Chapter 11

Bond Valuation
 Bond Valuation

Learning Goals
1. Explain the behavior of market interest rates and
identify the forces that cause interest rates to change.
2. Describe the term structure of interest rates and note
how investors can use yield curves.
3. Understand how investors value bonds in the
marketplace.
4. Describe the various measures of yield and return and
explain how investors use these standards of
performance to value bonds.
5. Understand the basic concept of duration, how it can be
measured, and its use in the management of bond
portfolios.
6. Discuss various bond investment strategies and the
different ways investors can use these securities.

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 The Behavior of Market Interest
Rates
The required return on a bond can be expressed as:

For bonds, the risk premium addresses the default

(credit) risk of the issuer, liquidity and call risks.
The risk-free rate (real rate of return plus expected
inflation premium) accounts for interest rate and
purchasing power risk.
• Keeping Tabs on Market Interest Rates
• What Causes Rates to Move?
• The Term Structure of Interest Rates and Yield
Curves

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 The Behavior of Market Interest
Rates
• Keeping Tabs on Market Interest Rates
– The bond market is not a single market, but consists of
many different sectors:
• U.S. Treasury issues
• Municipal bond issues
• Corporate bond issues
– There is no single interest rate that applies to all the
segments of the bond market.
– Yield spreads: differences in interest rates between the
various market sectors.

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 The Behavior of Market Interest
Rates
• Keeping Tabs on Market Interest Rates
– Municipal bond rates are usually 20-30% lower than
corporate bond rates due to their tax-exempt feature.
– Revenue bonds pay higher rates than general obligation
bonds due to higher risk.
– Treasury bonds have lower rates than corporate bonds due
to no default risk and exemption from state income taxes.
– The lower the credit rating (and higher the risk), the higher
the interest rate.
– Bonds with longer maturities generally provide higher
yields than short-term issues (not ALWAYS the case).
– Freely callable bonds generally pay higher interest rates
than noncallable bonds.

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 The Behavior of Market Interest
Rates
• What Causes Rates to Move?
– Major Determinants of Interest Rates
• Inflation is the most important variable to have an
effect on market interest rates.

Expected inflation goes , interest rates go 

Expected inflation goes , interest rates go 
• In addition to inflation, five other economic variables
can significantly affect the level of interest rates.

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 Figure 11.1 The Impact of Inflation
on the Behavior of Interest Rates

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 The Behavior of Market Interest
Rates
• What Causes Rates to Move?
– Major Determinants of Interest Rates:
Economic Type of Effect
Variable Change on Rates
Change in money supply Slow increase Decrease
Slow decrease Increase

Fast increase Increase

Fast decrease Decrease

Federal Budget Deficit Increase

Surplus Decrease

U.S. Economic Activity Recession Decrease

Expansion Increase
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 The Behavior of Market Interest
Rates
• What Causes Rates to Move?
– Major Determinants of Interest Rates:
Economic Type of Effect
Variable Change on Rates
Federal Reserve Policies Expansionary Decrease
Contractionary Increase

Foreign Interest Rates Higher Increase

Lower Decrease

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Term structure of interest rates: the relationship
between interest rates (yield) and time to maturity for any
class of similar-risk securities.
– Yield curve: a graph that depicts this relationship.

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 Figure 11.2 Two Types of Yield
Curves

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Types of Yield Curves
• Most common type is upward-sloping
– Indicates yields tend to increase with longer maturities.
• Occasionally, the yield curve becomes inverted
– Occurs when short-term rates are higher than long term
rates.
• Flat: rates for short- and long-term debt are essentially
the same.
• Humped: when intermediate rates are the highest.

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Plotting Your Own Curves
• Treasury securities (bills, notes, bonds) are usually used
to construct yield curves, for several reasons:
– Treasury securities have no risk of default.
– They are actively traded, so their prices and yields are
easy to observe.
– They are relatively homogeneous with regard to quality
and other issue characteristics.
– Can also construct yield curves with other classes of debt
securities, such as A-rated municipal bonds, Aa-rated
corporate bonds, and even certificates of deposit.

