Investment in Fixed Income Securities

Learning Goals Determine what is bond and the type of bond How bond is being rating Bond valuation model

Introduction Liabilities, 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 issue Capital gain – derived when the redeemable price of more than principal. Usually earned when ever market interest fall.

Features of Bonds Coupon is the amount of annual interest income Current 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 repaid Term Bond is a bond that has a single maturity date Serial Bond is a bond that has a series of different maturity dates

Zero-Coupon Bond has no coupons Sold 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 date Freely callable Noncallable Deferred 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 Debt Secured debt is backed by pledged collateral Senior bonds are backed by legal claim to specific assets Mortgage bonds are backed by real estate. Collateral trust bonds are backed by securities (stocks, bonds) held in trust by a third party Equipment 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) bond Subordinated debentures are unsecured bonds whose claim is secondary to other claims Income bond requires interest to be paid only after a specific amount of income has been earned

Exposure to Risk Interest Rate Risk is the chance that changes in interest rates will affect the bond’s value Purchasing Power Risk is the chance that bond yields will lag behind inflation rates Business/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 Ratings Bond ratings are letter grades that designate investment quality Private 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 ratings MARC (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 Behavior Price 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 value Occur when market interest rates are below bond’s coupon rate Discount bond has a market value that is below par value Occur when market interest rates are above bond’s coupon rate

Advantages and Disadvantages of Investing in Bonds Advantages Returns are quite high compared to common stock Tax shield can be obtained from certain issues Bonds are senior to common stock on claims of assets of issuer Disadvantages Coupons are usually fixed for the life of the bond Bonds’ return are exposed to interest rate risk Most bonds have no voting rights

Bond Valuation and Analysis Price 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 Bonds Coupon 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 price Holding 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 Maturity is 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 rate PV= Par value (RM1, 000) m= How many times the coupon payment is paid in a year n= Years remaining to maturity MP= 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 ) = RM957.83