Chapter Three, Investment Analysis and Portfolio Management (AcFn 3201), Jig-Jiga University.

August, 2021 (2013

E.C.)
Unit-Three.
Fixed income securities.
Definition:
 An investment that provides a return in the form of fixed periodic payments and the
eventual return of principal at maturity.
 Unlike a variable-income security, where payments change based on some underlying
measure such as short-term interest rates, the payments of a fixed-income security are known
in advance.
An example of a fixed-income security would be a 5% fixed-rate government bond where a
$1,000 investment would result in an annual $50 payment until maturity when the investor
would receive the $1,000 back.
 Generally, these types of assets offer a lower return on investment because they guarantee
income.
 Because the income you receive from a bond is generally fixed at the time the bond is
created, bonds are often considered fixed-income investments.
3.1. Bond characteristic.
Bonds are securities with following basic characteristics:
 They are typically securities issued by a corporation or governmental body for specified
term. Bonds become due for payment at maturity, when the par value/face value of bonds
are returned to the investors. Par value or face value is the amount you’re lending and
expect to be paid back, usually $1,000 per bond, but sometimes in multiples of $1,000
 Bonds usually pay fixed periodic interest installments, called coupon payments. Some
bonds pay variable income. Interest is the percentage of the loan amount the borrower will
pay you for the use of your money over the term
 When investor buys bond, he or she becomes a creditor of the issuer. Buyer does not gain
any kind of ownership rights to the issuer, unlike in the case with equity securities.
The main advantages of bonds to the investor:
• They are good source of current income.
• Investment to bonds is relatively safe from large losses.
• In case of default, bondholders receive their payments before shareholders can be
compensated.
A major disadvantage of bonds is that potential profit from investment in bonds is limited.
Currently in the financial markets there are a lot of various types of bonds and investor must
understand their differences and features before deciding what bonds would be suitable for
his/ her investment portfolio.
3.2. Bond price.
• A bond is a debt instrument: It pays periodic interest payments based on the stated
(coupon) rate and return the principal at the maturity.

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• Cash flows on a bond with no embedded options are fairly certain and the price of bond
equals the present value of future interest payments plus the present value of the face
value (which is returned at maturity) based on the interest rate prevailing in the market.
• The present value of interest payments is calculated using the formula for present value
of an annuity and the present value of the face value (also called the maturity value) is
calculated using the formula for present value of a single sum occurring in future.
• If r is the interest rate prevailing in the market, c is the coupon rate on the bond, t is the
time periods occurring over the term of the bond and F is the face value of the bond, the
present value of interest payments is calculated using the following formula:
Present Value of Interest Payments = c × F 1 − (1 + r)-t
×  r
• The present value of the face value (i.e. the maturity value) is calculated as follows:
F
Present Value of Face Value of a Bond = (1+r)t

Therefore, the price of a bond is given by the following formula:

Present Value of Interest Payments + Present Value of Face Value of a Bond. So that;
1 − (1 + r)-t F
Price of bonds = c × F ×  +
R (1 + r)t

Example 1:  Bond with annual coupon payments;

Company A has issued a bond having face value of $100,000 carrying annual coupon rate of
8% and maturing in 10 years. the market interest rate is 10%. The price of the bond is
calculated as the present value of all future cash flows:
1 − (1 + 10%)-10 $100,000
Price of Bond = 8% × $100,000 × +
10% (1 + 10%)10

= 8% x $100,000 x 1- (0.3855) + $100,000 = 8% x $100,000 x 0.6145 +38550.50

0.1 2.594 0.1
= 8% x $100,000 x 6.145 +38550.50 = 49160 +38550.50=$ 87,710.50

Example 2: Bond with semiannual coupon payments;

Company S has issued a bond having face value of $100,000 carrying coupon rate of 9% to
be paid semiannually and maturing in 10 years. The market interest rate is 8%.
Since the interest is paid semiannually the bond interest rate per period is 4.5% (= 9% ÷ 2),
the market interest rate is 4% (= 8% ÷ 2) and number of time periods are 20 (= 2 × 10).
Hence, the price of the bond is calculated as the present value of all future cash flows as
shown below:
1 − (1 + 4%)-20 $100,000
Price of Bond = 4.5% × $100,000 ×  +
4% (1 + 4%)20
Price of Bond = $106,795.