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 Figure 11.3 Yield Curves on U.S.
Treasury Issues (1 of 2)

(Source: U.S. Department of the Treasury, June 4, 2015.)

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 Figure 11.3B Yield Curves on
U.S. Treasury Issues (2 of 2)

(Source: U.S. Department of the Treasury, June 4, 2015.)

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Explanations of the Term Structure of Interest Rates
• The shape of the yield curve can change over time.
• There are three commonly cited theories to explain
reasons for the general shape of the yield curve:
– Expectations hypothesis
– Liquidity preference theory
– Market segmentation theory

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Explanations of the Term Structure of Interest Rates
• Expectations Hypothesis: the yield curve reflects
investor expectations about the future behavior of
interest rates.
– When investors expect interest rates to go up, they will
only purchase long-term bonds if those bonds offer higher
yields than short-term bonds; hence the yield curve will
be upward sloping.
– When investors expect interest rates to go down, they will
only purchase short-term bonds if those bonds offer
higher yields than long-term bonds; hence the yield curve
will be downward sloping.

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Explanations of the Term Structure of Interest Rates
• Liquidity Preference Theory: long-term bond rates
should be higher than short-term rates because of the
added risks involved with the longer maturities.
– Investors may view long-term bonds as being riskier
because long-term bonds are less liquid and are subject to
greater interest rate risk.
– Borrowers will also pay a premium to obtain long-term
funds. Borrowers thus assure themselves that funds will
be available and avoid having to roll over short-term debt
at unknown and possibly unfavorable rates.

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Explanations of the Term Structure of Interest Rates
• Market Segmentation Theory: the market for debt is
segmented on the basis of the maturity preferences of
different financial institutions and investors.
– The yield curve changes as the supply and demand for
funds within each maturity segment determines its
prevailing interest rate.
– If supply is greater than demand for short-term loans,
short-term rates will be relatively low. If at the same
time, demand for long-term loans is higher than the
available supply of funds , then long-term rates will move
up. The yield curve will slope upward.

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Explanations of the Term Structure of Interest Rates
• Which Theory is Right?
– Upward-sloping yield curves result from:
» Expectations of rising interest rates.
» Lender preferences for shorter-maturity loans.
» Greater supply of shorter-term loans.
– Downward-sloping yield curves result from:
» Expectations of falling interest rates.
» Lender preference for longer-maturity loans.
» Greater supply of longer-term loans

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Using the Yield Curve in Investment Decisions
• Analyze the changes in yield curves.
– provides investors with information about future interest
rate movements, which affect the prices and returns on
different types of bonds.
– Example: if the entire yield curve begins to move upward,
indicating inflation is going to be increasing, then
investors expect interest rates too will rise. Seasoned
bond investors would turn to short or intermediate (3 to 5
years) maturities.

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 The Behavior of Market Interest
Rates
• The Term Structure of Interest Rates and Yield
Curves
– Using the Yield Curve in Investment Decisions
• Consider the difference in yields on different
maturities—the “steepness” of the curve.
– Steep yield curves are generally viewed as a bullish sign.
Aggressive bond investors would look to move into long-
term securities.
– Flatter yield curves reduce the incentive for moving to
long-term maturities because the difference in yield
between different maturities is small.

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 The Pricing of Bonds

All bonds are priced according to the present value of

their future cash flow streams.
Market yields largely determine bond prices.
• The Basic Bond Valuation Model
• Annual Compounding
• Semiannual Compounding
• Accrued Interest

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 The Pricing of Bonds

• The Basic Bond Valuation Model

– When you buy a bond you receive two distinct types of
cash flow:
• Periodic interest income (i.e. coupon payments).
• Principal (par value) at the end of the bond’s life.
– Bonds are priced according to the present value of their
future cash flow streams.

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 The Pricing of Bonds

• Annual Compounding
– You need the following information to value a bond
• Annual Coupon payment (C)
• Par value (usually $1,000 (PVn)
• Number of years remaining to maturity (N)
• Prevailing market yield to use as the discount rate (ri)

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 The Pricing of Bonds

• Example:
– What is the market price of a $1,000 par value 20 year
bond that pays 4.5% compounded annually when the
market yield is 5%?

