Chapter three

Fixed Income Securities

What are fixed Income
Securities?
A fixed income security is a financial obligation of
an entity that promises to pay a specified sum of
money at specified future dates.
The cash flows promised to the buyer of fixed
income securities represent contractual obligations
of the respective issuers.
The entity promising the payment is called the
issuer of the security
Two categories of fixed income securities:
Debt obligationsBond s
Preferred Stock
 Debt markets
Debt markets are used by both firms and
governments to raise funds for long-term
purposes, though most investment by firms is
financed by retained profits.
Bonds are long-term borrowing instruments for
the issuer.
Major issuers of bonds are governments
(Treasury bonds in US, gilts in the UK, Bunds in
Germany) and firms, which issue corporate bonds
 Meaning of a Bond

Bond: is a debt instrument with periodic payments

of interest and repayment of principal at maturity

It is a debt instrument requiring:

the issuer (borrower)to repay to the investor
(lender)
the amount borrowed plus interest
over some specified period of time.
 Types of bonds
Debentures: The term debentures applied to any
unsecured long-term debt.
Mortgage bonds: is a bond secured by a lien on real
property.
Euro bonds. These are bonds denominated in euros and
issued in the euro currency area. If bonds denominated in
euros would be issued outside the euro currency area, they
would be euro eurobonds.
Floating rate notes (FRNs). These are corporate bonds
where the coupon can be adjusted at pre determined
intervals.
Zero coupon bonds: allow the issuing firm to issue
bonds at a substantial discount from their face value
with a zero coupon rate.
Junk bonds: are high-risk debt with very low
ratings. Junk bonds are also called high-yield bonds
for the high interest rates they pay the investor.
Eurobonds- are bonds issued in a country other
than that of the currency of denomination. Thus
bonds issued in US dollars in London are eurobonds,
as are yen bonds issued in New York.
 Callable and putable bonds.
Callable bonds can be redeemed at the
issuers discretion prior to the specified
maturity redemption) date.
Putable bonds can be sold back to the
issuer on specified dates at the holders
discretion, prior to the redemption date.
Convertible bonds. These are usually corporate
bonds, issued with the option for holders to
convert into some other asset on specified terms
at a future date.
Bond characteristics

Par value: is its face value that is returned

to the bondholder at maturity.

Coupon Interest Rate: indicates the

percentage of the par value of the bond that
will be paid out annually in the form of
interest.
Bond characteristics

Term to Maturity: indicates the length

of time until the bond issuer returns the par
value to the bondholder and terminates or
redeems the bond.
Current yield: refers to the ratio of
the annual interest payment to the
bonds current market price
 Characteristics of Bonds

Price changes as market interest changes.

If market rates rise, people prefer to
hold the new, higher-yielding issues
than existing bonds.
Existing bonds will be sold and their
price will fall.
Interest payments are commonly periodic
(semiannual)
Bond investors receive full face amount
when bonds mature
Zero coupon bonds no periodic
payment (no interest reinvestment rate)
Originally sold at a discount
Bond indenture

Bond indenture: a legal and binding contract

between a bond issuer and the bondholders
The bond indenture describes the details of a
bond issue:
Description of the loan (interest rate, maturity
date)
Terms of repayment
Collateral
Protective covenants
Default provisions
 Bond market

Debt markets include:

Primary markets for bonds, i.e. the markets in which
newly issued instruments are bought,
Secondary markets , in which existing or second hand
instruments are traded.
Majority of world bond markets have different institutional
arrangements for the issue and trading of government bonds
and corporate bonds.
The reason is that governments should be able to sell the
debt, which they use for budgetary and other purposes.
 Bond valuation
Book value : is the value of an asset as shown on a
firms balance sheet.
Liquidation value is the dollar sum that could be
realized if an asset were sold individually and not as
part of a going concern.
The intrinsic/Discounted Model/economic value of
an asset ,also called the fair value is the present
value of the assets expected future cash flows.
This value is the amount an investor should be
willing to pay, given the amount, timing, and
riskiness of future cash flows.
 Bond valuation
The value of a bond is the present value of the
expected cash flows on the bond, discounted at an
interest rate that is appropriate to the riskiness of
that bond.
It is the intrinsic value or the fair value of the
bond.
As interest rates rise, the price of a bond will decrease and vice
versa.
Valuation of bond is usually made by the bond seller/issuer so as
to determine the price at which the bond should be sold.
Bond Valuation

