41
i=8% V = $100 increase 8.21%

20
Convexity
Price-Yield Relationship
V
Yield
The shape of the curve depends on
the coupon rate and term to maturity

High coupon + Short term -----> Linear
Low coupon + Long term ------> Convex
21
Convexity (Contd)
Higher convexity means that when interest
rates go up, bond value declines slowly; but
when rates decline, increase in bond price is
large

Therefore high convexity is a desirable
feature.

Factors that increase convexity:

* Low coupon
* Long term to maturity
* Low yield
22
Convexity (Contd)

=
+
+ +
=
=
n
t
t
t
t t
i
C
i di
V d
V
di
V d
1
2
2 2
2
2
2
) (
) 1 ( ) 1 (
1
Convexity
(1) (2) (3) (4) (5)
Year Ct PVIF(8%,n) (1) x (2) t2 + t (3) x (4)
1 8 0.9091 7.27 2 14.55
2 8 0.8264 6.61 6 39.67
3 8 0.7513 6.01 12 72.13
4 8 0.6830 5.46 20 109.28
5 108 0.6209 67.06 30 2011.79
92.42 2247.41
Convexity = [1/(1.10)
2
][2247.41][1/92.42]
= 20.10
Appox. Change in V = -MD x Ai + K x (Ai)
2

23
Alternative Measures of
Yield
Current Yield = rM / V
Yield-to-maturity
Bond is held until maturity
All coupon and principal
repayments are made on time
Bond is not called before maturity
Coupon payments are reinvested
at yield-to-maturity
Yield-to-call
Holding period yield
V
t+1
- V
t
+ rM
HPY = --------------------
V
t

24
Approximate yield-to-
maturity
2
M V
n
V M
rM
i
+

+
~
Example V= $877.11 n=3 yrs r=8% M=$1000
0983 . 0
2
1000 11 . 877
10
11 . 877 1000
80
=
+

+
~ i
25
Bond Investment Strategies
I. Passive Strategies

Investing $100 in 1925
T-bill
Deposits
Stock Market
AAA Corporate Bonds
Gold
Inflation

Passive Strategies are better when:
Interest rate risk is low, and
Inflation is low and stable
26
II. Active Strategies
Strategies based on maturity
structure
Maturity matching - duration
Spreading the maturity
Investing only in short term bills
and long term bonds
Strategies based on forecasting
interest rate movements
Interest rate fluctuations
Buy when rates are high, sell when
low
Increase duration if higher rates are
forecast, reduce duration otherwise
27
- Riding the yield curve
Investing in bonds assuming that the
yield curve will not shift
i
Maturity
B
A
Eg. 1 year bill i=6% V
1
= $943.40 B
2 year zero coupon i=8% V
2
= $857.34 A

Buy the 2-year bond at $857.34, sell it next year
at $943.40

HPY = (943.40 - 857.34) / 857.34 = 10.04%
28
Strategies based on lack of
market efficiency
Junk bonds
Bond swaps
Yield swap : same coupon, rating,
maturity and industry, different yield
Exchange swap: same rating, maturity,
industry, yield, different coupon.
Exchange current yield for capital gains
Tax swap: Selling a bond to realize a
loss, and replacing it with a similar
bond
Swapping bonds with different tax
status: eg. AAA corporate bond vs.
municipal bond
29
Strategies based on lack of
market efficiency (contd)
Possible shortcomings of bond
swaps:
time to execute the swap
taxes
transaction costs
risk level of bonds
Portfolio rebalancing:
adjusting the bond portfolio
for the changes in market
conditions