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 The Pricing of Bonds

• Semiannual Compounding
– In practice, most bonds pay interest every six months, so
it is appropriate to use semiannual compounding to value
bonds.

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 The Pricing of Bonds

• Semiannual Compounding
– Example:
• What is the price of a 20-year, $1000 par value bond
that pays 4.5% semiannually and yields 5%.

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 The Pricing of Bonds

• Accrued Interest
– What happens if you sell a bond at some time between
scheduled coupon dates?
• Accrued interest: the amount of interest earned on a
bond since the last coupon payment.
• The bond buyer adds accrued interest to the bond’s
price.
– Clean price of a bond equals the present value of its cash
flows.
– Dirty price of a bond is the clean price plus accrued
interest.

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 Measures of Yield and Return

There are three widely used metrics to assess the

return on a bond.
Expected return measures the expected (or actual)
rate of return earned over a specific holding period.
• Current Yield
• Yield to Maturity
• Yield to Call
• Expected Return
• Valuing a Bond

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 Measures of Yield and Return

• Current Yield
– Current yield: indicates the amount of current income a
bond provides relative to its prevailing market price.
– Simplest of all bond return measures.
– Looks at only one source of return: a bond’s annual
interest income (current income).

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 Measures of Yield and Return

• Yield to Maturity
– Yield to maturity (YTM): the most important and widely
used measure of the return provided by a bond.
• Also known as the promised yield.
• The rate of return earned by an investor given the bond
is held to maturity an all principal and interest
payments are made in a prompt and timely fashion.
– Implicitly assumes the investor can reinvest all the coupon
payments at an interest rate equal to the bond’s yield to
maturity.
– Basically, the internal rate of return on a bond.

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 Measures of Yield and Return

• Yield to Maturity
– Using Annual Compounding:
• Finding yield to maturity is a matter of trial-and-error.
• Using a handheld calculator or computer software can
help make it less time-consuming.
– Example:
– Find the yield-to-maturity on a 7.5%
– ($1,000 par value) bond that has
– 15 years to maturity and is currently
– trading in the market for $809.50?

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 Measures of Yield and Return

• Yield to Maturity
– Using Semiannual Compounding
• Bond equivalent yield: a market convention that
states the annual yield as twice the semiannual yield.
– Example:
– Find the yield-to-maturity of a 7.5%,
– 15-year bond (par value of $1,000)
– currently priced at $809.50?

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 Measures of Yield and Return

• Yield to Maturity
– Yield Properties
• Critical assumptions of YTM
– Bond is held to maturity
– Assumes each coupon payment is reinvested when it
arrives, for the remainder of the bond’s life at a rate equal
to the YTM.
– Assumes you reinvest your interest income (interest on
interest) at a rate equal to the YTM.

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 Measures of Yield and Return

• Yield to Maturity
– Finding the Yield on a Zero
• Equations 11.4 and 11.3 can be used to solve for Yield
to maturity of a zero-coupon bond. The coupon portion
of the equations can be ignored since for a zero, they
will of course equal zero.
• Solve for this expression:

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 Measures of Yield and Return

• Yield to Maturity
– Finding the Yield on a Zero
• Example: Suppose today you buy a 15-year, zero-
coupon bond for $315. If you purchase this bond at that
price and hold it to maturity, what is your YTM?

Annual compounding:

– If we use semiannual compounding,

replace the 15 with 30 and solve,
to find Yield = 3.926% (per half year).
The bond equivalent
yield = 2*3.926%=7.85%.

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 Measures of Yield and Return

• Yield to Call
– YTM is not always a good measure of the return you can
expect from the purchase of a callable bond, since the
issue may not remain outstanding to maturity.
– Yield to call (YTC): shows the yield on a bond if the issue
remains outstanding not to maturity but rather until its
first (or some other specified) call date.
– The length of the investment horizon (N) is defined as the
number of years to the first call date, rather than years to
maturity.
– Use the bond’s call price (premium) instead of the par
value.

