Bond valuation principles and methods

Finance

The WSJ Treasury rate table is as follows. Note that WSJ doesn' t list the 15 and 20-year Treasury rates on its table; Yahoo was used for those instead.

Rate

This gives the following yield curve:

This is a normal yield curve. The yield curve reflects the expectations of future interest rates. At present, the yield curve shows low interest rates in the short-term, then an acceleration of rates in the longer term indicating that these rates are expected to rise slightly in the next few years, before the curve starts to flatten out at its tail. This illustrates the normal relationship that the longer the term is the higher the rate will be.

The portfolio is as follows:

Coupon

Mat

YTM

Current Yield

Duration

ModD

Treasury

4.125%

15-May-15

0.075%

3.964%

Treasury

3.125%

15-May-19

1.646%

2.918%

Freddie Mac

1.250%

12-May-17

0.692%

1.230%

Federal Farm Credit

2.125%

15-May-23

2.689%

2.225%

8.22

8.11

JP Morgan

3.625%

13-May-24

3.540%

3.599%

8.48

8.33

GE Capital

5.250%

15-May-34

4.346%

4.688%

13.05

12.78

6.39

6.30

a. The duration of the portfolio is the weighted average of the durations in the portfolio. In this case, that number comes out to 6.39, the mean of the six durations.

b. That would be quite something if interest rates fell 100 bps, considering where short-term rates are right now. But this portfolio would gain in value especially those securities that are further out. Half of this portfolio is in 9,10, and 20 years securities that are quite vulnerable to interest rate changes, but they would benefit from a rate drop.

c. For this exercise we want to take advantage of the volatility, because falling rates will increase the value of the bonds. Thus, the more of the higher duration bonds, the better the portfolio will perform.