Bond Trading Strategies

Objective: Session IV- V

At the end of the session, you will be able to

Understand the relationship between bond price and yield.

Understand the methods to calculate yield to maturity.

Understand the significance of various types of yields from trading

perspective.

Understand how the yield curve can be derived.

Understand the concept of Duration, Modified Duration in bond trading

strategies.

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Bond Pricing: Interest Rate Risks

Inverse relationship between bond prices and yields.

Prices of a long term bond are more sensitive to interest rate changes
than prices of a short term bond.

Price of low-coupon bond are more sensitive to interest rate change than
prices of high coupon bonds.

Interest rate risk is inversely related to the bonds coupon rate i.e. prices
of high coupon bonds are less sensitive to changes in interest rate than
prices of low coupon bonds.

An increase in a bonds YTM results in a smaller price change than a

decrease in YTM of equal magnitude.

The sensitivity of bond prices to changes in yields increases at a

decreasing rate as maturity increases.
Link: Interest Rate & Bond Valuation
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Bond Pricing: YTM Linear

Interpolation
Complicated way of measuring YTM but useful as it provides with a range of
an expected yield.
It can also assist us in showing what a small deviation, for example 12.3%
to 12.4% can do to the bond price
Formula:
LR Market Rate: LMR
HR Market Rate: HMR
Lower Bond Price (LBP) due to HMR
Higher Bond Price (HBP) due to LMR
(HBP Market Price)
YTM = LMR + (HMR - LMR)
(HBP LBP)

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Bond Pricing: YTM Linear

Interpolation
Example:
Bond Face Value:$1000.
Market Price:$1050.
Bond Price @ 15 % discount rate: $ 966.48.
Bond Price @ 13 % discount rate: $1035.17.
Coupon Rate:14%.
Coupon Payment: $140.
Terms to Maturity: 5 years
(1035.17 1050)
YTM* = 13% + (15% - 13%)
(1035.17 966.48)
YTM* = 12.57%
Link: YTM Linear Interpolation

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Bond Pricing: Current Yields

Current Yields relates the annual coupon interest to the market price.

Annual Interest
Current Yields =
Price of the Bond

The relationship between yield to maturity (YTM) and coupon rate is as

follows:

Bond at a discount, YTM > current yield > coupon yield.

Bond at a premium, coupon yield > current yield > YTM.

Bond sells at par, YTM = current yield = coupon yield.

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Bond Pricing: Weighted Yield

Weighted Yield is calculated when an investor is holding a series of bond in
his/her portfolio.
Steps to calculate:
1)

As is the case with all investment assets, the first step in calculating
bond portfolio is to calculate the market value of portfolio.

2)

Calculate individual Current Yield of the bond.

3)

Calculate the Weighted Yield by taking the product of each individual

bond market value and its corresponding yield.

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Bond Pricing: Weighted Yield

Purchase
Date

7/11/2001

Coupon Rate

Maturity

11.68%

YTM

No. of
Bonds

Market
Value

Weighted
Current Yield

8/6/2002

7.37%

5400

563436.00

41541.28

11.15%

9/1/2002

7.38%

5560

578406.80

42669.01

13.82%

5/30/2002

7.27%

5720

603460.00

43890.49

12.69%

5/10/2002

6.51%

5880

616812.00

40127.09

11.00%

5/23/2003

7.63%

6040

638669.60

48735.94

Sum

3000784.4
0

216963.82

Portfolio
Yield

7.23%

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Bond Pricing: Realised Yields

Realised Yield actual yield to the investor in a bond over a given

period.

It represents the horizon returns to the investor from all the 3

components of bond return coupons, returns from reinvestment of the
coupon and capital gain/loss from selling the bond at the end of the
holding period.

Realised yield to the investor is the rate which equates cash flow from all 3
sources to the initial cash flow.

Link: Realised Yields

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Callable Bonds

Bonds that allow the issuer to alter the tenor of a bond, by redeeming it
prior to the original maturity date, are called callable bonds.

The inclusion of this feature in the bonds structure provides the issuer
the right to fully or partially retire the bond, and is therefore in the
nature of call option on the bond.

The call option provides the issuer the option to redeem a bond, if
interest rates decline, and re-issue the bonds at a lower rate.