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 Measures of Yield and Return

• Yield to Call
– Example: Find the YTC on a 20-year, 10.5% deferred-call
bond that is trading at $1,204 but can be called in 5 years
at a call price of $1,085?

• Use trial and error or use a calculator to

– solve for the YTC = 7%.
• In comparison, YTM = 8.37%; market
convention is to use the lower, more
conservative measure of yield.

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 Measures of Yield and Return

• Expected Return
– Used by investors who expect to actively trade in and out
of bonds rather than hold until maturity date.
– Expected return: indicates the rate of return an investor
can expect to earn by holding a bond over a period of time
that’s less than the life of the issue.
• Also called realized yield, because it shows the return
an investor would realize by trading in and out of bonds
over short holding periods.
– Uses estimates of market price of the bond at the expected
sale date instead of par value.
• Lacks precision (subject to uncertainty)

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 Measures of Yield and Return

• Expected Return

– Example (semiannual compounding):

– Find the expected return on a 7.5%
– bond that is currently priced in the
– market at $809.50 but is expected to
– rise to $960 within a 3-year holding
– period?

– Bond equivalent yield=7.217 X 2=14.43%

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 Measures of Yield and Return

• Valuing a Bond
– Conservative, income-oriented investors focus on YTM.
• Earning interest income over extended periods of time
is their primary objective.
– More aggressive bond traders, hoping to profit from swings
in market interest rates, calculate the expected return.
• Earning capital gains by purchasing and selling bonds
over relatively short holding periods is their chief
concern.

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 Duration and Immunization

Duration: A measure of bond price volatility, which

captures both price and reinvestment risk and which
is used to indicate how a bond will react in different
interest rate environments.
– Improvement over YTM because it accounts for
reinvestment risk and price (or market) risk.
• The Concept of Duration
• Measuring Duration
• Bond Duration and Price Volatility
• Effective Duration
• Uses of Bond Duration Measures

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 Duration and Immunization

• The Concept of Duration

– In general, bond duration possesses the following
properties:
• Higher coupons result in shorter durations.
• Longer maturities mean longer durations.
• Higher yields (YTMs) lead to shorter durations.
• These variables (coupon, maturity, yield) interact to
determine an issue’s duration.
– Shorter the duration, the less volatility in bond prices (and
vice versa).

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 Duration and Immunization

• Measuring Duration
– Bond Duration is the average amount of time that it takes
to receive the interest and the principal.
• Weighted-average life of a bond: Calculates the
weighted average of the cash flows (interest and
principal payments) of the bond, discounted to the
present time.
• Macaulay duration

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 Duration and Immunization

• Measuring Duration
– Steps in Calculating Duration
• Step 1: Find present value of each coupon or principal
payment. Use prevailing YTM on the bond as the
discount rate.
• Step 2: Divide this present value by the current market
price of the bond. This is the “weight”.
• Step 3: Multiply this weight by the year in which the
cash flow is to be received.
• Step 4: Repeat steps 1 through 3 for each year in the
life of the bond, then add up the values computed in
Step 3.

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 Table 11.1 Duration Calculation for a
7.5%, 15-Year Bond Priced to Yield 8%

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 Duration and Immunization

• Measuring Duration
– Duration for a Single Bond
• Calculation is illustrated in Table 11.1.
• Keep in mind the duration on any bond will change over
time as YTM and term to maturity change.
– Duration for a Portfolio of Bonds
• Need duration of the individual securities in a portfolio
and their weights in the portfolio.
• The duration of portfolio is the weighted average of the
durations of the individual securities in the portfolio.

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 Duration and Immunization

• Bond Duration and Price Volatility

– The duration measure helps investors understand how
bond prices will respond to changes in market interest
rates, as long as those changes are not too large.
• A bond’s duration can be used as a viable predictor of
its price volatility only as long as yield swings are
relatively small.
– As interest rates change, bond prices change in a
nonlinear fashion.
– However, duration predicts as interest rates change, bond
prices move in the opposite direction in a linear fashion.