Generally, value of financial asset is

affected by three elements:
1. The amount and timing of the
asset's expected cash flows
2. The riskiness of these cash flows
3. The investor's required rate
(YTM) of return for undertaking the
investment
Bond valuation formula

Coupon t .is coupon payment at end of time t

r is the period discount rate(IRR/YTM/RRR).
N is the number of periods remaining .
 Bond valuation

From valuation formula, there are three

basic steps in the valuation process:
Step l: Estimate the Coupon interest payment (Ct ),
which is the amount and timing of the future cash
flows the security is expected to provide.
Step 2: Determine k, the investor's required rate of
return (YTM).
Step 3: Calculate the intrinsic value, V, as the
present value of expected future cash flows
discounted at the investor's required rate of return.
 Typically a single rate, the redemption yield or
redemption yield, is applied to discounting all future
cash flows.
The redemption yield of a bond could be viewed as an
average of discount rates applicable to the various
future cash flows.
The redemption yield indicates the average annual
return to be received by an investor holding a bond to
maturity.
The rate of discount is the required rate of return from
a bond.
The required rate of return can be regarded as the sum
of the yield on bonds that are free of default risk
(government bonds) and a risk premium to reflect
the default risk of the bond being valued.
 Example 1
A bond pays a coupon of 4% every six months,
and 100 birr will be repaid at maturity. There
are two years to maturity and the next coupon
is due in six months.
The redemption yield (yield to maturity or IRR/RRR) on
similar bonds is 6% p.a.
What is the fair price/intrinsic value of the bond?
An interest rate of 6% p.a. indicates a rate of 3% per six
month period.
P = 4/(1,03) + 4/(1,03)2 + 4/(1,03)3 +4/(1,03)4+ 100/(1,03)4
P = 3,88 + 3,77 + 3,.66 + 3,55 + 88.85 = 103,71 Birr
 Example 2
Consider a $1,000 bond issued by
Ethiopian Airlines with a maturity date
of Dec 31, 2027 and a stated coupon rate
of 9 percent. On Jan 1, 2015, with 12
years left to maturity, investors owning
the bonds were requiring an 8 percent
rate of return.
What is the value of the bond on Jan
1, 2015?
 Basic Terminologies

Clean price - the price of a bond

ignoring any interest which may have
accrued since the last coupon payment.
Dirty price - the price of a bond,
including any accrued interest.
Quoted prices are usually clean prices
whereas the price to be paid is the dirty
price.
 Yield on bonds

The yield/income/profit on bonds are

expressed commonly in two forms:
Yield to maturity or redemption yield;
interest yield/running/current yield.
Interest/current yield - the return on a bond
taking account only of the coupon payments.
Yield to maturity or redemption yield: The
return on a bond taking account of the coupon cash
flows and the capital gain or loss at redemption.
Yield (yield to maturity, YTM)

The (quoted, stated) discount

rate over a year.
Determined by the market.
Time-varying.
Yield to Maturity
Yield to maturity is expected total rate
of return if investor were to buy and
hold the bond until maturity date.
Internal rate of return of the bond
that equates the present value of the
cash flow with the price of the bond.
Solve for I in
Bond price = PV of Annuity (pmt, I, N) + PV (FV , I, N)
Example:

Consider a bond with a 10%

annual coupon rate, 15 years to
maturity and a par value of
$1,000. The current price is
$928.09.
What is the Yield to maturity on
the bond?
 Current Yield
The current yield:
Measures only the return associated with
the interest payments
Current Yield = annual interest
Current bond price
Does not include the anticipated capital
gain or loss resulting from the difference
between par value and the purchase price
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Current Yield (contd)

