 Answers to Concepts in Review

1. There is no single market rate of interest applicable to all segments of the bond
market. Instead, a series of market yields exists for a variety of market instruments.
In general, the interest rate on a particular bond issue will depend on a variety of
issue characteristics, including the type of issuer,
the amount of tax exposure, its call feature, coupon, and time to maturity. The
investment implications of such a market are simple: Investors can pick the segments
that have the return,
risk, and other characteristics that best meet their investment needs. For example,
they can move
from agency bonds with a fairly low return (and risk) to corporate bonds and receive
a higher return. In short, it opens up the investment alternatives and investment
opportunities for investors.
2. The behavior of interest rates is perhaps the single most important element in
determining the level of return from a bond investment program. Interest rates affect
the level of current income earned by conservative investors, as well as the amount
of capital gains generated by aggressive bond traders. Whereas conservative
investors are primarily concerned with the level of interest rates, aggressive investors
are interested chiefly in movements in interest rates (the amount of interest rate
volatility). Some of the major determinants of interest rates include: inflation, the
money supply, the demand for loanable funds, the amount of deficit spending by the
federal government, and actions of the Federal Reserve (like changes in the discount
rate). Individual investors can monitor interest rates and formulate interest rate
expectations on an informal basis through the use of reports obtained from their
brokers, from investor services (e.g., S&P’s Creditweek), and/or by following
columns/articles in such business and financial publications as The Wall Street
Journal or BusinessWeek.
3. The term structure of interest rates is the relationship between the interest rate or yield
and the time to maturity for any class of similar risk securities. The yield curve is just a
graphic representation of the term structure of interest rates at a given point in time. To
plot a yield curve, you need to know the yield to maturity for different maturities of
similar risk bonds. As market conditions change, the yield curve’s shape and location
also change.
The upward-sloping yield curve indicates that yields tend to increase with longer
maturities. The longer a bond has to go to maturity, the greater the potential for price
volatility and the risk of loss. Thus, investors require higher yields on longer
maturity bonds. Flat yield curves indicate that yields will be the same across
maturities. Given that longer-term bonds have more default and maturity rate risk, a
flat yield curve implies that inflation rates are expected to decline.
4. Analyzing the changes in yield curves over time provides investors with information
about future interest rate movements and how they can affect price behavior and
comparative returns. For example, if over a specific time period, the yield curve
begins to rise sharply, it usually means that inflation is increasing. Investors can
expect that interest rates, too, will rise. Under these conditions, most seasoned bond
investors would turn to short or intermediate (three- to five-year maturities).
A downward-sloping yield curve would signal that rates have peaked and are about
to fall.
Differences in yields on different maturities at a particular point in time, or the
“steepness” of the curve, is an indication that long-term rates are likely to fall
somewhat to narrow the spread,
providing an incentive to invest in longer-term securities. Steep yield curves are
generally viewed
as a signs that long-term rates are near their peak.
Even among longer-term maturities, the spread between different longer-term
maturities should be considered before making a decision to invest. For example, if
the spread between ten and thirty-year maturities is not large enough (say, less than
20 basis points), then the investor should favor the
ten-year bond, because he would not gain enough to compensate for investing in the
much riskier
thirty-year maturity. In any case, the investor would have to consider his or her own
risk tolerance to determine whether the risk premium was sufficient for the
additional risk of buying longer-term securities.
5. Bond prices are driven by market yields. In the marketplace, the appropriate yield at
which the bond should sell is determined first, and then that yield is used to find the
price of the bond. The yield is a function of certain market and economic forces,
such as the risk-free rate and inflation, as well as key issue and issuer characteristics,
such as the maturity of the issue and agency rating assigned to the bond.
You cannot value a bond without knowing its market yield, which functions as the
discount rate in the bond valuation process.
6. Bonds are usually priced using semiannual compounding because in practice, most
bonds pay interest every six months. Semiannual compounding makes discounting
of semiannual coupon payments more precise, resulting in more accurate valuation.
However, using annual compounding simplifies the valuation process a bit and does
not make very much difference in value. With higher coupons and longer maturities,
the difference increases more. Bonds offering semiannual payments will be priced
higher.
 7. Current yield is a measure of a bond’s current income. It is the amount of current
income a bond provides relative to its prevailing market price. Yield-to-maturity is a
more complete measure
and evaluates both interest income and price appreciation. Yield-to-maturity
indicates the
fully compounded rate of return earned by an investor, given that the bond is held to
maturity
and all principal and interest payments are made in a prompt and timely fashion.
Promised yield is the same as yield-to-maturity. Promised yield is computed
assuming the bond is held to maturity and the coupon cash flows are reinvested at
the bond’s computed promised yield. Realized yield is the rate of return an investor
can expect to earn by holding a bond over a period of time that is less than the life of
the issue. Realized yield is used by bond traders who trade in and out of bonds over
short holding periods.
