Bond Markets

What is a Bond?
A bond is simply a loan When corporations, municipalities, and governments issue bonds, they are seeking to borrow money from investors Investors pay an upfront lump sum (the loan amount) on the expectation that they will receive interest payments (coupons) over time, as well as the par amount of the loan on the maturity date of the bond This is why bonds are sometimes referred to as Fixed Income instruments

Types of bonds (taxable fixed income)

Bank CDs U.S. Treasuries Corporate bonds High yield bonds = = = =

safety and insurance safety high/medium quality lower quality/high volatility (junk bonds)

Tax-exempt

Municipal bonds

federal, state, local

Cash Flows From a Fixed Coupon Bullet Bond

Coupon: A fixed interest payment in each period. Face value (or principal) in the final period.

Example: 10yr bullet bond, 5% annual coupon, $100 face value

105 Cash flows ($)
coupon payments principal payment

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Time (years)

Calculating the Price of a Bullet Bond

Example: Face = $100, coupon = 5% , r = 6%
Cash flows ($) 105 coupon payments principal payment 5 1 2 3 4 5 6 7 8 9 10

Bond Price: sum of discounted cash flows: 5 + 5 + 5 + ...+ 5 + 100 = 92.64 P = 2 3 10 10 (1.06) (1.06) (1.06) (1.06) (1.06) General Formula:
coupon cashflow C, Face value F, time to maturity n years, annual discount rate r: P =
C (1+r) + C (1+r)2 + C (1+r)3 + .... + C (1+r)n + F (1+r)n 4

US Treasury Bonds make semi-annual payments

Example: 5 year semi-annual 10% coupon bond, discount rate 6%
Cash flows ($) 105 coupon payments principal payment 5 1 2 3 4 5 6 7 semi-annual periods 8 9 10 5 years

P = =

5 + 5 + 5 + .... + 5 + 100 (1.03) (1.03)2 (1.03)3 (1.03)10 (1.03)10

5 [ 1 - (1.03) 0.03
- 10

] +

100 (1.03 )
10

= 117.06

What Assumptions Do We Make When Calculating Present Value?

Cash flows are of known magnitude. Cash flows are of known timing. Assume a discount rate for the cash flows
Where does the discount rate come from? What if the timing of the cashflows is not annual?

Yield To Maturity
The discount rate that equates the present value of the expected cash flows (interest and principal) to its observed price. For a semi-annual bond:
Price = C/2 (1 + y/2) C/2 y/2 + C/2 (1 + y/2) 2 + ... + F + C/2 (1 + y/2)2n

[1 - (1 + y /2)-2n] +

F (1 + y/2) 2n

Where:

N = Years until maturity C = Annual Coupon F = Face (or Principal) y = Yield to maturity
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Bond Yield: Example

P = C/2 y/2 [1 - (1 + y /2 )
- 2n]

F (1 + y/2 ) 2n

C, n, F: stated in the contract. P: price of the bond in the market.

Solve for yield y.

Example: 10 yr bond, coupon = 5%, market price = 92.56

92.56 = Try y = 7% 2.5 0.035 [1 - (1 + 0.035)
-20]

2.5 [ 1 - (1+y/2) y/2

-20

] +

100 (1+y/2)20

=> y/2 = 3.5% + 100 (1 + 0.035)20 = 85.79

Result: price too low. Is 7% yield too high or too low ?

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Bond Yield
Example: 10 yr bond, coupon = 5%, market price = 92.56 7% yield => Price = 85.79 (too low). Try 6%: 2.5 [1 - (1.03) 0.03 Correct yield = 6%.
Relationship between bond price and yield Bond Price
-20]

100 (1.03)20

= 92.56

As price increases, yield decreases.

Bond Yield
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Relationship between Bond Yield and Coupon: two different bonds

Example 1: 5yr bond, 8% coupon, 7% yield: P = 4 [ 1 - (1.035) 0.035
-10

100 (1.035)10

Coupon > yield => Price > 100. Bond trading at a Premium

= 104.16

Example 2: 5yr bond, 6% coupon, 7% yield: P = 3 [ 1 - (1.035) 0.035

-10

100 (1.035)10

Coupon < yield => Price < 100. Bond trading at a Discount

= 95.84

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Bond Yield: Summary

Yield is the single discount rate that discounts all of the bonds cash flows to its observed price Yield is a device, used by the market as a means of assessing a bonds value A bonds yield, not its price, is a measure of its value Price is todays present value of coupon flows, discounted at an appropriate rate How do we distinguish between a bond with a price of 103, versus one with a price of 98? If the bond with a price of 98 has a yield of 4%, and the 103 bond has a yield of 5%, then the 103 bond is perceived as riskier because its cash flows are being discounted by the market at a higher rate Bottom line: you cannot compare bonds on the basis of their price, because the price reflects the size of the bond coupon.

Yield is a proxy for the bonds rate of return If (1) you hold the bond to maturity, and (2) you re-invest coupon flows at the same rate, then your realized ROR will equal the yield Note that this almost never happens! Because it is very unlikely that you will be able to reinvest coupon flows at the same rate
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Term Structure of Interest Rates (also called "The Yield Curve") Which yield curve

shape is more common? Why?

yield

"normal" yield curve

"inverted" yield curve

Trade ideas in current macro climate?