3.3. Bond yield.

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In the bond market, investment decisions are made more on the bond’s yield than its price
basis.
There are three widely used measures of the yield:
• Current Yield.
• Yield-to-Maturity.
• Yield- to- Call. 
Current yield (CY) is the simplest measure of bond‘s return and has an imitated application
because it measures only the interest return of the bond.
The interpretation of this measure to investor:
Current yield indicates the amount of current income a bond provides relative to its market
price.
• CY is estimated using formula; CY = I / Pm.
Where: I - annual interest of the bond.
Pm - current market price of the bond.

Yield- to- Maturity (YTM) is the most important and widely used measure of the bonds
returns and key measure in bond valuation process.
• YTM is the fully compounded rate of return earned by an investor in bond over the life
of the security, including interest income and price appreciation.
• YTM is also known as the promised yield-to- maturity.
• Yield-to-maturity can be calculated as an internal rate of return of the bond or the
discount rate, which equalizes present value of the future cash flows of the bond to its
current market price (value).
• Then YTM of the bond is calculated from this equation:

P=
Where:
P - current market price of the bond;
n - Number of periods until maturity of the bond;
Ct - coupon payment each period;
YTM - yield-to-maturity of the bond.
Pn - face value of the bond.
“0r”
c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-Y + B(1 + r)-Y = P.
 Where; c = annual coupon payment (in dollars, not a percentage).
Y = number of years to maturity
B = par value
P = purchase price.
r= Yield-to-maturity of the bond(YTM).

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Example: Suppose your bond is selling for $950, and has a coupon rate of 7%; it matures in 4
years, and the par value is $1000. What is the YTM?
The coupon payment is $70 (that's 7% of $1000), so the equation to satisfy the Yield to
Maturity is:
70(1+r)-1+70(1+ r)-2+70(1+r)-3+70(1 + r)-4+1000(1 + r)-4  = 950

Of course you aren't really going to solve this, so you just use the pop up calculator instead
(Trial and Error), and find that r is 8.53%.
• If you want, you can plug this number back into the above equation, just to make sure
it checks out.
• One thing to notice is that the YTM is greater than the current yield, which in turn is
greater than the coupon rate. (Current yield, CY = I / Pm = $70/$950 = 7.37%).
Therefore, this will always show that a bond is selling at a discount.
In fact, you will always have this:
Bond Selling At . . .
• Discount; Coupon Rate < Current Yield < YTM
• Premium; Coupon Rate > Current Yield > YTM
• Par Value; Coupon Rate = Current Yield = YTM
Approximate Yield to Maturity:
Approx YTM = C + F-P/n_
F+P/2
Example of Yield to Maturity Formula;
• The price of a bond is $920 with a face value of $1000 which is the face value of many
bonds. Assume that the annual coupons are $100, which is a 10% coupon rate, and that
there are 10 years remaining until maturity.
This example can be solved by using the approximate formula; Approx YTM = C + F-P/n =
F+P/2
$100 + $1000 - $920/10 = $100 + $80/10 = $108 = 0.1125 “or” 11.25%.
$1000 + $920/2 $1920/2 $960
After solving this equation, the estimated yield to maturity is 11.25%.

