Investment Analysis and Portfolio Management

Session 13

Bond Portfolio Analysis

Senani Thenuwara
Department of Finance
Faculty of Management and Finance
University of Colombo

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 Content
• Recap on prior learnings
• The Global Bond-Market Structure
• Bond Ratings
• Bond Issues
• International Bonds
• Interpreting Bond Quotes
• Analysis and Valuation of bonds
• Interest Rate

• Present value model

• Yield Model
• Nominal Yield
• Current Yield
• Promised yield to maturity
• Promised yield to call
• Realized yield
• Price Volatility
• Duration
• Bond Portfolio Management Strategies
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 Recap on bonds
You have already learned;
1. What is a bond?
2. Features of bonds To do:
Try out the
3. Classification of bonds question at
home to refresh
4. Valuation of bonds your memory

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The Global Bond-Market Structure
Participating issuers Participating Investors

1. Federal governments Individual investors

2. Agencies of the federal government Institutional investors
3. State and local political subdivisions Life Insurance Companies
(municipalities) Commercial Banks
4. Corporations Property and Liability Insurance Companies
5. International issues Pension Funds
Foreign bonds Mutual Funds
Eurobonds

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 Bond Ratings
• Ratings Services
1. Duff and Phelps
2. Fitch Investors Service To do:
Read about two
3. Moody’s bond rating agencies
and study how they
4. Standard & Poor’s rate bonds. Make a
short note

• Non-rated bonds

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 Bond Issues
• Domestic government bonds
• Government Agency Issues
• Municipal Bonds
• Corporate Bonds To do:
• Mortgage bonds Read about different
bond issues ,make a
• Collateral trust bonds
short note and
• Equipment trust certificates present it in the next
• Collateralized mortgage obligations (CMOS) class
• Other asset-backed securities (ABS)
• Variable rate notes
• Zero-coupon and deep-discount bonds
• High-yield bonds

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 International Bonds
• Foreign bonds are sold in one country and currency by a borrower of
a different nationality
e.g. Yankee bonds, Euro bonds, Samuri bonds, Euroyen bonds,
Bulldog bonds, Eurosterling bonds

• Some international bonds are underwritten by international bond

syndicates and sold in several national markets

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 Interpreting Bond Quotes
• Quoted on basis of yield or price

• Price quotes are the percentage of the par

e.g: 98 1/2 is not Rs.98.50 but 98.5% of par value

A Rs5000 bond quoted 98 1/2 would be ………………………..

Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4

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Interpreting Bond Quotes
• Corporate Bond Quotes
Notations
• “cv” = convertible
• “zr” = zero coupon
• “dc” = deep discount (at time of issue)

• Treasury and Agency Bond Quotes

Notations
• “n” = treasury note
• “p” = treasury note on which nonresident aliens are exempt from withholding
taxes on interest

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 The Analysis and Valuation of Bonds

The Fundamentals of Bond Valuation

The present-value model
2n
Ct 2 Pp
Pm =  +
t =1 (1 + i 2) (1 + i 2)
t 2n

Where:
• Pm=the current market price of the bond
• n = the number of years to maturity
• Ci = the annual coupon payment for bond i
• i = the prevailing yield to maturity for this bond issue
• Pp=the par value of the bond

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The Fundamentals of Bond Valuation

• If yield < coupon rate, bond will be priced at a premium

• If yield > coupon rate, the bond will be priced at a discount

• Price-yield relationship is convex (not a straight line)

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 The Yield Model
The expected yield on the bond

Ci 2 2n Pp
Pm =  +
t =1 (1 + i 2) (1 + i 2)
t 2n

Where:
i = the discount rate that will discount the cash flows to equal the current market price of the bond

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 Computing Bond Yields
Yield Measure Purpose
Nominal Yield Measures the coupon rate

Current yield Measures current income rate

Promised yield to maturity Measures expected rate of return for bond held to
maturity

Promised yield to call Measures expected rate of return for bond held to
first call date

Realized (horizon) yield Measures expected rate of return for a bond likely to
be sold prior to maturity.

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 Computing Bond Yields
Nominal Yield
Measures the coupon rate that a bond investor receives as a percent of the bond’s
par value

Current Yield
Can understand in relation to dividend yield for stocks
Important income-orientated investors

CY = Ci/Pm
where:
CY = the current yield on a bond
Ci = the annual coupon payment of bond i
Pm = the current market price of the bond
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 Computing Bond Yields
• Promised Yield to Maturity

• Widely used bond yield figure

• Assumes
• Investor holds bond to maturity
• Bond’s cash flow are reinvested at the computed yield to maturity

2n
Ci 2 Pp
Pm = 
Solve for i that will equate the
+ current price to all cash flows

t =1 (1 + i 2) (1 + i 2)
t 2n from the bond to maturity,
similar to IRR
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 Computing the
Promised Yield to Maturity
• Approximate Promised Yield

Pp − Pm
Ci +
APY = n
Pp + Pm
2
Coupon + Annual Straight-Line Amortization of Capital Gain or Loss
Average Investment

Pm=the current market price of the bond

Ci = the annual coupon payment for bond i
Pp=the par value of the bond

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 Computing the
Promised Yield to Maturity
• Present-Value Model

Ci 2 2n Pp
Pm =  +
t =1 (1 + i 2) (1 + i 2)
t 2n

Pm=the current market price of the bond

n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
Pp=the par value of the bond 17
 Promised Yield to Call

• May be less than yield to maturity

• Reflects return to the investor if bond is called and cannot be held to
maturity
Approximation Method
Where:
Pc − Pm
Ct +
AYC = approximate yield to call (YTC)
Pc = call price of the bond
AYC = nc Pm = market price of the bond
Pc + Pm Ct = annual coupon payment