For a discount bond, the yield to

maturity is greater than the
current yield
For a premium bond, the yield
to maturity is less than the
current yield
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Example:

Consider a bond with a 10%

annual coupon rate, 15 years to
maturity and a par value of
$1,000. The current price is
$928.09.
Will the yield to maturity be
more or less than current yield?
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Bond Risks

Risks on a bond are the

following
Interest rate risk
Default risk
Price risks
Convenience risks 29
Interest Rate Risk

Interest rate risk is the chance of loss

because of changing interest rates
The relationship between bond prices and
interest rates is inverse
If market interest rates rise, the market price of
bonds will fall (Malkiels theorems)
Bonds with Longer term to maturity have
more interest rate risk (Malkiels theorems)
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Default Risk

Default risk measures the likelihood

that a firm will be unable to pay the
principal and interest on a bond
Standard & Poors Corporation and
Moodys Investor Service are two
leading advisory services monitoring
default risk
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Default Risk (contd)

Investment grade bonds are

bonds rated BBB or above
Junk bonds are rated below BBB
The lower the grade of a bond,
the higher its yield to maturity

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Convenience Risk

Convenience risk refers to added demands

on management time because of:
Bond calls

The need to reinvest coupon payments

The difficulty in trading a bond at a reasonable

price because of low marketability
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Call Risk

If a company calls its bonds, it retires its

debt early

Call risk refers to the inconvenience of

bondholders associated with a company
retiring a bond early
Bonds are usually called when interest rates
are low

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Reinvestment Rate Risk

Reinvestment rate risk refers to the

uncertainty surrounding the rate at which
coupon proceeds can be invested

The higher the coupon rate on a bond, the

higher its reinvestment rate risk

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Marketability Risk

Marketability risk refers to the difficulty of

trading a bond:
Most bonds do not trade in an active
secondary market
The majority of bond buyers hold bonds until
maturity
Low marketability bonds usually carry a
wider bid-ask spread
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 What are Bond Ratings?

A bond rating is an opinion of the

ability of issuer to honor their
financial obligation to make
coupon or principle payments.
The higher the rating the less
likely an issuer will default.
Who issues bond ratings?

Moodys Investor Services

1909 John Moody published a book of Railroad Investments that
included concise analysis of their relative investment quality.
Standard & Poors Corporation
1860 Henry Varnum Poor began supplying European investors
with financial information on their holdings in the developing
infrastructure of America
Fitch Ratings
1913 John Knowles Finch published Fitch Bond Book and
other books on financial markets. Fitch is credited with
introducing the AAA through D rating system now used
Comparison of Bond Ratings
Bond Ratings Investment Quality

High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more impact on
the firms ability to pay

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Bond Ratings - Speculative

Low Grade
Moodys Ba and B
S&P BB and B
Considered possible that the capacity to pay
will degenerate.
Very Low Grade
Moodys C (and below) and S&P C (and
below)
income bonds with no interest being paid, or
in default with principal and interest in arrears

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 Convertible Bonds

Securities which are issued as Debentures

Over time, may be converted into a certain
number of shares
Normally Freely Callable which may
lead to Forced Conversion

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 Convertible Bonds (continued)

Options at forced conversion

Convert to shares or
Redeem the Bond for cash at the stipulated call price
Conversion Privilege
Stipulates the conditions and nature of the conversion
Conversion period may have a limited life

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Convertible Bonds (continued)

Conversion Ratio
Number of common shares which the Bond
may be converted into
Example: A Ratio of 20 states that a $1000
Bond may be converted into 20 shares of the
Common
Implied conversion price is $50/ common Share
Ratios are normally fixed but can be variable

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 Sources of Value of Convertibles

Convertible Securities trade like a Common

Stock. They derive value from the Common
Stock.
Example: Assume a Convertible bond has a ratio of 20 and the
Stock sells for $45. what is the price of the convertible bond?
Soln
a ratio of 20 means for every point the stock goes up or
down the Convertible Security will move by 20x.
Hence, Price of Convertible Security in example is: $45 *
20 = $900
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