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 Duration and Immunization

• Bond Duration and Price Volatility

– Modified duration:

– Percent change in bond price:

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 Duration and Immunization

• Effective Duration
– An alternative duration measure used for bonds that may
be called or converted before they mature is effective
duration (ED):

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 Duration and Immunization

• Uses of Bond Duration Measures

– Bond Immunization
• Immunization: allows you to derive a specified rate of
return from bond investments over a given investment
interval regardless of what happens to market interest
rates over the course of the holding period.
• Seeks to offset the opposite changes in bond valuation
caused by price effect and reinvestment effect:
– Price effect: change in bond value caused by interest rate
changes.
– Reinvestment effect: as coupon payments are received,
they are reinvested at higher or lower rates than original
coupon rate.
• Bond immunization occurs when the average duration of
the bond portfolio just equals the investment time
horizon.

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 Table 11.2 Bond Immunization

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 Duration and Immunization

• Uses of Bond Duration Measures

– Bond Immunization
• Table 11.2 provides an example of bond immunization
using a 10-year, 8% coupon bond, with a duration of 8
years. Assume a desired investment horizon of also 8
years. Assumes you purchased the bond at par and
that market interest rates drop from 8% to 6% at the
end of the fifth year.
• Maintaining a fully immunized portfolio (of more than
one bond) requires continual portfolio rebalancing.

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 Bond Investment Strategies

There are a number of strategies investors can use

with fixed-income securities in order to reach their
different investment objectives.
• Passive Strategies
• Trading on Forecasted Interest Rate Behavior
• Bond Swaps

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 Bond Investment Strategies

• Passive Strategies
– Characterized by a lack of input regarding investor
expectations of changes in interest rates and or bond
prices.
– Typically do not generate significant transactions costs
– Examples of some passive strategies:
• Bond immunization
• Buy-and-hold: replace bonds as they mature or are
called, or when quality declines.
• Bond ladders:
– Set up “ladder” by investing equal amounts into varying
maturity dates (i.e. 3-, 5-, 7- and 10-year)
– As bonds mature, purchase new bonds with 10-year
maturity to keep ladder growing
– Provides higher yields of longer-term bonds and dollar-
cost averaging benefits
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 Bond Investment Strategies

• Trading on Forecasted Interest Rate Behavior

– Forecasted interest rate approach: strategy essentially
about market timing.
• Investors seek to increase the return on a bond
portfolio by making strategic moves in anticipation of
interest rate changes.
– Seek attractive capital gains when they expect interest
rates to decline.
– Seek preservation of capital when they anticipate an
increase in interest rates.
• Trading is mostly done with investment-grade securities
because active traders hope to profit from their
increased sensitivity to interest rate movements.

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 Bond Investment Strategies

• Bond Swaps
– Bond swap: occurs when investor sells one bond and
simultaneously buys another bond in its place
– Can be executed to:
• Increase current yield or yield to maturity
• Take advantage of shifts in interest rates
• Improve the quality of a portfolio
• For tax purposes
– May go by names such as “profit takeout”, “substitution
swap” or “tax swap”, but they are all used for portfolio
improvement.

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 Bond Investment Strategies

• Bond Swaps
– Yield pickup swap: investor switches out of a low-coupon
bond into a comparable higher-coupon issue in order to
realize an instantaneous pickup of current yield and yield
to maturity.
• Such swap opportunities arise because of the yield
spreads that normally exist between different types of
bonds.
• Must be careful of transaction costs.
– Tax swap: Sell a bond that has declined in value, use the
capital loss to offset other capital gains, and repurchase
another bond of comparable credit quality.
• Watch out for wash sales—new bond cannot be an
identical issue to old bond.

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 Chapter 11 Review Learning
Goals
1. Explain the behavior of market interest rates and
identify the forces that cause interest rates to change.
2. Describe the term structure of interest rates and note
how investors can use yield curves.
3. Understand how investors value bonds in the
marketplace.
4. Describe the various measures of yield and return and
explain how investors use these standards of
performance to value bonds.
5. Understand the basic concept of duration, how it can be
measured, and its use in the management of bond
portfolios.
6. Discuss various bond investment strategies and the
different ways investors can use these securities.

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