FM250 - Finance

Bonds

Liliana Varela
London School of Economics
Lecture 2

LSE Summer School

 Plan for Today

• Types of Bonds
• Yield to Maturity
• Yield Curve/Term Structure
• Duration
• Immunization
 Bonds
• The issuer of a bond pays a fixed periodical interest and is
obliged to repay the debt at the maturity time.
• Issuers: governments, municipalities, companies.
• Contrary to the stock, the bond holders do not own a
company, they lend to a company.
– Bond holders have priorities over equity investors in case
of a bankruptcy
– Equity investors are the residual claimants
 Bonds
• Bond holders receive interest payments called coupons each
period until maturity and receive the principal at maturity.
• Stream of cash flows is as follows:

years: 1 2 3 … T
C C C P+C
• C/P is called coupon yield. A bond is called y% bond if the
coupon yield is y%.
– Example: in 1991, US Treasury issued 8% bonds maturing
in 2021. They are called the “8s of 2021”
• What defines a bond

– Face value (principal), Coupon (frequency, rate), Maturity

 Bonds

• Typical example is US Treasury bonds. They usually

have face value $1000 and pay interest semi-annually.
Cash flows of a 4% bond:
Dec 2007 Jun 2008 Dec 2008 Jun 2009 Dec 2009 Jun 2010
$20 $20 $20 $20 $20 $1,020

• Treasury Bills mature in less than a year. Notes mature

in 10 years or less. Bonds mature in over 10 years.
 Zero Coupon Bonds
• A zero-coupon bond, or a zero, maturing at time T is a
bond that pays its face value at that time and no
coupons prior.
• Stream of cash flows is as follows:
years: 1 2 3 … T

0 0 0 P

Very popular zero-coupon bonds are Treasury strips

which make just one cash payment. Treasury can split
coupon bonds into strips.
 Zeroes and Interest Rates

• Consider a zero with face value £1 and maturity t

years: year: 0 t

dt £1
– Let dt denote the current price of this zero and rt denote the
current annually-compounded interest rate on a t-period
investment.
– The fair value of the t-period zero:
1
dt =
(1 + rt ) t

where rt is time-t discount rate and dt is the discount factor.

 Other types of bonds

• Some popular bond types differ from standard coupon

bonds along certain dimensions. These include:
– Floating rate bonds: Many bonds have coupon rates which vary
over the bond's lifetime. Generally, the floating coupon rate is set
at a premium over some market interest rate (e.g., LIBOR or the
U.S. T-bill rate) and is reset on a pre-specified basis.

– Index-linked bonds: for such bonds, coupons and principal grow in

line with inflation (in the relevant country). First issued in the U.K.
and increasingly frequently issued by Governments. As such, they
can be thought of as real, risk-free securities (although in most
cases indexation is not perfect).
 Bonds with option features
• Certain bonds also have options embedded in them. For
example:
– Callable bonds: can be repaid early (i.e. before maturity) by the
issuer. Early repayment might be restricted to a specified date
(European) or may be allowed at any time prior to maturity
(American).
– Puttable bonds: in this case the redemption date is under the
control of the holder i.e. the opposite to the callable bond case.
– Convertible bonds: corporations sometimes issue debt which
(either at a specific date or at any time) can be converted into a
share in the firm's equity. As such, this type of debt allows
bondholders, as well as shareholders, to participate in upside gains.
 Default risk and bond rating
• A bond (generally) obliges a borrower to repay nominal
cashflows at specified dates. However, the borrower may
be unable to meet the obligations (default).

• Obviously, the likelihood of a borrower defaulting will

affect the terms on which individuals are willing to lend to
a borrower: if I consider agent A to be more likely to
default than agent B, I'll charge agent A a higher rate of
interest, reflecting a higher default risk premium.