The call option, therefore, can effectively alter the term of a bond, and
carries an added set of risks to the investor, in the form of call risk, and
re-investment risk.

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Bond Pricing: Call Provisions

Most bonds have call (buy) provisions

Allows issuers to repay the investors principal early than specified date.

It is commonly Called when the market interest rate drops.

It is also Called when the issuer sees a surge in its credit quality.

If the bond is Called, then the call date is usually one of the two dates
that semiannual interest is due i.e. next payment date.

Reason for calling when market rate drops, new bonds can be issued
at a lower interest rate.

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Bond Pricing: Yield to Call

YTM is calculated on the assumption that the bond will be called only on maturity. If
the bond is callable before maturity, how would we measure the average rate of
return for the bonds subject to the call provision ?
Link: Yield to Call
From a trading perspective,

Bond market analyst believe that YTC is more relevant than YTM.

Bond is more susceptible to the prevailing market sentiments.

YTC is calculated the same way as YTM but the TTM will change to the amount of
time left for the bond to expire or mature and the call price replaces the par value.

Bonds are callable by the issuer if the prevailing market rate is below the Bonds
calculated YTM.

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Bond Pricing: Investor Protection

Call protection is the amount of time before a newly issued bond is

callable.

Call provisions, which must explicitly state the callable options by the
issuer, must be fully considered and understood by investors.

Bonds with limited or no call provisions have higher expected returns to

compensate for the risk that the bond might be called for redemption.

Repurchase of the bond by the issuer is done at a slightly higher price

than the prevailing market price i.e. premiums are offered.

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Horizon Analysis

A method of measuring the discounted cash flow from an investment,

using time periods or series that differ from the investments
contractual maturity.

The horizon date might be the end of a business cycle or some other
date determined in the perspective of the investors overall portfolio
requirement.

Horizon analysis calculation include reinvestment assumptions, permit

comparison with alternative investments that is more realistic in terms
of individual portfolio requirements than traditional YTM calculations.

Link: Horizon Analysis

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Holding Period Returns

It is generally perceived that high yield bonds provide higher rate of

returns which is false.

In principle, all bonds must offer identical rates of return over any holding
period.

If Bond A dominates Bond B, the possibility of market forces forcing the

price of the bond A to drop or for lower returns Bond B to appreciate in
value is significant.
In other words, we will see a convergence of returns of all bonds.

In fact despite their different YTMs, each bond will provide a rate of return
over the coming years equal to this years short term rate.
Link: Holding Period

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Holding Period Returns

In principle, despite different YTMs, each bond will provide a rate of

return over the coming year equal to this years short term rate.

Example:
Zero Coupon Bond Face Value: $1000
Bond Price: $925.93
TTM: 1 year
Capital Gain: $74.07 (1000-925.93)
Rate of Return: $74.07 / $925.93 = 8%

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Holding Period Returns

Zero Coupon Face Value: $1000
Bond Price: $841.75
TTM: 2 years
Year 2 Interest Rate: 10%
Year 2 Bond Price: 1000/(1.10) = $909.09.
Holding Period Returns:
(909.09 841.75) / 841.75 = 8%
Similarly, a 3 year zero coupon bond bought at $758.33 being sold
after 1 years with 2nd year likely interest rate of 10% and 3rd year
rate of 11%.
Price for the 3 year bond after one year is
1000/(1.10)(1.11) = $819.
Rate of Return: (819 758.33)/(758.33) = 8%

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Term Structure of Interest

Inverse relationship between bond prices and yields.

Prices of a long term bond are more sensitive to interest rate changes than
prices of a short term bond.

Price of low-coupon bond are more sensitive to interest rate change than
prices of high coupon bonds.

An increase in a bonds YTM results in a smaller price change than a

decrease in YTM of equal magnitude.

The sensitivity of bond prices to changes in yields increases at a decreasing

rate as maturity increases.

Interest rate risk is inversely related to the bonds coupon rate i.e. prices of
high coupon bonds are less sensitive to changes in interest rate than prices
of low coupon bonds.

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Bonds: Yield Curve

Plotting of YTM against the Terms to Maturity
Yield curve shows the term structure of interest rates by plotting the yieldto-maturity of all bonds of the same quality with the maturities ranging
from the shortest to the longest available.

If the short term yield rates are lower, it is called a positive yield curve.

If the short term yield rates are higher, it is called a negative yield
curve.

