bond markets have different conventions on how the accrued interest is calculated. Accrued interest for US treasuries is calculated on an actual/actual basis with semi-annual payments. For example, a bond that pays coupon on February 15 and August 15, if it is purchased on March 15 of a non-leap year, the amount of accrued interest would be calculated by the ratio 28/181 multiplied by the amount of semi-annual coupon payment. This ratio is the number of days between February 15 and March 15 (28) divided by the number of days in the period between February 15 and August 15 (181).
Corporate or agency bond markets use the 30/360 convention, implying that a month is 30 days and a year is 360. In the above example, the number of days between February 15 and March 15 would be 30 and the number of days from February 15 to August 15 would be 180.
If we denote the fractional accrual period by x, our present value formula will change to
1.3
In this equation, 1 − x is the fractional period to the next cash flow or coupon payment. We can convert it to the fraction of a year by multiplying it by m. Thus,
If we denote the cash flow at time ti by ci and the invoice price by pm, we can simplify the above equation to
Equation (1.5) is a generalization of (1.4) and allows for cash flows to be different. It can be used for bonds with step coupons or sinking or capitalizing principals. As can be seen, the market yield of a security depends on the accrual frequency. For example, German government bonds (Bunds) accrue on an annual basis while US treasuries pay coupon semi-annually. If you buy 100 units of a Bund at a yield of 6 %, after 1 year the value of principal and interest will be 106. For US treasuries with the same yield, there is a semi-annual interest payment of 3 %, which if reinvested at the same rate will result in 106.09. The effective yield of the US treasury is 6.09 %. We therefore need to analyze all bonds on the same footing to be able to make fair comparisons.
1.2 SIMPLE BOND ANALYTICS
A problem that bond managers are faced with on a regular basis is the impact of changes in interest rates on the price of a bond. For a small change in interest rates, we can expand the pricing function using Taylor series as follows:
After some simplification, the first term in the expansion is
1.7
The expression within the summation is the weighted average time to future cash flows multiplied by the price and is called the Macaulay duration. The negative sign implies that the price of bonds falls if interest rates rise. The modified duration of a bond is defined as
1.8
where D is the Macaulay duration of the bond. Modified duration measures the price sensitivity of a bond to changes in interest rates. For example, if the modified duration of a bond that is priced at 104 is 11 years, for a change of 10 bps in interest rates (10/10, 000 = 0.001 = 0.1 %), the change in the price of the bond is expected to be 0.001 × 11 × 104 = 1.144.
The second order term in (1.6) can be simplified to
1.9
This expression, denoting convexity multiplied by price, is always positive for bonds with fixed coupon payments. Market yield, modified duration, and convexity of bonds depend on coupon frequency and therefore cannot be used to compare bonds with different coupon frequencies. For example, the duration of a corporate bond that pays quarterly coupons cannot be combined with the duration of a treasury bond that pays semi-annually in a portfolio. We need to do all the calculations using the same accrual convention. Our solution is to use a continuously compounded framework.
Consider a bond with principal continuously growing at a rate of y per year. The change in the principal after a short time dt is
1.10
Integrating the above equation leads to
1.11
where p is the future value of an initial investment of p0. Likewise, the present value of a future cash flow p will be
1.12
The present value of a number of cash flows discounted by the same yield will be
Comparing (1.13) with (1.5), we find that they are identical if we make the following substitutions:
1.14
We can derive the continuously compounded yield and durations in the limit as
1.15
In the continuously compounded framework, duration (D) and convexity (X) become much simpler to handle, and modified duration and Macaulay duration converge to the same value:
1.16
1.17
The change in the price of a security due to a small change in its yield in the continuously compounded framework is
1.18
1.3 PORTFOLIO ANALYTICS
A bond portfolio can be composed of many bonds along the maturity, credit quality, and currency spectrums. For regulatory, policy, or strategy purposes, the portfolio manager needs to know the duration of the portfolio. Since different market sectors may have different coupon frequencies, it is important that all calculations for the duration be done on a consistent basis.
Most bond portfolios are managed against a benchmark. The benchmark can be an index or it can be the peer group. In the cases of indices, such as the Barclays Aggregate Bond Index, the composition of the index is known on or before the last business day of a month for the following month. Portfolio managers can adjust the duration