• Rating agencies characterize the default risk of bonds by

providing credit ratings.
 Bond Ratings

Moody's S&P's & Fitch

Investment Grade
Aaa AAA
Aa AA
A A
Baa BBB
Junk Bonds The highest quality bonds
Ba BB are rated triple-A.
Investment grade bonds
B B
have to be equivalent to
Caa CCC
Baa or higher. Bonds that
Ca CC
don’t make this cut are
C C
called “high-yield” or
“junk” bonds.
 Valuing a Bond

• The present value of a bond

C1 C2 1, 000 + C N
PV = + + ... +
(1 + r1 ) (1 + r2 )
1 2
(1 + rN ) N
 Valuing a Bond

Example
• If today is October 2005, what is the value of the following
bond? A US T-Bond pays $115 every Sept for 5 years. In
Sept 2010 it pays an additional $1000 and retires the bond.
Assume constant interest rate (flat term structure) of 7.5%.

115 115 115 115 1,115

PV = + + + +
1.075 (1.075 ) (1.075 ) (1.075 ) (1.075 ) 5
2 3 4

= $1,161.84
 Yield to Maturity

• Yield to Maturity (YTM) is an implicit constant

interest rate based on future cash flows and current
price of a bond that makes the present value of
future cash flows equal to current price.
• Consider a bond with cash flows C1, C2, …, CT:
C1 C2 CT
Bond price = + + ... +
(1 + r1 ) (1 + r2 ) 2
(1 + rT )T
• Yield to maturity y is such that:
C1 C2 CT
Bond price = + + ... +
(1 + y ) (1 + y ) 2
(1 + y )T
 Yield to Maturity

• Consider a 3-year bond with annual coupon rate

10%, face value £100 and current price £98. The
(annually compounded) yield to maturity for this
bond, y, solves:
10 10 110
98 = + +
(1 + y ) (1 + y ) (1 + y ) 3
2

Solving gives: y =10.82%

• When y = 10%, Price = 100 trading at par

y > 10%, Price < 100 trading at discount
y < 10%, Price > 100 trading at premium
 Yield to Maturity
• YTM is a fictional and constant interest rate which justifies
the market price of the bond.
• It is a complicated average of discount rates.
• It depends not only on discount rates but also on the
coupon payments. Therefore, bonds that pay different
coupons with identical maturity dates in general have
different YTMs.
• A higher YTM does not necessarily mean that the bond is
a better buy. Bonds with different yields can all be fairly
priced.
• Yield is analogous to IRR (internal rate of return) and can
be computed using IRR function in Excel.
 Yield to Maturity

Example
• A $1000 treasury bond expires in 5 years. It pays
a coupon rate of 10.5%. If the market price of this
bond is 1078.80, what is the YTM?

C0 C1 C2 C3 C4 C5
-1078.80 105 105 105 105 1105

Calculate IRR = 8.5%

 Yield to Maturity

• Example:
– On May 15 2008, US Treasury sold $9M of
4.375% bond rate to 2038. It was issued at a
price 96.36% ($963.6 for face value $1000) and
had a YTM 4.6%.

– During the Global Financial Crisis, US

Treasury bond prices increases (flight to safety)
to 138.05% and YTM dropped to 2.5%.

ØCapital gain: $1380.5-$963.8=$416.70

Yield to Maturity of a 1-Year Bond
 Percent

0
2
4
6
8
10
12
14
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Real Yield on UK 10 yr bonds
Jan-94
Jan-95
Jan-96
Jan-97
UK Bond Yields

Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Nominal Yield on UK 10 yr bonds

Jan-03
Jan-04
 Forward rates

• Interest rate guaranteed today for an investment

that will occur in the future.

• Forward rate for 1 year is the rate on an

investment that starts today and is repaid in 1 year.

• Equivalent to an investment in one-year, zero

coupon bond. By LOP,
f1=YTM1
 Forward rates
• Consider two alternative investment strategies:
– (i) invest £1 in a three-year zero;
– (ii) invest £1 in a two-year zero, and after two years invest the
proceeds in a one-year-zero at a predetermined rate.