If the difference between them is not significant, then we will have a flat
yield curve.

Link: Yield Curve

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Bonds: Yield Curve

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Bond Duration
Developed by a financial economist, Frederick R. Macaulay, duration is an
estimate of the economic life of a bond as measured by the weighted
average time to receipt of interest and principal payments.
In simplest of words, it indicates the time required to recover the cost
incurred i.e. the time it takes for the coupons and principal to cover the
bond price incurred.
More technically, we attach weight to each of this payments and the weight
applied to each payment time should be proportional to the total value
of the bond accounted for by that payment.
Link: Duration Explained

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Bond Duration
In simple words, it measures bond price volatility by measuring the length
or life of a bond.
Significance:

Bonds duration, measured in years, shows the bondholders how

sensitive the bonds price is to changes in the prevailing interest rate.

Shorter the duration, the less sensitive is a bonds price to fluctuations

in market interest rate.

In other words, greater the duration of a bond, greater is the percentage

volatility.

Recall, Prices of a long term bond are more sensitive to interest rate
changes than prices of a short term bond.
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Bond Modified Duration

Modified duration is the percentage change in the bond price for each
percentage point change in YTM. It is also the degree of variance in
the bond price for each percentage point change in the YTM.
Percentage change in the bond price is just the product of modified
duration and the percentage change in the bonds YTM.
Modified Duration = Macaulay Duration / (1+(YTM/n))

Link: Modified Duration

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Convexity

Modified duration measures the sensitivity of bond prices to changes in

YTM.

Convexities measures the sensitivity of modified duration to changes in

interest rates.

In other words,
Modified duration measures the speed at which bond prices changes to
changes in YTM.
Convexities measures the rate of acceleration i.e. degree of acceleration at
T
which bond prices
toCF
changes in YTM.
1 changes

Convexities
P*(1+
=
y)2

( ( 1 +

t=1

t 2 + t)

y )t
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Convexity
Reasons for Yield Curve adopting convex shape:

As yield change, weights given to each cash flow timing fluctuates more than
yields.

As stated earlier, low coupon bonds tend to be more prone to price

fluctuation.

In other words, lower the coupon, longer the maturity and lower the yield,
larger the convexity.

Duration with Convexities Rule is more accurate measure to analyze the

changes in Bond Price.
P/P = - MD * y + 0.5 * (Convexities) * (y) 2
Link: Convexity

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Bootstrapping

Bootstrapping is a very popular method with bond market dealers, for

estimating the term structure from market price.

Bootstrapping method is sensitive to the liquidity and depth in the market. In

a market with few trades and limited liquidity, bootstrapping is only an
approximation of the true term structure.

It is easy to find the r for a zero coupon bond once we know the bond price.
However in a coupon paying bond, we know that the r is not the same for
all the tenors of the bond. If r is assumed as being constant for all periods,
then yield curve would remain flat.

The r for each period or for each respective tenors is called Spot Rates.
These rates are also called Zero Coupon Rates and the yield curve drawn
from these rates are called ZERO COUPON YIELD CURVE.

Thus the process of finding the zero rates from the prices of the coupon bond
by substituting zero rates estimated for shorter duration is called
bootstrapping.
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Bootstrapping

It would be difficult to obtain zero rates for the first cash flow of the
bond, if we are unable to find a matching treasury bill with a matching
maturity date.

For Example:
Supposing that a coupon paying bond has 54 days for the next coupon
date. To find the present value of the coupon we need to find the
discount rate in order to value the bond. It would be difficult to find a
treasury bill having exactly 54 days to mature. This problem can be
resolved by using the Linear Interpolation method.
We can use the rates on bills maturing in 50 days and 60 days.

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Thank You

Bodie, Kane, Marcus & Mohanty; Investments, 6th Edition; TATA

McGraw Hill.

Hirschey & Nofsinger; Investments Analysis and Behaviour; TATA

McGraw Hill.

Sharan; International Financial Management; 4th Edition; Prentice Hall

Ross, Westerfield 7 Jaffe; Corporate Finance; 7th Edition.

Prasanna Chandra; Investment Analysis and Portfolio Management; 2nd

Edition; TATA McGraw Hill.

Michael C. Ehrhardt & Eugene F. Brigham; Corporate Finance A

Focused Approach.

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