Yield- to- Call  — As the callable bond gives the issuer the right to retire the bond
prematurely, so the issue may or may not remain outstanding to maturity. Thus the YTM may
not always be the appropriate measure of value. Instead, the effect of the bond called away
prior to maturity must be estimated. For the callable bonds the yield-to-call (YTC) is used.
YTC measures the yield on the bond if the issue remains outstanding not to maturity, but
rather until its specified call date. YTC can be calculated similar to YTM as an internal rate of
return of the bond or the discount rate, which equalizes present value of the future cash flows
of the bond to its current market price (value). Then YTC of the bond is calculated from this
equation:
n
P = Σ Ct / (1 + YTC) t + Pc / (1 + YTC)
t=1

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where: P - current market price of the callable bond;
n - number of periods to call of the bond;
Ct - coupon payment each period before the call of the bond;
YTC - yield-to-call of the bond;
Pc - call price of the bond.

But the result from the estimation of the yields using the current market price could be a
relevant measure for investment decision making only for those investors who believe that
the bond market is efficient. For the others who do not believe that market is efficient, an
important question is if the bond in the market is over valuated or under valuated? To
answer this question the investor need to estimate the intrinsic value of the bond and then
try to compare this value with the current market value. Intrinsic value of the bond (V)
can be calculated from this equation:
n
V = Σ Ct / (1 + YTM*) t + Pn / (1 + YTM*)ⁿ
t=1
where: YTM* - appropriate yield-to-maturity for the bond, which depends on the
investor’s analysis – what yield could be appropriate to him/ her on this
particular bond;
n - number of periods until maturity of the bond;
Ct - coupon payment each period;
Pn - face value of the bond.

The decision for investment in bond can be made on the bases of two alternative approaches:
(1) using the comparison of yield-to-maturity and appropriate yield-to-maturity or (2) using
the comparison of current market price and intrinsic value of the bond (similar to decisions
when investing in stocks). Both approaches are based on the capitalization of income method
of valuation.
(1) approach:
_ If YTM > YTM* - decision to buy or to keep the bond as it is under valuated;
_ If YTM < YTM * - decision to sell the bond as it is over valuated;
_ If YTM = YTM * - bond is valuated at the same range as in the market
and its current market price shows the intrinsic value.
(2) approach:
_ If V > P - decision to buy or to keep the bond as it is under valuated;
_ If V < P - decision to sell the bond as it is over valuated;
_ If P = V - bond is valuated at the same range as in the market and its
current market price shows the intrinsic value.

3.4. Risks in bond.

Many people believe they can't lose money in bonds. Wrong! Although the interest payments
you'll get from owning a bond are "fixed," your return is anything but Here are the major risks
that can affect your bond's return:
1. Inflation risk

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Since bond interest payments are fixed, their value can be eroded by inflation. The longer the
term of the bond, the higher the inflation risk.
On the other hand, bonds are a classic deflation hedge; deflation increases the value of the
dollars that bond investors get paid.
2. Interest rate risk.
• Bond prices move in the opposite direction of interest rates. When rates rise, bond prices
fall because new bonds are issued that pay higher coupons, making the older, lower-
yielding bonds less attractive.

Conversely, bond prices rise when interest rates fall because the higher payouts on the old
bonds look more attractive relative to the lower rates offered on newer ones.
• The longer the term of the bond, the greater the price fluctuation - or volatility - that
results from any change in interest rates.
• But what if interest rates fall and the issuer of your bond wants to lower its interest
costs? This brings us to the next type of risk . . .
3. Call risk.
• Many corporate and muni bond issuers reserve the right to redeem, or "call," their bonds
before they mature, at which point the issuer is required to pay bondholders only par
value. Typically, this happens if interest rates fall and the issuer sees it can lower its
costs by selling new bonds with lower yields.
• If you happen to own one of the called bonds, not only do you get less than the market
price of the bond, but you also have to find a place to reinvest the money.

Because of the risk that you won't get the income you expect, callable bonds usually pay
a higher rate of interest than comparable, non-callable bonds.