Both strategies transfer £1 currently owned into a certain

amount of Pounds in three years time. What are the payoffs
to these strategies?
Payoff (i) = (1+y3)³
Payoff (ii) = (1+y2)2 (1+ft+3)

(1+ft+3) is the forward rate for the period from t+2 to t+3.
 Forward rates
• The forward rate is the future one-period interest rate that
is implied by the comparison of the two zero-coupon
bonds. Using these bonds, we can lock this interest in at
the current date.
(1 + y ) 3
(1 + y3 )3 = (1 + y 2 )2 (1 + f t +3 ) Þ (1 + f t +3 ) = 3
(1 + y 2 )2
• Investors can infer (and contract on) future one-period
interest rates (i.e. forward rates) by comparing yields on
long-dated zeros.
• To compute a k-period forward rate we use
(1 + y k ) k
(1 + f t + k ) =
(1 + y k-1 ) k-1
 Spot/Forward rates

• Example
What is the 3rd year forward rate?
2 year zero treasury YTM = 8.995%
3 year zero treasury YTM = 9.660%

(1 + y3 )3 (1.0966)3
(1 + f t +3 ) = =
(1 + y 2 ) 2
(1.08995) 2
f t +3 = 11.00%
 Yield Curve

• Plots the yields of bonds that have equal credit

quality but different maturity dates.
• The slope of the yield curve is thought as an
indicator of future interest rate changes and
economic activity.
• Most common yield curve reported is 3-month, 2-
year, 5-year, 10-year and 30-year US Treasury
Debt.
 Yield Curve (Term Structure)
YTM(t)

1981
1987 & Normal

1976
Years to
1 5 10 20 30
Maturity
Spot Rate - The actual interest rate for a given period as of
today (YTM on zeros).
Forward Rate - The interest rate, set today, on a loan made in
the future at a fixed time, implied by two spot rates.
Future Rate - The spot rate in the future, which is unknown as
of today.
 Yield Curve (Term Structure)
YTM(t)

1981
1987 & Normal

1976
Years to
1 5 10 20 30
Maturity
• What can we learn from the yield curve?

• Future short rates are unknown, but we can say

something about future rates based on forward
rates.
 Yield Curve (Term Structure)
YTM(t)

1981
1987 & Normal

1976
Years to
1 5 10 20 30
Maturity
Normal Yield Curve (upward sloping):
– Low yield for short-term maturity bonds and increases for longer maturity.
Yields on longer-term bonds raise à periods of economic expansion
Inverted Yield Curve (downward sloping):
– Short-term interest rate exceed long-term rates. Periods of economic
recession: investors expect longer-maturity bonds to trend lower in the
future. Investors look for safety and buy longer maturity bonds, price
increases (YTM decreases)
Flat Yield Curve:
– Similar yield across maturities. Uncertain economic situation.
 Yield Curve

• What explains the shape of the yield curve?

I. Unbiased Expectations Hypothesis
II. Liquidity Premium Hypothesis
III. Market Segmentation Hypothesis
 (I) The expectations hypothesis

• Assume that all investors are risk neutral. This

implies that they only care about the expected
returns of investment strategies and are not
affected by the risk embedded in these strategies.
• Question: what does this imply for the
relationship between yields on long-term bonds
and (uncertain) future short rates?
 The expectations hypothesis

• Compare two investment strategies used to transfer cash

from the current date t to date t+k;
1. Invest £1 in a k-period zero
2. Invest £1 at the short rate in period t, then invest the proceeds at
the short rate in t+1, …, and finally invest the proceeds at the short
rate in period t+k.

• These strategies have the following payoffs:

1. The payoff of strategy 1 is certain and is equal to (1+yk)k.
2. The payoff of the second strategy is uncertain and is equal to
(1+rt+1) (1+rt+2) (1+rt+3) … (1+rt+k), where rt is the future interest
rate in period t.
 The expectations hypothesis
• The risk neutral investor compares the expected payoffs of
these two strategies and this leads, in equilibrium, to the
following condition:
(1 + y k ) k = E t [(1 + rt +1 )(1 + rt + 2 )(1 + rt +3 )...(1 + rt + k )]

(1 + y k ) k = (1 + y k -1 ) k-1E t [1 + rt + k ]
 Expectations and forward rates
• Notice that the k period forward rate is
(1 + y k ) k
(1 + f t + k ) =
(1 + y k-1 ) k-1

This is a rate which can be locked in at time t using two

long dated bonds.

