Modern Portfolio Theory and Investment Analysis, 9th Edition

21

Interest Rate Theory and the Pricing of Bonds

Until the last few decades, bond valuation was considered a rather dull subject. After all, a bond is easier to value than a stock because the issuer has agreed to a certain stream of payments (coupon and principal) and the bond has a maximum life (maturity).

Two factors led to a change in the difficulty of valuation. First, the timing of cash flows became more variable and their payment less certain because new types of instruments were issued. For example, bonds were issued with more complex options, which could affect both the timing and magnitude of the cash flows. In addition, more risky debt was issued with less certain cash flows. Second, valuation became more difficult because interest rates become more volatile. When interest rates go up, bond prices fall so that outstanding bonds offer returns similar to those earned by new issues. Interest rates were volatile during the 1970s and the 1980s. Accompanying this increased volatility were huge swings in the market value of bond portfolios. This increased volatility in market values was viewed as an opportunity and as a risk. Active bond portfolio management began to receive a lot of attention.

Table 21.1 presents the yearly holding period return that would have been earned by holding three different portfolios of bonds from 1999 to 2011. Returns from holding long-term government bonds were extremely volatile during this period. For example, the return from this portfolio was ...