Chapter Three

Analysis of Bond
 Fixed Income Investment
• Fixed income broadly refers to those types of
investment security that pay investors fixed interest
or dividend payments until its maturity date.
• At maturity, investors are repaid the principal
amount they had invested.
• Unlike equities that may pay no cash flows to
investors, or variable-income securities, where can
payments change—the payments of a fixed-income
security are known in advance.
 Types of Fixed Income Products
•Here are the most common types of fixed income products:
• Treasury bills (T-bills) are short-term fixed-income
securities that mature within one year that do not pay
coupon returns. Investors buy the bill at a price less than its
face value and investors earn that difference at the maturity.
• A certificate of deposit (CD) is a fixed income vehicle
offered by financial institutions with maturities of less than
five years. The rate is higher than a typical saving account.
• Bonds is a fixed income instrument that represents a
loan made by an investor to a borrower (typically
corporate or governmental).
 What Is a Bond?
• A bond is a fixed income instrument that represents a
loan made by an investor to a borrower (typically
corporate or governmental).
• Bonds are used by companies, municipalities, states,
and sovereign governments to finance projects and
operations.
• Many corporate and government bonds are publicly
traded; others are traded only over-the counter
(OTC) or privately between the borrower and lender.
 Properties of Bonds
• Every bond, irrespective of issuer or type, has a set of basic properties.
• Maturity- is the date on which the bond issuer will have repaid all of
the principal and will redeem the bond.
• Coupon Rates- is the stated annual interest rate as a percentage of the
price at issuance. Once a bond has been issued, its coupon never
changes.
• Coupon Dates are the dates on which the bond issuer will make
interest payments. Payments can be made in any interval, but the
standard is semiannual payments
• The par or redemption value- is the price at which bonds are first
issued.
 Categories of Bonds
•There are four primary categories of bonds sold in the markets..
 Corporate bonds are issued by companies.
 Municipal bonds are issued by states and municipalities.
Some municipal bonds offer tax-free coupon income for
investors.
 Government bonds -issued by the government Treasury.
 Agency bonds are those issued by government-affiliated
organizations such as Fannie Mae or Freddie Mac.
 Varieties of Bonds
• An increasing variety of bonds is available in the
marketplace.
• 1. Straight bonds- straight bonds are the basic fixed-
income investment.
• The owner receives interest payments of a
predetermined amount on specified dates, usually
every six months or every year following the date of
issue.
• The issuer must redeem the bond from the owner at its
face value, known as the par value, on a specific date.
 Varieties of Bonds

• 2. Zero-coupon bonds- Zero-coupon bonds do not pay

periodic interest. Instead, they are issued at less than par
value and are redeemed at par value, with the difference
serving as an interest payment.
• Zeros are designed to eliminate reinvestment risk, the
loss an investor suffers if future income or principal
payments from a bond must be invested at lower rates
than those available today.
• The owner of a zero-coupon bond has no payments to
reinvest until the bond matures, and therefore has
greater certainty about the return on the investment.
 Varieties of Bonds

• 3. Callable bonds- The issuer may reserve the right to call the
bonds at particular dates. A call obliges the owner to sell the
bonds to the issuer for a price, specified when the bond was
issued, that usually exceeds the current market price.

• 4. Puttable Bonds- Putable bonds give the investor

the right to sell the bonds back to the issuer at par
value on designated dates. This benefits the investor
if interest rates rise, so a putable bond is worth more
than an identical bond that is not putable.
 Varieties of Bonds

• 5. Convertible bonds- Under specified conditions and

strictly at the bondholder’s option, convertible bonds
may be exchanged for another security, usually the
issuer’s common shares.
 Junk bonds—also called high-yield bonds—are
corporate issues that pay a greater coupon due to the
higher risk of default. Default is when a company
fails to pay back the principal and interest on a bond
or debt security.
 Pricing Bonds
• A bond's price changes on a daily basis, just like that
of any other publicly-traded security, where supply and
demand in any given moment determine that observed
price.
•The price of a bond changes in response to changes in
interest rates in the economy. This is due to the fact that
for a fixed-rate bond, the issuer has promised to pay a
coupon based on the face value of the.
 Pricing Bonds
• To value a security, we discount its expected cash flows by the
appropriate discount rate.
• The cash flows from a bond consist of coupon payments until
the maturity date plus the final payment of par value.
 Pricing Bonds
• Assume an 8% coupon, 30-year maturity bond
with par value of $1,000 paying 60 semiannual
coupon payments of $40 each. Suppose that the
interest rate is 10% annually, then determine the
value of the bond.
• Price = $40 Annuity factor(5%, 60) + $1,000
PV factor(5%, 60)
• $757.17 + $53.54
• = $810.71
 Factors Affecting Bond Price/Interest
• Default Risk- the higher the default risk, the higher
the interest rate, the lower the default risk the lower
the interest rate.
• Taxability of Interest- interest income from securities
is taxable unless otherwise exempted. The tax-exempt
feature of securities is an attractive feature to an
investor because it reduces taxes and, therefore, the
interest is lower than a comparable-non tax exempted
issue.
 Factors Affecting Bond Price/Interest
• Attractive and Unattractive
• (1) call provision, the inclusion of a call provision benefits the
issuer by allowing it to replace that bond issue with a lower
interest cost bond issue should interest rates in the market
decline. For this reason, investors require compensation for
accepting reinvestment risk and they receive this
compensation in the form of a higher interest.
• (2) put provision, A bond issue with a put provision grants the
bondholder the right to sell the issue back to the issuer at par
value on designated dates. Hence, a bond issue that contains a
put provision will have a lower interest.
 Factors Affecting Bond Price/Interest