(1 + f t + k ) = (1 + y k ) k /(1 + y k-1 ) k-1 , we get

(1 + f t + k ) = E t [1 + rt + k ] or f t + k = E t [rt + k ]
 Expectations and forward rates

• Interpretation: under the pure expectations hypothesis,

forward rates are equal to expected future short rates.

• If this were not true, investors would attempt to exploit the

discrepancy and hence drive forward rates and expected
short rates back to equality.
• If we believe that the pure expectations hypothesis is
realistic, we can infer market expectations of future interest
rates from the observed yield curve.
 (II) The liquidity preference hypothesis

• The LP hypothesis assumes that investors are risk-averse

and, further, that investors are faced with uncertain
liquidity shocks, e.g., the need to consume.
• If a risk-averse investor faces a choice between two
investments with identical expected returns but different
horizons, he will choose the short-term security, in order to
hedge against liquidity shocks.
• Hence, the long-term security should offer a higher
expected return than the short-term security.

(1 + y k ) k >E t [(1 + rt +1 )(1 + rt + 2 )(1 + rt +3 )...(1 + rt + k )]

 The liquidity preference hypothesis
• To choose the long-term strategy, the investor will require
a risk premium. This term premium is the compensation
the investor earns for bearing the risk of the long-dated
bond.
(1 + f t + k ) > E t [(1 + rt + k ], " k > 1

f t + k > E t [rt + k ]

The increase in the term premium with maturity comes

from the "increased (liquidity) risk" of longer dated bonds.
 The liquidity preference hypothesis

In summary:
• Long term bonds are riskier;
• Investors demand a term premium for the risk
associated with long-term bonds;
• Forward rates contain a liquidity premium and are
not equal to expected future short rates.
 (III) Market segmentation hypothesis

• In the expectations theory and in the liquidity preference

theory of the term structure, bonds are viewed by investors
as substitutes.
• The notion of market segmentation is that long and short
term bonds are traded in distinct, separated markets. Each
of these markets finds an equilibrium independently of the
other.
– Interactions of long-term borrowers and lenders determine long
dated yields
– Interactions of short-term borrowers and lenders determine short
rates.

• Hence, there is no relation between the forward rate the

future short rate.
 Inference from the term structure
• What can we infer from the slope of the yield curve?
• For example: if the yield curve is upward sloping, which
implies
Y2 > Y1 => f t + 2 > Y2 > Y1

• what can we conclude?

• Under the EH, an upward sloping yield curve indicates that
investors anticipate a rise in the future short rate.
• Under the LPH, we cannot infer much about future short
rate, as the LPH implies a positive term premium.
• Under the SMH, we cannot infer much about future short
rate either.
 Duration
• Assume that you have a bond portfolio, and you are
concerned about the value of your bond portfolio in
relation to interest rate movements.

• What is interest rate risk?

Interest rate movements can affect the value of a bond
portfolio.

• How do we measure the sensitivity of bond value to

interest rate fluctuations?
The concept of duration.
 Duration
• Definition: The duration of a bond is the elasticity of its
price with respect to changes in yields. Duration is the %
change in price associated with a 1% change in yield.
ΔP
(1+y) ΔP
Macaulay D=- P =-
Δ(1+y) P Δ(1+y)
1+y

D ΔP/P
Modified D*= =-
1+y Δ(1+y)

=> ΔP/P=Δ(1+y)(-D*) We can use this formula

to predict changes in
bond prices
 Duration
• Macaulay duration can be shown as:

N C j /(1 + y) j
D=å *j
å
N
j=1
j=1
C j /(1 + y) j

å [PV(C ) * j ]
j =1
j

=
PV(bond)

• Modified Duration is:

D
D*=
1+y
 Duration

N
PV of cashflow j
D=å *j
j=1 PV of all cashflows

• Macaulay Duration is the value-weighted average of the

payment time of the individual cash flows.
• The weights are the proportion of the total value of the
bond that is accounted for by each payment.
 Duration
• Example: what is the duration of a five-year bond with
10% annual coupon and the term structure is flat at
r=5%?
t Ct PV(Ct) PV(Ct)/PV PV(Ct)/PV×t
1 10 9.524 0.078 0.078
2 10 9.070 0.074 0.149
3 10 8.638 0.071 0.213
4 10 8.227 0.067 0.271
5 110 86.187 0.709 3.543
B=PV =121.647 1 D =4.253

N
PV of cashflow j
D=å *j
j=1 PV of all cashflows
 Duration
• How does the bond price change if r goes up from 5%
to 6%? What change does the duration model predict?
– Bnew = 116.8495 (computed using PV formula)
– Hence, percentage change in bond price is:
Bnew - B
= -3.9%
B

– Modified duration is: D*= D/(1+r) = 4.05.

– Duration model predicts the following change in prices:

Bnew - B
» -D* ´ change in r
B
= -4.05%
 Duration
• Bonds with larger durations are more sensitive to interest
rate movements.
• Duration generally increases with maturity.
• The duration of a coupon bond is lower than its maturity
because a lot of the cash flows accrue before maturity.
Zeros have durations equal to their maturities.
• Duration falls as the coupon rate rises: a larger proportion
of cash flow is received earlier (i.e. the weights on the
early payments are higher).
• (Macaulay) Duration falls as yield rises: a higher yield
reduces the value of later cash flows by a greater
proportional amount. Weights of earlier cash flows in the
total become greater.
 Duration

• A more general expression of duration, when we

have a portfolio of bonds:
N
PV of cashflow j
D=å * Duration of cashflow j
j=1 PV of all cashflows

B1 D1 + B2 D2
D=
B1 + B2
B1 B2
= D1 + D2
B1 + B2 B1 + B2
 Immunization
• Immunization is a strategy used by financial institutions to
shield their financial wealth from exposures to interest rate
fluctuations.

• Put differently, they want to set the D* (modified duration)

of their net wealth (assets minus liability) to 0.

• Financial institutions usually have a mismatch between the

durations of their assets and liability.
– Banks' liabilities consist mostly of deposits owed to customers
which are typically of low durations. Their assets tend to be
commercial loans, mortgages etc. which are generally of much
longer durations.
 Immunization
• Suppose, you are a manager of an insurance company.
Your assets consist of £30mln in cash and the liabilities
consist of four £10mln payments in years 5, 6, 7, and 8
from now. The current term structure is flat at 5%.
However, you are concerned that the interest rates may go
down in the future. What is the immunization strategy in
year t = 0?

Balance Sheet
Assets Liabilities
£30 mln year: 5 6 7 8

£10 £10 £10 £10

PV=L=29.173
 Immunization
• Net worth W is defined as the difference between the
values of assets and liabilities:
10 10 10 10
W = 30 - - - -
(1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05)8
5 6 7

= 0.82 mln
• If r falls to 4% W becomes:
10 10 10 10
W = 30 - - - -
(1 + 0.04) (1 + 0.04) (1 + 0.04) (1 + 0.04)8
5 6 7

= -1.02 mln
• The company loses money if the interest rate drops!
 Immunization

• What the insurance company manager can do is to

convert his cash into securities with longer durations.

• For example, he can use part of the cash to purchase 10

year zero coupon treasury notes. In doing so, he can set
the D* of his total (net) worth to 0.
 Example Immunization

A saving and loan company has the following balance sheet

Example Immunization
Example Immunization
Example Immunization
 Example Immunization

• New balance sheet

Extra Slides
 Bonds traded at a discount

• Why would a bond be traded at a discount?

(P<FV)
– Fixed coupon bonds can trade at a discount when the
market interest rate increases (lower value of holding
that bond relative to newly issued bonds with same
risk)
– A drop in credit ratings
– A higher perceived default probability
 Yield to Maturity of a 1-Year Zero

• The yield to maturity of a 1 year zero (zero

coupon)

𝐹
𝑌𝑇𝑀 = −1
𝑃!

• The higher the bond price, the lower the

Yield to maturity