8. When we are dealing with semi-annual cash flows, to be technically correct, we
should find the bond’s “effective” annual yield. However, the market convention for
finding the annual yield is to double the semiannual yield. This practice produces
what the market refers to as the bond-equivalent yield. Thus, given a semi-annual
yield of 4 percent, according to the bond-equivalent yield convention, the annual rate
of return of this bond if held to maturity is 8 percent. This is also the same as the
bond’s promised yield or yield-to-maturity.
9. The reinvestment of interest income is an important consideration, because it is this
rate that an investor must earn on each of the interim cash throw-offs in order to
realize a return equal to or greater than the promised yield on a bond. As cash is
received from interest income, the equation
for promised yield implicitly assumes this cash payment will be reinvested at a rate
of return equal
to the issue’s promised yield; failure to do so means the investor will generate a
realized yield that is less than promised.
10. Duration is a measure of bond price volatility. It captures both price and
reinvestment risks in a single measure and indicates how a bond’s price will react to
different interest rate environments. It is the effective maturity of a fixed-income
security. On the other hand, the bond’s actual maturity does not consider all of the
bond’s cash flows nor does it consider the time value of money. Duration is a far
superior measure of the effective timing of a bond’s cash flows, because it explicitly
considers both the time value of money and the bond’s coupon and principal
payments.
 When the market undergoes a big change in yield, duration will understate price
appreciation when rates fall and overstate the price decline when rates increase.
Modified duration is used to overcome this problem by linking interest rate changes
to changes in bond price. First, you can compute the modified duration using the
bond’s computed duration and the computed yield-to-maturity. Then,
the change in bond price based upon a change in interest rates can be computed as
follows:
Percent change in bond price  –1  Modified duration  Change in interest rates

11. Market interest rate changes have two effects: the price effect and the reinvestment
effect, which occur in opposite directions. When a bond portfolio is immunized,
these two effects exactly offset each other and leave the value of the portfolio
unchanged. This happens when the weighted average duration of the bond portfolio
is exactly equal to the desired investment horizon. If a portfolio is constructed and
continuously rebalanced such that the weighted average duration is equal to the
desired investment horizon at any particular point in time, then the portfolio is said
to be immunized from the effects of interest rate changes.
Bond immunization allows an investor to derive a specified rate of return from bond
investments regardless of what happens to market interest rates over the course of
the holding period. That is,
the investor’s bond portfolio is “immunized” from the effects of changes in market
interest rates
over a given investment horizon.
Portfolio immunization is not a passive investment strategy; it requires continual
portfolio rebalancing on the part of the investor in order to maintain a fully-
immunized portfolio. The composition of the portfolio should change every time
interest rates change, and also with the
passage of time.
12. Bond ladders are a passive investment strategy whereby an equal amount of money
is invested in a series of bonds with staggered maturities. Suppose an investor wants
to confine her investing to fixed income securities with maturities of ten years or
less. She could set up the ladder by investing in roughly equal amounts of three-,
five-, seven-, and ten-year issues. When the three-year issue matures, the proceeds
would be reinvested in a new ten-year note. Similar rollovers would occur whenever
a bond matures. Eventually, the investor would hold a full ladder of staggered ten-
year notes. Rolling into new ten-year issues every two or three years allows the
investor to do a kind of dollar cost averaging and thereby lessen the impact of
swings in market rates.
Tax swaps involve replacement of a bond with a capital loss with a similar security.
By selling the bond with the capital loss, an investor can offset a capital gain
generated in another part of the portfolio and thereby reduce the overall tax liability.
Identical issues cannot be used for this kind of swap; the IRS will rule such swaps as
“wash sales” and therefore disallow the capital loss.
13. An aggressive bond investor would employ the highly risky forecasted interest rate
behavior strategy. The intent of this strategy is to take advantage of interest rate
swings by timing the market. Usually these swings are short-lived, so aggressive
bond traders will try to magnify their returns by trading on margin. These investors
try to generate capital gains when interest rates are expected to decline and to
preserve capital when an increase in interest rates is expected.
14. The interest sensitivity of a bond determines how much the bond’s price will
fluctuate for a given change in interest rates. Obviously, when rates drop, bond
traders want to capitalize on this and as such, require issues that will respond to these
interest rate changes. Bonds with longer maturities and/or lower coupons respond
more vigorously to changes in market rates; therefore, they undergo greater price
swings. High-grade issues are widely used by active bond traders since these issues
are generally more interest-sensitive than lower-rated bonds—for example, market
behavior is such that a triple A corporate will generally be far more responsive to
interest rates than a triple B issue. A deteriorating economy will result in a decline in
the demand for money and hence interest rates, but it might cause more default risk
to the holder of the triple B bond issue.