LONG TERM

FINANCE - BONDS
CHAPTER 10a
 A bond is a long-term contract under which a borrower
agrees to make payments of interest and principal on
specific dates to the holder of the bond.

Bonds are similar to term loans, but a bond issue is

generally advertised, offered to the public, and actually
sold to many different investors.
Introduction
of Bonds Thousands of individual and institutional investors may
purchase bonds when a firm sells a bond issue, whereas
there is generally only one lender and borrower in the
case of a term loan agreement.
Bonds are long term debt under which a borrower
(issuer) agrees to make payments on interest (coupon)
and principal on specific dates to the bond holders
(lenders of fund).
Introduction to
bonds
• Issuing organisations (issuers) agrees to pay:
▪ a fixed amount of coupon (interest) periodically
▪ to pay a fixed amount of principal upon maturity
• Examples:
▪ Project Lebuhraya Utara-Selatan (PLUS)
Bonds
▪ Telekom Bonds
▪ Malaysian Government Securities (MGS)
• Bonds are issued to finance a particular project or
purpose.
 Characteristics of bonds
1. Nominal/ Par/ Face/ Principal Value
• The amount that the issuer agreed to repay the bondholder at the maturity
date.
• It is usually in the amount of RM1,000.00

2. Coupon Rate / Interest Payment

• A rate that determines the actual interest the bondholder receives on
owing the bond.
• Payable annually and quarterly (half yearly)
 Characteristics of bonds
3. Terms to Maturity
• The number of years over which the issuer of the bond has promised to
meet the conditions and obligations of the bond issue.
• The bondholder is paid the promised coupon payment
• It also indicates the remaining life of the bond.
• Maturity of the bond is the date the bond will cease (bring) to exist, at
which time the issuer will pay back to the bondholders, the principal.
 Characteristics of bonds
4. Yield to Maturity (YTM)
• The indicated (promised) compounded rate of return an investor
will receive from a bond purchase at the current market price
and held to maturity.
• The effective interest rate earned on the bond investment.
• Prices of bonds are quoted in relation to their yield.
 Characteristics of bonds
5. Call Provision
• Entitles the issuer to redeem or call the bonds from their
holders.
• Investors will receive some compensation for the risk that the
bond will be called away under specified terms prior to the
normal maturity date.
• The investor will then be subjected to re-investment risk.
 Characteristics of bonds
6. Sinking Fund
• An account managed by the bond issuer for the purpose of
repaying the bonds.
• Money put aside by the issuer periodically for the eventual
(occurring at the end) repayment of the debt.
• Ensures enough money to redeem the bond upon maturity.
VALUING
BONDS

7-10
 THE VALUE OF FINANCIAL ASSETS

0 1 2 n
r ...
%
Value C C C
F1 F2 F
n
•

7-11
 CALCULATING PV OF BONDS

0 1 2 n
...

Bond’s INT1 INT2 INTn + M

Value
•

• 7-12
 CALCULATING PV OF BOND: EXAMPLE

What is the value of a 15-year, 10% annual coupon bond, if rd = 10% and
par value of the bond is RM1,000?
0 1 2 15
……

VB = ? 100 100 100 + 1,000

7-13
7-14
 USING PV TABLE

VB = (1,000x10%)PVIFA (10%,15) + 1000PVIF(10%,15)

= 100(7.6061) + 1000(0.2394)
= 760.61 + 239.40
= 1000.01

7-15
Advantages of bonds
To issuing firm:

1. Tax deduction of interest payment

• Coupon payments to bondholders are tax-deductible for the issuing firm.
2. Increase in earnings per share
• Since a bond is a fixed-income security, the surplus earnings available to shareholders
after deducting interest payment to bondholders during good times would be higher.
3. Maintain control of the firm
• Since bondholders are creditors of the firm, they do not have controlling rights over the
management of the firm as in the case of the shareholders. As such the shareholders of
the firm still maintain control of the firm.
Disadvantages of bonds
To issuing firm:

1. Debt must be paid.

• The fixed interest charge must be paid whether the firm is having a good or a bad year.
Failure to meet these payments may lead to bankruptcy suits by the bondholders.
2. Increased risk due to financial leverage
• Bonds are categorised as long-term debts and the issuance of such security would
increase the financial leverage of the firm.
3. Restrictions on issuing firm
• To protect themselves, bondholders may place certain restrictions or agreement on the
issuing firm to prevent it from defaulting on its obligations.
 Advantages of bonds
To investors:

1. Fixed Returns
• Bonds are fixed-income security and investors who purchase bonds can
expect a stable return since the interest payment is fixed.

2. Lower Risk
• The bondholders would be able to have prior claims on the assets of the
firm before the shareholders in the event of liquidation of the firm.
 Disadvantages of bonds
To investors:

1. Fixed interest payment 2. Decline in real interest payment

• If the issuing firm has good earnings, • Since bondholders get a fixed interest
bondholders do not get to enjoy the payment, they may lose out during
additional earnings. times of high inflation.

