Tutorial 6 & 7: Fixed Income Securities

1. Explain why bond value decreases when an interest rate rise

• Bond values decrease when interest rate rises and can be understood from the
following:

• When interest rates rise, new issues come to market with higher yields than older
securities, making those older ones worthless. Hence, their prices go down.

• When interest rates decline, new bond issues come to market with lower yields than
older securities, making those older, higher-yielding ones worth more. Hence, their
prices go up.

• Example: A zero-coupon bond trading at RM950 with a par value of RM1,000 (paid in
one year) has a current rate of return of 5.26 percent ((1000-950) / 950 = 5.26%).

• To pay RM950 for this bond, one must be satisfied with a 5.26 percent return.

• But his or her satisfaction with this return is tied to the bond market.

• Bond investors, like all investors, seek the highest possible return.

• If current interest rates rise, giving newly issued bonds a 10% yield, the 5.26 percent
zero-coupon bond would not only be less attractive, but also out of demand.

• Who wants a 5.26% yield when 10% will do?

• To attract demand, the price of the existing zero-coupon bond must fall to the same
level as current interest rates.

• In this case, the bond's price drops from RM950 (5.26%) to RM909 (10%) (using the
bond value formula).

2. Explain price rate risk and reinvestment risk. Discuss which types of bonds have
higher reinvestment risk.

• Price risk refers to the possibility that the market price of a bond will fall, typically
because of a market interest rate increase.

• The bond which has the highest interest rate risk is the bond which has the longest
duration. The higher the duration of the bond, the higher will be the interest rate risk.
 • The reinvestment risk is the risk that the future cash flows are reinvested at lower
rates of interest. The bond which has the highest reinvestment risk are the bonds
which have the longest duration and high coupon rate. So, if the interest rate falls,
the bondholder will receive the new lower coupon rate rather than the previous
coupon rate.

• Callable bonds are particularly prone to reinvestment risk due to the fact that they
are typically redeemed as interest rates decline.

3. Discuss how good credit rating agency to investors.

- Bond-rating is an important process because the rating alerts investors to the

quality and stability of the bond
- Credit rating gives an idea to the investors about the credibility and the risk factor of
the issuer.So, it might help the investors to decide whether to invest in such
companies or not.
- The rating agency regularly reviews the rating given to bonds. Here, investors can
decide whether to sell the existing bond or not.
- High credit rating gives assurance to the investors about the safety of the bond and
minimizes the risk of default.
- Credit rating enables investors to select or view bonds with ease from many
alternatives available.
- Credit rating enables an investor to save time and effort in analyzing the financial
strength of the issuer company - where investors can depend on the rating done by
a professional.

4. Explain what bond indenture is. Discuss the function of a trustee with respect to the
bond indenture.

The bond indenture is a contract between the issuer and the bondholder，specifying all the important
features of a bond, such as its maturity date ， timing of interest payments ， method of interest
calculation and callable or Convertible features and the characteristics of the bond ，the purpose of
the bond issue eg to finance project, working capital, to pay bank loans etc.

Function of a trustee

i. Making Interest and Principal Payments

This is the most visible aspect of a bond trustee ， who invoices and then collects these payments
from the bond issuer and disperses them to bondholders. The trustee holds all such funds until they
are disbursed and ensures that those on both sides of the transaction are satisfied in a timely manner
as promised.

ii. Compliance Officer

The bond trustee keeps accounts, sending monthly statements and answering questions from all
parties. The trustee must approve any document amendments so that they remain fair to both sides, a
key function given the complexity of some indentures。The trustee also ensures that all federal and
state requirements are met and terms carried out in a timely way.

iii. Representing Bondholders in Case of Default

In the worst-case scenario of a default, “the obligations and the authority of trustees increase
considerably。The trustee takes on a more discretionary role and is subject to ：higher legal norm
(the 'prudent person' standard). “Bond trustees serve as the central clearing house for all default-
related issues ， and are responsible for using all possible legal means to protect the interests of
bondholders.

5. By looking to the movement of market interest rate, explain your recommendation,

whether an investor should purchase or sell the bond.

● The market interest rates are negatively correlated with bond values.
● When the market interest rate rises, the value of bonds will decrease.
● When the market interest rate decreases, the bond price will increase.
● The investors should sell their existing bonds before the interest rate rises.
● The investors should purchase bonds before the interest rate drops.

6. Merdeka Steel 15 year, RM1000 par value bonds pay 8 per cent interest annually.
The market price of bonds is RM1085, and your required rate of return is 10
percent.

i. Determine the value of the bond.

Vb = (8% x 1000) [ (1- (1+0.1) ^-15) / 0.1]] + 1000 (1+0.1) ^-15

Vb = RM608.49 + RM239.39

Vb = RM847.88
ii. Should you purchase the bond?

The market price, RM1,085 exceeds the value of the bond, RM847.88. The bond is
not an acceptable investment. I will not purchase the bond.

7. You own a bond that pays RM100 in annual interest, with a RM1000 par value. It
matures in 15 years. Your required rate of return is 12 percent.

a. Calculate the value of the bond

Vb = 100 [ (1- (1+0.12) ^-15) / 0.12] + 1000 (1+0.12) ^-15

Vb = 681.09 + 182.70

Vb = RM863.79

b. How does the value change if your required rate of return

(i) increase to 15 per cent or

Vb = 100 [ (1- (1+0.15) ^-15) / 0.15] + 1000 (1+0.15) ^-15

Vb = 584.74 + 122.89

Vb = RM707.63

The value of the bond decreases.

(ii) decrease to 8 per cent?

Vb = 100 [ (1- (1+0.08) ^-15) / 0.08] + 1000 (1+0.08) ^-15

Vb = 855.95 + 315.24

Vb = RM1171.19

The value of the bond increases.

c. Explain the implications of your answers in part (b) as they relate to interest rate risk,
premium bonds and discount bonds.

When the required rate of return changes, the value of the bond will also change, resulting in
interest rate risk. When the required rate of return increases, the value of the bond will
decrease, it is considered as a discount bond. When the required rate of return decreases,
the value of the bond will increase, it is considered as a premium bond.

8. Calculate the duration of Bond A and Bond B below:

Bond A: 4 years to maturity, annual coupon rate and required rate of return is 8%, face-
value RM5000. The current price of Bond A is RM5000

Bond B: A zero-coupon bond with 3 years to maturity.

Bond A

Bond A

Year Cash flow to be received (C) t x C(1+i) ^-n

1 400 370.37

2 400 685.87

3 400 952.60

4 5400 15876.64

Total 17885.48
 Bond A Value

Year Cash flow to be received (C) C(1+i) ^-n

1 400 370.37

2 400 342.94

3 400 317.53

4 5400 3969.16

Total 5000

Duration of Bond A = 17885.48/5000

= 3.58 years

Bond B

Since it is a zero-coupon bond, the duration is 3 years.