• (3) conversion provision; the conversion provision

allows the bondholder the opportunity to benefit from
a favorable movement in the price of the stock.
Hence, the conversion provision results in a lower
interest.
• Expected Liquidity; The greater the liquidity risk that
investors perceive there is with a particular bond
issue, the greater the interest or risk premium relative
to a comparable-maturity security.
 BOND YIELDS
• Yield to maturity (YTM): The discount rate
that makes the present value of a bond’s
payments equal to its price.
• This rate is often viewed as a measure of the
average rate of return that will be earned on a
bond if it is bought now and held until
maturity.
• To calculate the yield to maturity, we solve the
bond price equation for the interest rate given
the bond’s price.
BOND YIELDS
 BOND YIELDS
• For example, suppose an 8% coupon, 30-year bond is
selling at $1,276. What average rate of return would
be earned by an investor purchasing the bond at this
price if the par value is $1000?
• Solution;
• Given;
– Coupon =80
– Principal=1000
– Price=1276
– Number of coupons=30
 BOND YIELDS
• Coupon + (Principal-Price)/Number of coupons
(Principal +price)/2
• =80+(1000-1276)30
(1000+1276)/2
= 70.8/1138
=0.061
6.1%
 Risks in Bond
• Like any investment Bonds are subject to
diverse risks;
• Market Risk (interest rate risk): Interest rate
tends to vary over time, causing fluctuation in
bond prices.
• A rise in interest rate depress the market price
of outstanding bonds whereas a fall in interest
rate will push the market price up.
 Default Risk

•Default risk occurs when the bond's issuer is unable to

pay the contractual interest or principal on the bond in a
timely manner or at all.
•If the bond issuer defaults, the investor loses part or all
of their original investment plus any interest they may
have earned.
 Reinvestment Risk
•Another risk associated with the bond market is
called reinvestment risk.
•In essence, a bond poses a reinvestment risk to
investors if the proceeds from the bond or future cash
flows will need to be reinvested in a security with a
lower yield than the bond originally provided.
 Call Risk for Bond Investors

•Callable bonds have call provisions that allow the

bond issuer to purchase the bond back from the
bondholders and retire the issue.
•This is usually done when interest rates fall
substantially since the issue date.
•Call provisions allow the issuer to retire the old,
high-rate bonds and sell low-rate bonds in a bid to
lower debt costs.
 Inflation Risk
•This risk refers to situations when the rate of price
increases in the economy deteriorates the returns
associated with the bond. This has the greatest effect
on fixed bonds, which have a set interest rate from
inception.
•The interest rates of floating-rate bonds or floaters are
adjusted periodically to match inflation rates, limiting
investors' exposure to inflation risk.
 Enhancing Security

• An issuer frequently takes steps to reduce the risk

bondholders must bear in order to sell its bonds at lower
interest rate. There are three common ways of doing this:
• 1. Sinking funds- ensure that the issuer arranges to
retire some of its debt, on a prearranged schedule, prior
to maturity. The issuer can do this either by purchasing
the required amount of its bonds in the market at
specified times, or by setting aside money in a fund
overseen by a trustee, to ensure that there is adequate
cash on hand to redeem the bonds at maturity.
 Enhancing security

• 2. Bond insurance- is frequently sought by issuers with

unimpressive credit ratings. An issuer pays it a premium
to guarantee bondholders that specific bonds will be
serviced on time. With such guarantee, the issuer is able
to sell its bonds at a lower interest rate.
• 3. Covenants- are legally binding promises made at the
time a bond is issued. A simple covenant might limit the
amount of additional debt that the issuer may sell in
future, or might require it to keep a certain level of cash
at all times.
 Bond Rating
• Before issuing bonds in the public markets, an issuer will
often seek a rating from one or more private ratings
agencies.
• The selected agencies investigate the issuer’s ability to
service the bonds such as financial strength, the intended
use of the funds, the political and regulatory environment,
and potential economic changes.
• After completing its investigation, an agency will issue a
rating that represents its estimate of the default risk.
Three well-known companies, Moody’s Investors Service
and Standard & Poor’s.
 Pros & Cons
•Pros
 Steady income stream
 More stable returns than stocks
 Higher claim to the assets in bankruptcies
•Cons
 Returns are lower than other investments
 Credit and default risk exposure
 Susceptible to interest rate risk
 Sensitive to Inflationary risk