Investment in Fixed Income Securities

Learning GoalsDetermine what is bond and the type of

bondHow bond is being ratingBond valuation model

IntroductionLiabilities, or “publicly traded IOUs”

Also called “fixed income securities” since payments are fixed amounts

Bondholders are lending money to the issuer.

Borrower agrees to repay a fixed amount of principal at a predetermined maturity date

Borrower agrees to pay a fixed amount of interest over a specified period of time

bonds can be described as negotiable, publicly traded, long term debt security and fixed income securities.

Bonds provide two kinds of income:Current income – derive from interest

payments received over the life of the issueCapital gain – derived when the redeemable

price of more than principal. Usually earned when ever market interest fall.

Features of BondsCoupon is the amount of annual interest

incomeCurrent Yield is a measure of the annual

interest income a bond provides relative to its current market price

Principal (par value) is the amount of capital that must be repaid at maturity

Maturity Date is the date when a bond matures and the principal must be repaidTerm Bond is a bond that has a single maturity dateSerial Bond is a bond that has a series of different

maturity dates

Zero-Coupon Bond has no couponsSold at discount from par value and then increase

in value over time at a compound rate of return at maturity

Pay nothing to the investor until the issue matures.

Treasury Notes is a debt security originally issued with a maturity from 2 to 10 years

Call feature allows the issuer to repurchase the bonds before the maturity dateFreely callableNoncallableDeferred call

Call premium is the amount added to bond’s par value and paid upon call to compensate bondholders

Call price is the bond’s par value plus call premium

Refunding provision prohibits the premature retirement of an issue from proceeds of a lower-coupon refunding bond

Sinking fund stipulates how a bond will be paid off over time

Applies only to term bonds

Issuer is obligated to pay off the bond systematically over time

Secured and Unsecured DebtSecured debt is backed by pledged collateralSenior bonds are backed by legal claim to

specific assetsMortgage bonds are backed by real estate.Collateral trust bonds are backed by securities

(stocks, bonds) held in trust by a third partyEquipment trust certificates are backed by

specific pieces of equipment, such as railcars or airplanes

First and refunding bonds - a combination of first mortgage and junior lien bonds

Unsecured debt is backed only by the promise of the company to pay

Junior bonds are backed only by promise and good faith of the issuer to pay

Debenture is an unsecured (junior) bondSubordinated debentures are unsecured bonds

whose claim is secondary to other claimsIncome bond requires interest to be paid only

after a specific amount of income has been earned

Exposure to RiskInterest Rate Risk is the chance that changes

in interest rates will affect the bond’s valuePurchasing Power Risk is the chance that

bond yields will lag behind inflation ratesBusiness/Financial Risk is the chance the

issuer of the bond will default on interest and/or principal payments

Liquidity Risk is the risk that a bond will be difficult to sell at a reasonable price

Call Risk is the risk that a bond will be “called” (retired) before its scheduled maturity date

Default risk refers to the inability of the issuer to pay the promised interest and principal payments as stated in the bond indentures.

Reinvestment rate of interest is the inability to reinvest the interest payments at the same rate as used in the YTM calculation.

Maturity risk refers to the risk involved in holding bonds for a long maturity period. Bond with longer maturities has bigger risk than bonds with shorter maturities.

Bond RatingsBond ratings are letter grades that designate investment

qualityPrivate bond rating agencies assign ratings based upon

financial analysis of the bond issuer. It is assigned to a bond issue by rating agency (ex: S&P, Moody’s, RAM, MARC)

Investment grade ratings are received by financially strong companies

Junk bond ratings are received by companies making payments, but default risk is high

Split ratings occur when a bond issue is given different ratings by major rating agencies

Higher rated bonds have less default risk and pay lower interest rates

How rating works (RAM and MARC)RAM (AAA, AA, A, BBB) - long term ratings; (P1,

P2, P3, NP) - short term ratingsMARC (AAA, AA, A, BBB) - long term ratings;

MARC-1, MARC-2, MARC-3, MARC-4) - short term rating

B/B or C/C are reserved junk bonds. Means that although the principal and interest payments on the bonds are still being met in a timely fashion, the risk of default is relatively high.

D rating class is meant to designate bonds that are already in default or getting very close to it.

Principles of Bond Price BehaviorPrice of a bond is a function of its coupon rate, its

maturity, and market movements in interest rates

Longer maturities move more with changes in interest rates

Premium bond has a market value that is above par valueOccur when market interest rates are below bond’s

coupon rate

Discount bond has a market value that is below par valueOccur when market interest rates are above bond’s

coupon rate

Advantages and Disadvantages of Investing in Bonds

AdvantagesReturns are quite high compared to common

stockTax shield can be obtained from certain issuesBonds are senior to common stock on claims of

assets of issuerDisadvantages

Coupons are usually fixed for the life of the bondBonds’ return are exposed to interest rate riskMost bonds have no voting rights

Bond Valuation and AnalysisPrice or value of a bond is inversely related to

the interest rate. As interest rate increase (decrease), the price decrease (increase).

Value of a bond will be less than the face value of the bond if the investor’s required rate of return is above the coupon rate

Bond with longer maturities has greater interest rate risk than bonds with shorter maturities.

Value of the bond also depends on the pattern of its cash flows

Valuation Models for BondsCoupon rate

Coupon rate is the stated annual interest rate by which the company will pay annually to the bond holders. It represents the percent of face value as annual interest to investors.

Current yield Current yield is a simple return measure and it is not widely

used. The current yield indicates the return of the bondholder will get in terms of the current market price. It is given as:

Current yield = Coupon amount Current priceHolding period return

Holding period return is the average of return earned for holding a bond for a certain period. It is expressed as follows:

HPR =total interest payment + (selling price – purchase price)

Purchase price

Yield to Call is the interest rate that will make the present

value of the bond’s interest payments and call price equal to its current market price. 

Yield to Maturityis the interest rate that makes the present value

of the bond’s interest payments and principal equal to its current market price. The YTM for bond is pays interest annually.

When YTM = coupon rate, the bond will sell at par

When YTM > coupon rate, the bond will sell at discount

When YTM < coupon rate, the bond will sell at premium 

Formula for YTM YTM = C/m + PV - MP

n x m PV + MP 2

Where,CP = annual coupon ratePV = Par value (RM1, 000)m = How many times the coupon payment is

paid in a yearn = Years remaining to maturityMP = Market price

P = (I x PVIFA k,n) + (PV x PVIF k,n)

Example: consider 20-year, 9 ½ % bond that is being priced to yield 10%. From this we know the bond pays an annual coupon of 9 ½ % or

(1,000 x 9 ½ % = RM 95), has 20 years left to maturity, and should be

priced to provide a market yield of 10%. Bond price = (RM95 x PVIFA 10%, 20) + (RM1, 000 x PVIF 10%, 20)

= (RM95 x 8.514) + (RM1, 000 x 0.1486) = RM957.83