1yr

2yr

5yr

10yr

20yr

30yr maturity

Relationship between the yield and the maturity of bonds in the US Treasury market. No default risk Most liquid bond market Yield curve over time: http://www.econ2.jhu.edu/People/Wright/loop_repealed.html
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Theories relating to Yield Curve Slope

Expectations Hypothesis
Yield curve shape determines the market's view of likely interest movements If rates are expected to rise Investors purchase short-maturity bonds so they can reinvest at higher rates soon Investors who hold long-maturity bonds sell because (1) as rates go up, prices go down, (2) long-maturity bond prices fall further than short-maturity bonds (higher duration) Borrowers looking for longterm funding will borrow (i.e., sell bonds) now If rates are expected to fall the reverse is true Drawbacks to this theory Ignores price risk (duration) Ignores reinvestment risk on interest income in the interim

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Theories relating to Yield Curve Slope

Price Risk theory
The longer the maturity of the bond, the greater its price risk (duration) All else equal, investors prefer lower risk investments Hence longer-maturity bonds have higher yields (i.e., discount rates) to compensate investors for increased risk

Price Risk theory + Expectations Hypothesis

Curve Shape Price Risk Theory Expectations Investors expect rates to rise Investors expect rates to fall Upward Upward Upward Downward Net Upward ???

Other Theories
Market Segmentation Preferred Habitat
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See BKM Section 15.4

Credit Curves
yield Credit curve for AA bonds (say)

Treasury yield curve: Zero default risk

Trade ideas in current macro climate?

1yr

2yr

5yr

10yr

20yr

30yr maturity

Observations Spread between Tsy curve and credit curve is greater as maturity increases Curves for different credits exist Credit curves tend to tighten in falling rate environments, and widen in increasing rate environments
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Duration
Duration: a measure of the bonds price sensitivity to changes in interest rates. Higher duration => more price change for a given interest rate change Duration at any given yield: estimated as the slope of the price-yield function. Duration = dP dy (note that DV01 is always negative)

Bond Price p0

As the bonds yield changes, so does the slope of the price-yield function.

Bond Price

Bond with high duration

Bond with low duration

p1 y0 y1 Bond Yield Bond Yield

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Using DV01
What is DV01? It is the approximate bond price change for a 1% change in yield.

Example The 10yr UST has the following characteristics: Price Yield DV01 = = = 102.688 5.81% 7.572

Now bond yield goes up by 20bp to 6.01%. What is the new price? Price change New Price = = = = - (20/100) * 7.572 - 1.514 102.688 - 1.514 101.174
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Why use Duration when we can reprice a bond accurately?

1.

Calculating market value changes

2. Duration weighting for curve trades 3. Weighted average portfolio duration provides insight into how an entire portfolios value will change, based on re-pricing just benchmark bond(s)

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Using Duration to calculate market value changes

Duration: a measure of the price sensitivity of a bond for a given change in yield: DV01 = change in market value of $100 par amount for a 1% change in yield Example: What is the change in market value of $1MM par amount (or face value) of the 5yr US Treasury for a 15bp increase in yield? The 5yr UST has the following characteristics: Price DV01 102.688 3.368

Hence, the change in market value of $1MM for a 15bp change in yield : = 3.368 *(15/100) * 10,000 = $5,052

Question: why are we multiplying by 10,000 here (after all, the 'par' or 'face' value that we own is 1,000,000, not 10,000)?
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Using Duration weighting for curve trades

Duration-weighting: used to neutralize a curve trade against purely directional
market moves. If you believe that the yield curve will steepen, you might want to buy shortmaturity bonds, and sell long maturity bonds However, you do not have a view as to whether all interest rates will move up, or down You want to be neutral to parallel yield curve shifts

Method: Find the hedge ratio, which is the par amount of the bond you sell
for a given par amount of the bond you buy: Buy par amount X of bond A, which has DV01A Sell par amount Y of bond B, which has DV01B

Hedge Ratio

= DV01A / DV01B

Sell amount Y = X * hedge ratio This portfolio is duration-neutral: for parallel yield-curve shifts the value of this portfolio will not change.

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Hedging via Duration-Weighting: Example

Buy Bond 15yr UST Price = 96.078 DV01 = 12.00 Par amount = $1MM Hedge Ratio = 12.00 4.00 = 3 Sell Bond 5yr UST Price = 100.672 DV01 = 4 Par amount = ???

Sell $3MM par amount of 5yr USTs Now: suppose the yield curve increases by 27bp in a parallel shift.
Market value change in the 15yr UST = 12 * (27/100) * 10,000 = 32,400 Market value change in the 5yr UST = 3 * (27/100) *(4 * 10,000) = 32,400

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Problems with Duration: (1)Yield Curve Shape

What assumption are we making about yield curve shape when we use duration-weighting to hedge a position?

