®1999 South-Western College Publishing 1 Chapter 17 Bonds-Analysis And Management

®1999 South-Western College Publishing 2 Bond Pricing Principles Bond Prices and the Passage of TimeBond Prices and the Passage of Time Bond Prices and Changes in Yield to MaturityBond Prices and Changes in Yield to Maturity Bond Price Sensitivity and MaturityBond Price Sensitivity and Maturity Changes in Bond Price Sensitivity and Changes in Time to Maturity for Various MaturitiesChanges in Bond Price Sensitivity and Changes in Time to Maturity for Various Maturities Bond Price and CouponBond Price and Coupon

®1999 South-Western College Publishing 3 Bond Prices And The Passage Of Time Price and Value Change with the Passage of TimePrice and Value Change with the Passage of Time PremiumPremium ParPar DiscountDiscount

®1999 South-Western College Publishing 4 Bond Prices And Changes In Yield To Maturity Prices are Inversely Related to Yield to MaturityPrices are Inversely Related to Yield to Maturity Price-Yield Relationship is ConvexPrice-Yield Relationship is Convex

®1999 South-Western College Publishing 5 Bond Price Sensitivity And Maturity Different for Various Bond MaturitiesDifferent for Various Bond Maturities The Longer the MaturityThe Longer the Maturity –The more sensitive the bond’s price to change in the yield to maturity

®1999 South-Western College Publishing Does a 1-year or 10-year 10% bond have more interest rate (or price) risk? kdkd 1-yearChange10-yearChange 5%$1,048$1,386 10%1, % -4.4% 1, % -25.1% 15% Interest rate risk: Rising k d causes bond’s price to fall.

®1999 South-Western College Publishing ,000 1,500 0%5%10%15% 1-year 10-year kdkd Value......

®1999 South-Western College Publishing 8 Changes In Bond Price Sensitivity And Changes In Time To Maturity For Various Maturities Increases at a Decreasing RateIncreases at a Decreasing Rate –With the length to maturity 5 and 10-Year Bond5 and 10-Year Bond 25 and 30-Year Bond25 and 30-Year Bond

®1999 South-Western College Publishing M Bond Value ($) Years remaining to Maturity 1,372 1,211 1, k d = 7%. k d = 13%. k d = 10%.

®1999 South-Western College Publishing 10 Bond Price And Coupon Linear RelationshipLinear Relationship Drift Towards Par ValueDrift Towards Par Value –With just the passage of time The Higher the Coupon RateThe Higher the Coupon Rate –The less sensitive the bond to changes in yield to maturity

®1999 South-Western College Publishing 11 Is There A Way To Reduce Or Eliminate The Interest-Rate Risk? DurationDuration –Holding period –Price effect –Reinvestment effect –Calculating duration next slide –Measures the sensitivity –Used by investment analysts

®1999 South-Western College Publishing 12 Calculating Duration D =  tW t T t = 1

®1999 South-Western College Publishing 13 Duration Principles DurationDuration –Declines over time –Inversely related to yield to maturity –Directly related to maturity –Inversely related to level of coupon payment –Bond portfolio More Than One FactorMore Than One Factor –Relationship becomes more complex

®1999 South-Western College Publishing 14 How Do You Measure The Curvature Of A Bond’s Price- Yield Relationship? ConvexityConvexity –Basic principles Inversely related to yield to maturityInversely related to yield to maturity Inversely related to the couponInversely related to the coupon Positively related to durationPositively related to duration

®1999 South-Western College Publishing 15 Immunization Income Price

®1999 South-Western College Publishing 16 Income Immunization StrategiesStrategies –Cash matching –Duration matching –Horizon matching Protects Future Income NeedsProtects Future Income Needs Ignores Current Market ValueIgnores Current Market Value

®1999 South-Western College Publishing 17 Price Immunization Protects Current Market ValueProtects Current Market Value Uses ConvexityUses Convexity The Greater the ConvexityThe Greater the Convexity –The greater the gain from changes in interest rates

®1999 South-Western College Publishing 18 Passive Bond Management Mimic a Bond Index Is the Bond Market Efficient? –Y–Y–Y–Yes Passive management –N–N–N–No Active management Refining Immunization Techniques

®1999 South-Western College Publishing 19 Active Bond Management Contingent ImmunizationContingent Immunization –Timing strategies –Duration mismatches –Floor on active manager’s performance Popular Active Bond Management StrategiesPopular Active Bond Management Strategies –Substitution swap –Pure Yield pickup swap –Intermarket spread swap –Rate anticipation swap