So, when you buy bonds, make sure to ask not only about the time to maturity, but also
about the time to a likely call.
4. Credit risk.
• This is the risk that your bond issuer will be unable to make its payments on time - or at
all - and it depends on the type of bond you own and the borrower's financial health.
U.S. Treasuries are considered to have virtually no credit risk, junk bonds the highest.
• Bond rating agencies such as Standard & Poor's and Moody's evaluate corporations and
municipalities for their credit worthiness. Bonds from the strongest issuers are rated
triple-A.
Junk bonds are rated BA and lower from Moody's, or BB and lower from S&P.

5. Liquidity risk.
• In general, bonds aren't nearly as liquid as stocks because investors tend to buy and hold
bonds rather than trade them.

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While there is always a ready market for super-safe Treasuries, the markets for other
bonds, especially munis and junk bonds, can be highly illiquid.

If you are forced to unload a thinly-traded bond, you will probably get a low price.

6. Market risk.
As with most other investments, bonds follow the laws of supply and demand. The more
popular or less plentiful a bond, the higher the price it commands in the market. During
economic meltdowns in Asia and Russia, for example, the price of safe-haven U.S. Treasuries
rose dramatically.

You can't eliminate these risks altogether. Now that you understand them, you may be able to
reduce their impact by using some of the methods devised

3.4. Rating of bonds.

Definition.
 It is a grade assigned to a bond that indicates its credit quality.
 The grading of a debt security with respect to the issuer's ability to meet interest 
and principal requirements in a timely manner is called bond rating. 
 It is a rating system used by investment research firms such as Fitch Ratings, Moody's
Investors Service, and Standard and Poor's to reflect an opinion on
the creditworthiness of a company issuing a debt instrument. Each rating service has
developed its own variation on a letter-based designation system, but in general they
follow a similar pattern in which AAA denotes the least risk of default on the debt and
a rating of C or lower denotes the highest.
Independent agencies assess thelikelihood that bond issuers are likely to default on their loans 
or interest payments. The three major Independent agencies which provide the rating services
are;
 Fitch, 
 Moody's, and 
 Standard &Poor's.

3.5. Analysis of Convertible bonds.

Definition:
Convertible bonds are bond that can be converted into a predetermined amount of the
company's equity at certain times during its life, usually at the discretion of the bondholder.
As the name implies, convertible bonds, or converts, give the holder the option to exchange
the bond for a predetermined number of shares in the issuing company.

When first issued, they act just like regular corporate bonds, with a slightly lower interest
rate. Because convertibles can be changed into stock and thus benefit from a rise in the price
of the underlying stock, companies offer lower yields on convertibles.

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If the stock performs poorly there is no conversion and an investor is stuck with the bond's
sub-par return (below what a non-convertible corporate bond would get).
• As we mentioned earlier, convertible bonds are rather complex securities for a few
reasons.
First, they have the characteristics of both bonds and stocks, confusing investors right off the
bat. Then you have to weigh in the factors affecting the price of these securities; these factors
are a mixture of what is happening in the interest-rate climate (which affects bond pricing)
and the market for the underlying stock (which affects the price of the stock).

Conversion Ratio.
Most convertible bonds allow owners to convert bonds into stock according to a ratio set at
the time the bond was issued which is known as “conversion ratio”.

The conversion ratio (also called the conversion premium) determines how many shares can
be converted from each bond. This can be expressed as a ratio or as the conversion price, and
is specified in the indenture along with other provisions.

Example: A conversion ratio of 45:1 means one bond (with a $1,000 par value) can be
exchanged for 45 shares of stock.

Or it could be specified at a 50% premium, meaning that if the investor chooses to convert the
shares, he or she will have to pay the price of the common stock at the time of issuance plus
50%.

Forced Conversion.
One downside of convertible bonds is that Most convertible bonds have call risk; the issuer
can forcibly redeem the bond before maturity at a preset price, the call price.

Issuers often set the call price just above a conversion price based on the face value of the
bond. Issuers then call convertible bonds when the conversion value reaches the call price,
thereby forcing bondholders to convert their bond into shares.

This attribute caps the capital appreciation potential of a convertible bond.

The sky is not the limit with converts as it is with common stock.

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