Which of the two yield curve change scenarios depicted below is more likely?

yield

Scenario 1

yield

Scenario 2

1yr 2yr

5yr

10yr

30yr bond maturity

1yr 2yr

5yr

10yr

30yr bond maturity

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Yield Curve Shape: Example

Buy Bond
15yr UST Price Yield DV01 Par Amount = = = = 96.078 6.65% 12.00 $ 1 Million

Sell Bond
5yr UST Price = 100.672 Yield = 6.15% DV01 = 4.00 Par Amount = $ 3 Million

Now: suppose the 15 year sector drops

27bp and the 5 year drops 36bp

Market value change in the 15yr UST = 12/100 * (27/100) * 1,000,000 = 32,400

Market value change in the 5yr UST = 4/100 * (36/100) *3,000,000 = 43,200

Hence we lose $43,200 on our short 5yr, and only gain $32,400 on our long 15yr
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Hedging Using Volatility-Adjusted Duration Weighting

The short end of the yield curve is typically more volatile than the long end We can adjust our duration-weighting to account for the relative volatility differences We obtain expected yield volatility data from bond options

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Hedging Using Volatility-Adjusted Duration Weighting

Buy Bond
15yr UST Price Yield DV01 Yield vol = = = = 96.078 6.65% 12.00 14%

Sell Bond
5yr UST Price Yield DV01 Yield vol = 100.672 = 6.15% = 4.00 = 20% (14 x 6.65) (20 x 6.15)

Par amount = $1 million

Par amount = 3

= $ 2.27 million

Market value change in the 15yr UST = 32,400

Market value change in the 5yr UST = 4/100 * (36/100)*2,270,000 = 32,688

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Hedging Using Volatility-Adjusted Duration Weighting

Note that the above example worked almost perfectly because the yield moves were consistent with the implied volatilities: 5yr dropped 36bp 15yr dropped 27bp

Ratio = 27/36 = 0.75 5yr volatility = 20% 15 volatility = 14%

Ratio = 14/20 = 0.70 This methodology is only as good as the market's view on the expected volatility of the bonds over the trade horizon.
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Problems with Duration (2): Convexity

Bond Price y0 y1

( p1 - p1*)

p0 p1 p1* y0 y1 Bond Yield

Duration underestimates the new bond price following a change in yield from y0 to y1

Question 1: What can we say about our price estimate following a decrease in the bonds yield? Question 2: What can we say about the accuracy of our estimates for increasingly large yield changes?

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Improving on the Duration estimate: Convexity

Convexity: a first approximation to the duration measurement error. A bonds convexity is a measure of the curved-ness of the price/yield function.

( p1 - p1*) y0 y1 Convexity estimates the distance between p1 and p1*

Question: Why is convexity always added to the price estimate, regardless of whether the yield change is positive or negative?
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Using Convexity
Example The 10yr UST has the following characteristics: Price Yield DV01 Convexity = 102.688 = 5.81% = 7.572 = 0.822

Now bond yield increases 20 bp to 6.01%. What is the new price? Price change from DV01 and convexity = - (20/100) * 7.572 + (20/100)2 * 0.822 = - 1.5144 + 0.0164 = - 1.498 New Price = 102.688 - 1.498 = 101.19 The duration estimate alone underpriced the new value of the bond by 0.0164 Convexity is the coefficient of the 2nd term of the Taylor series expansion of the Price-Yield function. DV01 is the first term in the same series.
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Convexity
For equal maturity bonds, zeros have the most convexity. Doubling duration more than doubles convexity. For a given bond, as yield increases, convexity decreases The greater the change in yield, the greater the convexity correction

Bond Price

Bond Yield
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Bond Portfolio Risk Management

Example
Bond Portfolio Par Amt ($MM) Bond 3.0 UST 5yr 6.0 UST 10yr -4.0 UST 30yr PV 99.345 99.192 92.893 Dollar Duration 4.144 7.359 12.896

Questions: 1. What is the market value of my portfolio? 2. What is my portfolios interest rate risk and how do I measure it?

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What is the Market Value of my Portfolio?

Bond Portfolio Par Amt ($MM) 3.00 6.00 -4.00 Bond UST 5yr UST 10yr UST 30yr PV 99.345 99.192 92.893 Dollar Market Duration Value ($MM) 4.144 2.98 7.359 5.95 12.896 -3.72 5.22
Portfolio Market Value The portfolio market value is: The par amount (in $) of each bond, multiplied by the present value of the bond. dollar amount realized on 'unwinding' (selling or buying back the assets in) the portfolio $5.22MM
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Portfolio Market Value

What is my Portfolios Interest Rate Risk?

Par Amt ($MM) 3 6 -4 Dollar Market Duration Value ($MM) 4.144 2.98 7.359 5.95 12.896 -3.72 5.22 DV01 Risk 124,320 441,540 -515,840 50,020
Weighted Average Duration

Bond UST 5yr UST 10yr UST 30yr

PV 99.345 99.192 92.893

Portfolio Interest Rate Risk Measured using Weighted Average Duration. Weighted Average Duration shows change in Market Value of the portfolio for approximately 1% change in interest rates. (What assumption does this make about the changing yield curve?)

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