2 nc = the number of years to first call date

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 Promised Yield to Call

Present-Value Method
2 nc
Ci / 2 Pc
Pm =  +
t =1 (1 + i ) (1 + i)
t 2 nc

Where:
Pm = market price of the bond
Ci = annual coupon payment
nc = number of years to first call
Pc = call price of the bond
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 Realized Yield
Approximation Method
Pf − P
Ci +
hp
ARY =
Pf + P
2
Where:
ARY = approximate realized yield to call (YTC)
Pf = estimated future selling price of the bond
Ci = annual coupon payment
hp = the number of years in holding period of the bond
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 Realized Yield
Present-Value Method

2 hp
Ct / 2 Pf
Pm =  +
t =1 (1 + i 2) (1 + i 2)
t 2 hp

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 Calculating Future Bond Prices
2 n − 2 hp
Ci / 2 Pp
Pf = t =1
+
(1 + i 2) (1 + i 2)
t 2 n − 2 hp

Where:
Pf = estimated future price of the bond
Ci = annual coupon payment
n = number of years to maturity
hp = holding period of the bond in years
i = expected semiannual rate at the end of the holding
period
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 Interest Rates Determination
• Inverse relationship with bond prices
• Forecasting interest rates
• Fundamental determinants of interest rates

i = RFR + I + RP
where:
• RFR = real risk-free rate of interest
• I = expected rate of inflation
• RP = risk premium

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Interest Rates Determination
• Effect of economic factors
• real growth rate
• tightness or ease of capital market
• expected inflation
• or supply and demand of loanable funds
• Impact of bond characteristics
• credit quality
• term to maturity
• indenture provisions
• foreign bond risk including exchange rate risk and country risk

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What Determines Interest Rates
• Expectations hypothesis

• Liquidity preference hypothesis

• Segmented market hypothesis

• Trading implications of the term structure

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 Determinants of Price Volatility for Bonds
• Bond price change is measured as the percentage change in the price
of the bond

EPB
−1
BPB
Where:
EPB = the ending price of the bond
BPB = the beginning price of the bond
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 Determinants of price Volatility for Bonds
1. Par value
2. Coupon
3. Years to maturity
4. Prevailing market interest rate

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 Determinants of Price Volatility for Bonds
Five observed behaviors
1. Bond prices move inversely to bond yields (interest rates)
2. For a given change in yields, longer maturity bonds post larger price
changes, thus bond price volatility is directly related to maturity
3. Price volatility increases at a diminishing rate as term to maturity
increases
4. Price movements resulting from equal absolute increases or decreases in
yield are not symmetrical
5. Higher coupon issues show smaller percentage price fluctuation for a
given change in yield, thus bond price volatility is inversely related to
coupon

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 Determinants of price Volatility for Bonds
• The maturity effect
• The coupon effect
• The yield level effect
• Some trading strategies

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 The Duration Measure
• Since price volatility of a bond varies inversely with its coupon and directly
with its term to maturity, it is necessary to determine the best combination
• Duration of a bond with coupons is always less than its term to maturity
A zero-coupon bond’s duration equals its maturity
• There is an inverse relation between duration and coupon
• There is a positive relation between term to maturity and duration
• There is an inverse relation between YTM and duration
• Sinking funds and call provisions can have a dramatic effect on a bond’s
duration

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 The Duration Measure
n n
C t (t )
t =1 (1 + i )
t  t  PV (C ) t
D= n = t =1
Ct

price
t =1 (1 + i )
t

Developed by Frederick R. Macaulay, 1938

Where:
t = time period in which the coupon or principal payment
occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond
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 Trading Strategies Using Duration
• Longest-duration security provides the maximum price variation
• If you expect a decline in interest rates, increase the average duration
of your bond portfolio to experience maximum price volatility
• If you expect an increase in interest rates, reduce the average
duration to minimize your price decline

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 Bond Portfolio Strategies
1. Passive portfolio strategies
2. Active management strategies
3. Matched funding techniques
4. Contingent procedure (structured active management)

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 Passive Portfolio Strategies
• Buy and hold
• A manager selects a portfolio of bonds based on the objectives and
constraints of the client with the intent of holding these bonds to maturity
• Indexing
• The objective is to construct a portfolio of bonds that will equal the
performance of a specified bond index

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Active Management Strategies
• Interest-rate anticipation
• Risky strategy relying on uncertain forecasts
• Ladder strategy staggers maturities
• Barbell strategy splits funds between short duration and long duration
securities
• Valuation analysis
• The portfolio manager attempts to select bonds based on their intrinsic value
• Credit analysis
• Involves detailed analysis of the bond issuer to determine expected changes
in its default risk

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Active Management Strategies
• Yield spread analysis
• Assumes normal relationships exist between the yields for bonds in
alternative sectors
• Bond swaps
• Involve liquidating a current position and simultaneously buying a different
issue in its place with similar attributes but having a chance for improved
return

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 Matched funding techniques
• Dedicated Portfolios
Bond portfolio management techniques that are used to service a
prescribed set of liabilities
• Pure Cash-Matched Dedicated Portfolios
• Dedication With Reinvestment
• Immunization Strategies
• A decision that states the optimal strategy is to immunize the
portfolio from interest rate changes

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 Contingent Procedures
• A form of structured active management
• Constrains the manager if unsuccessful

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Reference
Frank K. Reilly & Keith C. Brown (2012). Investment Analysis and Portfolio Management. South – Western Cengage Learning.

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Thank You

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