3. Lower return 4. Reinvestment Risk on callable bonds

• Because the risk is low, the returns • Interest rate at which the money
are low too. received is reinvested may not be as
high as expected.
Types of
A. Government Bond
bonds B. Asset-backed Securities
C. Convertible Bonds
D. Zero Coupon Bonds
E. Floating Rate Bonds
F. Junk Bonds
(A) Government Bond
• A bond issued by a national government denominated in the country's
own currency.
• It is usually referred to as risk-free bonds with maturity exceeding more
than 3 years.
• Examples:
• Malaysian Government Securities (MGS)
• Khazanah Bond
• Bond Simpanan Merdeka 2009 (issued to Malaysian citizens who
are 56 years and above)
(A) Government Bond
Malaysian Government Securities (MGS)
• Long-term bonds issued by the Government of Malaysia for financing developmental
expenditure.
• Fixed-rate coupon bearing bonds with bullet repayment of principal upon maturity
while coupon payments are made semi-annually.
• Beginning December 2006, BNM has also introduced Callable MGS which provides
the Government of Malaysia with the option to redeem the issue at par by giving an
advance notice of five business days to the bond holders.
• MGS are issued via competitive auction by BNM on behalf of the government.
• The successful bidders are determined according to the lowest yields offered and the
coupon rate is fixed at the weighted average yield of successful bids.
(A) Government Bond
Malaysian Government Securities (MGS)
• The actual issuance size is announced a week before the issuance date. The typical issuance
size ranges from RM1 billion to RM4.5 billion depending on government financing
requirement.
• The Government is committed to continuously issue 3-year, 5-year, 7-year and 10-year MGS
as benchmark securities as part of its efforts to develop the benchmark yield curve.
• In addition, 15-year and 20-year MGS were also issued to lengthen the benchmark yield
curve.
• Secondary market for benchmark securities is liquid with average daily transaction volume
varying from RM100 million to RM500 million.
• Standard transaction is RM10 million per lot.
• Trades are settled in two business days (T+2) and are quoted on a price basis to two decimal
points (for transactions via money brokers, brokerage fee is payable).
(B) Asset-backed securities
• A security whose value and income payments are derived from and collateralised (or
"backed") by a specified pool of underlying assets.
• The pool of assets is typically a group of small and illiquid assets that are unable to be
sold individually eg. Credit card, receivables, housing loan payment.
• Pooling the assets into financial instruments allows them to be sold to general investors; a
process called securitisation (conversion of an asset) and allows the risk of investing in
the underlying assets to be diversified because each security will represent a fraction of
the total value of the diverse pool of underlying assets.
• An individual credit card loan might be very risky, but a pool of similar loans has a much lower risk of
default because it is quite improbable that all loans in the pool would default at the same time.
• Hence the concept of securitisation is similar to the traditional concept of risk diversification of a portfolio.
(C) Convertible Bonds
• A bond that is convertible into shares of common stock, at a
fixed price, at the option of the bondholder.
• Convertible bonds carry a lower coupon rates, but they offer
investors a chance for capital gains if the stock price increases.
(D) Zero Coupon Bonds
• A bond that pays no annual interest but is sold at a discount below par
value, thus providing compensation to investors in the form of capital
appreciation.
• A bond bought at a price lower than its face value, with the face value
repaid at the time of maturity
• It does not make periodic interest payments, or have so-called
"coupons," hence the term zero-coupon bond.
• When the bond reaches maturity, its investor receives its par (or face)
value.
• Examples of zero-coupon bonds include Treasury bills.
(E) Floating Rate Bonds
• A bond which interest rate fluctuates with shifts in the general level of
interest rates.
• The value of a floating-rate bond depends on exactly how the coupon
payment adjustments are defined.
• The majority of floaters have the following features:
• The holder has the right to redeem his note at par on the coupon payment date
after some specified amount of time. This is called a put provision.
• The coupon rate has a floor and a ceiling, meaning that the coupon is subjected
to a minimum and a maximum. In this case, the coupon rate is said to be
“capped,” and the upper and lower rates are called the collar.
(F) Junk Bonds
• A bond rated 'BB' or lower because of its high default risk.
• Also known as a "high-yield bond" or "speculative bond".
• These are usually purchased for speculative (high risk) purposes.
• Junk bonds typically offer interest rates 3% to 4% points higher than safer
government issues.
• Corporate debt securities bearing credit ratings below investment grade.
• Are low-rated, high-yielding, speculative vehicles issued primarily by
corporations usually to finance restructuring, mergers and takeovers.
Bond • Bond ratings are grades that are assigned to
bond issues on the basis of extensive,
professionally

Ratings • Conducted financial analysis to designate

investment quality.
• Ratings basically point to the default risk of an
issue. Higher ratings mean that issues are
investment grade.
• Lower ratings mean that issues are in the junk
category and more speculative.
• The higher the rating, the lower the default risk
and, hence, the lower the yield of an obligation.
• A lower rating means that the investor must
assume more of the default risk and has to be
compensated with a higher yield.
Rating Agencies in Malaysia
i. Rating Agency Malaysia (RAM)
ii. Malaysian Rating Corporation (MARC)
Bond Ratings Short Term Rating
AAA P1
AA P2
A P3
BBB --- Investable Grade --- NP
BB D
B
C
D
The use of bond ratings
i. Individuals can depend on agency ratings as a viable (possible)
measure of the creditworthiness of the issuer and the issuer’s default
risk.

i. These ratings are objective and reliable because they are done by an
independent party.

i. Investors are able to make comparison among bonds in terms of risk

and return.
Limitation of bond rating
• Bond ratings are intended to only measure an issuer’s default risk,
and as such, ratings provide no indication of the amount of market
risk imbedded (implant/set) in a bond
• Even the highest quality issues will go down in price when interest
rates increase, subjecting investors to capital loss and market risk.
If bond ratings are done by unreliable rating agencies.
Deciding on the appropriate source
• Key factors when deciding on the appropriate source of long-term loan:

The amount of the loan

The purpose of the loan
A cash budget should be Repayment of the loan
The reason for seeking prepared to check that the The detailed projections
finance should be fully
amount of finance sought is should identify repayment
evaluated to ensure that it is sufficient for the required schedules clearly.
financially justified.
purpose.

The term of the loan

This should be appropriate The cost of finance
to the type of asset being The relative costs of the
acquired. As a general rule, different forms of finance
long term assets should be available should be
financed from long term compared.
finance sources.