3/3/2019 Valuation

Basic of Fixed Income

Submitted to:

Names Registration No.

Tayyba Awan MBA1Y02181014

Submitted by: Sir Kaleemullah

Assignment 1

For Grading:

Comment: Marked
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Question No: 1

Define the following types of bonds:

 Catastrophe bond:

Catastrophe bonds, also known as cat bonds, are investment securities that work like insurance
products for the purpose of reducing the greatest risks associated with insuring catastrophic
events, such as major hurricanes and earthquakes.

They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and
the Northridge earthquake.

 Eurobond:

A Eurobond is denominated in a currency other than the home currency of the country or market
in which it is issued. It is an international bond issued in Europe or elsewhere outside the country
in whose currency its value is stated (usually the US or Japan).

The first Eurobond was issued in 1963 by Autostrada, the company that ran Italy's national
railroads.

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 Zero-coupon Bond:

A Zero-Coupon Bond is a debt security that is sold at a discount and does not pay any interest
payments to the bondholder. A zero-coupon bond is a bond that makes no periodic interest
payments and is sold at a deep discount from face value. zero-coupon bonds, is that the former
pays bondholders interest, zero-coupon bondholders merely receive the face value of the bond
when it reaches maturity.

 samurai bond

A samurai bond is a yen-denominated bond issued in Tokyo by non-Japanese companies, and is

subject to Japanese regulations. These bonds provide the issuer with an access to Japanese
capital, which can be used for local investments or for financing operations outside Japan.

 Junk bonds

Junk bonds are corporate bonds that are high-risk and high-return. Junk bonds are so called
because of their higher default risk in relation to investment-grade bonds. a high-yielding high-
risk security, typically issued by a company seeking to raise capital quickly in order to finance a
takeover.

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 convertible bond:

A convertible bond gives the bondholder the right to convert the bond into a fixed number
of shares of common stock in the issuing company. a convertible bond or convertible note
or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a
type of bond that the holder can convert into a specified number of shares of common stock in
the issuing company or cash of equal value.

 Serial bond

Serial bonds describes a bond issue that matures in portions over several different dates. A serial
bond is a bond issue that is structured so that a portion of the outstanding bonds mature at regular
intervals until all of the bonds have matured. Because the bonds mature gradually over a period
of years, these bonds are used to finance projects that provide a consistent income stream for
bond repayment.

Example:
For example, the issuer of $100 million in traditional bonds with ten-year maturities will have to
make a $100 million principal payment at the end of the tenth year (see the table below). But the
issuer of $100 million in serial bonds might structure the offering such that $20 million matures
after five years, another $20 million matures the year after, $20 million the year after that, and so
on.

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 Equipment obligation bond:

A bond that is issued with specific equipment pledged as collateral against the bond. These
are bonds that are issued intentionally with low coupon rates that cause the bond to sell at a
discount from par value.

 Original issue discount bond

Original issue discount bonds are less common than coupon bonds issued at par. These are bonds
that are issued intentionally with low coupon rates that cause the bond to sell at a discount from
par value. The original issue discount is the difference between a bond's selling price and the
face value. Face value is also called the par value of the bond. OID is a type of interest because
the buyer will receive the face value of the bond, even if they bought it for less.

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 Indexed bonds:

Indexed bonds make payments that are tied to a general price index or the price of a particular
commodity. A type of bond in which interest or other payments are connected to an index so that
they rise or fall with the rate of inflation: An index bond is a bond in which payment of interest
income on the principal is related to a specific price index, usually the Consumer Price Index.
This feature provides protection to investors by shielding them from changes in the underlying
index.

 Callable bond

A callable bond gives the borrower (issuer) the right to pay back the obligation to
the lender(bondholder) before the stated maturity date. A callable bond (redeemable bond) is a
type of bond that provides the issuer of the bond with the right but not the obligation to redeem
the bond before the maturity date. Callable bonds typically come with a period of call protection,
an initial time during which the bonds are not callable. Such bonds are referred to as deferred
callable bonds. While the callable bond gives the issuer the option to extend or retire the bond at
the call date,

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Example:

Company ABC decides to borrow $10 million in the bond market. The bond's coupon rate is 8%.
Company analysts believe interest rates will go down during the 7 year term of the bonds. To take
advantage of lower rates in the future, ABC issues callable bonds.

 Puttable bonds:

Puttable bonds are bonds that give the holder the

right to sell his or her bond to the issuer prior to
the bond's maturity date. The holder of the
puttable bond has the right, but not the obligation,
to demand early repayment of the principal. They
allow investors to sell the bonds back to the issuer
and reinvest the proceeds in new bonds paying higher yields.

the extendable or put bond gives this option to the bondholder.

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Example:

$100 par bond paying 4.5% annual coupon and maturing in 2 years. The bond-holder has an
option to put the bond to the issuer after at the end of each year. Current spot rate and forward
rate is 3%, 1-year forward rate one year from now is 5% and the 2-year spot rate is 4%. Find out
if the bondholder will sell the bond back or not and determine the bond price.

