1. Bond Yields and Prices Chapter 17
Charles P. Jones, Investments: Analysis and Management,
Twelfth Edition, John Wiley & Sons

2. Interest Rates Price for loanable funds Rates and basis points
100 basis points are equal to one percentage point
Short-term riskless rate foundation for other rates
Approximated by rate on Treasury bills
Other rates differ because of
Maturity differentials
Security risk premiums

3. Opportunity cost of foregoing consumption
Real risk-free rate of interest (real rate) unaffected by price changes or risk factors
Nominal (current) interest rates consist of real rate (rr) + adjustment for expected inflation (ei)
IR = rr + ei + rp
Equation for all interest rates
Rp = all risk premiums, including time and credit quality
17-3 3

4. The Term Structure of Interest Rates
Relationship between time to maturity and yields
Yield curves
Graphical depiction of the relationship between yields and time for bonds of same issuer
Default risk held constant
Observations involve tendencies rather than exact relationships
18-4

5. Term Structure of Interest Rates
Upward-sloping yield curve
typical, interest rates rise with maturity
Downward-sloping yield curves
Unusual, predictor of recession?
Term structure theories
Explanations of the shape of the yield curve and why it changes shape over time
18-5

6. Pure Expectations Theory
Long-term rates are an average of current short-term rates and those expected to prevail over the long-term period (“forward rates”)
Average is geometric rather than arithmetic
Forward rates cannot be easily measured but can be inferred
Theory is not that forward rates will be correct but that there is a relationship between them and current rates
18-6

7. Liquidity Preference Theory
Rates reflect current and expected short rates, plus liquidity risk premiums
Uncertainty increases with time
Investors prefer to lend for short run, borrowers to borrow for long run
Liquidity premium to induce long-term lending
Interest rate expectations are uncertain
18-7

8. Yield Spreads Risk premiums Result from
Different default risks, maturities, call features, coupon rates, marketability, taxes
Borrower actions
Interest rates
Function of variables associated with issue or issuer
Inversely related to business cycle

9. Measuring Bond Yields Premium: price > par value
Discount: price < par value
Interest payments (coupons) on bonds usually paid semi-annually
Current yield: ratio of coupon interest to current market price
Does not account for difference between purchase price and redemption value

10. Yield to maturity (YTM)
Most commonly used
Promised compound rate of return received from a bond purchased at the current market price
If held to maturity
And coupons reinvested at same YTM
Likelihood of meeting second condition is extremely small
17-10

11. Yield to Maturity
Solve for YTM:
For a zero coupon bond

12. Yield to First Call Some bonds callable after deferred call period
YTM unrealistic for bonds likely to be called
Often uses end of deferred call period
Substitute number of periods until first call date for and call price for face value

13. Realized Compound Yield
Rate of return actually earned on a bond given the reinvestment of the coupons at varying rates
Determined after investment concluded
Rarely equal to YTM

14. Reinvestment Risk Interest-on-interest Reinvestment rate risk
Risk that future reinvestment rates will be less than the YTM when bond is purchased
Total dollar return on a bond consists of
Coupons paid
Capital gains or losses
Interest income from reinvestment of coupons
17-14

15. Reinvestment Risk
Reinvestment increase in importance as coupon or time to maturity (or both) increases
For long-term bonds, interest-on-interest can be most important part of total return
Zero-coupon bonds eliminate reinvestment rate risk
Horizon return analysis
Bond returns based on assumptions about reinvestment rates and yield-to-maturity at end of investment horizon
17-15

16. Bond Valuation Principle
Intrinsic value
An estimated value
Present value of the expected cash flows
Required to compute intrinsic value
Expected cash flows
Timing of expected cash flows
Discount rate, or required rate of return by investors

17. Bond Valuation Value of a coupon bond:
Biggest problem is determining the discount rate or required yield
Required yield is the current market rate earned on comparable bonds with same maturity and credit risk

18. Bond Price Changes
Over time, bond prices that differ from face value must change
On bond’s maturity date, it must be worth its face value
Bond prices move inversely to market yields
Long-term bond prices fluctuate more than short- term
The change in bond prices due to a yield change is directly related to time to maturity and indirectly related to coupon rate

19. Bond prices
$1000
Passage of time
17-19

20. Bond Price Changes
Holding maturity constant, a rate decrease will raise prices a greater percent than a corresponding increase in rates will lower prices
Price
Market yield

21. Implications for Investors
Bond buyers should purchase low-coupon, long-maturity bonds
If interest rates expected to increase, investor should consider bonds with large coupons or short maturities or both
17-21

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