Question no:2

What is a bond indenture? Describe contents of a bond indenture.

A bond indenture is a legal document or contract between the bond issuer and the bondholder
that records the obligations of the bond issuer and benefits owed to the bondholder. The bond
indenture also includes the details of the rights of ownership as well as the rights of the
bondholder to receive interest payments and principle payments in the future. The annual
payment is the coupon rate times the bond’s par value. The coupon rate, maturity date, and par
value of the bond are part of the bond indenture, which is the contract between the issuer and the
bondholder.

Example:

A bond with par value of $1,000 and coupon rate of 8% might be sold to a buyer for $1,000. The
bondholder is then entitled to a payment of 8% of $1,000, or $80 per year, for the stated life of

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the bond, say, 30 years. The $80 payment typically comes in two semiannual installments of $40
each. At the end of the 30-year life of the bond, the issuer also pays the $1,000 par value to the
bondholder.

Question no:3

What are sinking funds? How does a sinking fund call differ from a
conventional bond call?

A sinking fund is a type of fund that is created and set up purposely for repaying debt. A sinking
fund is an account that is used to deposit and save money to repay a debt or replace a wasting
asset in the future.

The sinking fund call differs from a conventional bond call in two important ways.

 The firm can repurchase only a limited fraction of the bond issue at the sinking fund call
price. At best, some indentures allow firms to use a doubling option, which allows
repurchase of double the required number of bonds at the sinking fund call price.
 while callable bonds generally have call prices above par value, the sinking fund call
price usually is set at the bond’s par value.

Question no:4

Compare affirmative and negative covenants and identify examples of each.

Covenants are legally enforceable rules that parties (borrowers and lenders) agree on. The
purpose is to protect bondholders. There are two types of covenants.

Affirmative (or Positive) Covenant

These covenants require a party to do something, are administrative in nature and do not result in
additional costs and not limit operations of business. For example: what to do with proceeds
from the bond issue; promising to comply with laws and regulations; insuring assets adequately;
or delivering timely audit reports.

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Negative Covenants
Negative covenants state what issuers are forbidden from doing (or simply not to do). These
covenants are legally binding on the issuer, costly, and materially limit business decisions.

Example:

Restraints on asset withdrawals; or on additional debt; imposing a maximum acceptable debt

ratio such as leverage or gearing ratio or minimum acceptable interest coverage ratio. Negative
pledges could prevent the issuance of a more senior debt and restrict distributions to
shareholders; asset disposals; or (risky) investments; or could prevent mergers and acquisitions.

Question no:6

What are the determinants of bond safety?

Bond rating agencies base their quality ratings largely on an analysis of the level and trend of
some of the issuer’s financial ratios. The key ratios used to evaluate safety are

 Coverage ratios:

Ratios of company earnings to fixed costs. For example, the times-interest-earned ratio is the
ratio of earnings before interest payments and taxes to interest obligations. The fixed-charge
coverage ratio includes lease payments and sinking fund payments with interest obligations to
arrive at the ratio of earnings to all fixed cash obligations (sinking funds are described below).
Low or falling coverage ratios signal possible cash flow difficulties.

 Leverage ratio, debt-to-equity ratio

A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will
be unable to earn enough to satisfy the obligations on its bonds.

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 Liquidity ratios

The two most common liquidity ratios are the current ratio (current assets/current liabilities) and
the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the
firm’s ability to pay bills coming due with its most liquid assets.

 Profitability ratios

Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm’s
overall financial health. The return on assets (earnings before interest and taxes divided by total
assets) or return on equity (net income/equity) are the most popular of these measures. Firms
with higher returns on assets or equity should be better able to raise money in security markets
because they offer prospects for better returns on the firm’s investments.

 Cash flow-to-debt ratio

This is the ratio of total cash flow to outstanding debt.

Question no:7

What are credit ratings and credit rating agencies?

Credit ratings:

an estimate of the ability of a person or organization to fulfil their financial commitments, based
on previous dealings. A credit rating is an evaluation of the credit risk of a prospective debtor (an
individual, a business, company or a government), predicting their ability to pay back the debt,
and an implicit forecast of the likelihood of the debtor defaulting.

Credit rating agencies:

A credit rating agency (CRA, also called a ratings service) is a company that assigns credit
ratings, which rate a debtor's ability to pay back debt by making timely principal and interest
payments and the likelihood of default. credit rating agencies, evaluate the creditworthiness of
organizations that issue debt in public markets.

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Question no:8

Write a short note on the following:

Credit default swaps:

Credit default swaps (CDS) are a type of insurance against default risk by a particular
company. It is a contract between two parties, called protection buyer and protection seller.

A credit default swap (CDS) is in effect an insurance policy on the default risk of a bond or loan.

Collateralized Debt Obligation

A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents

different loans bundled together and sold by the lender in the market. A collateralized debt
obligation is a bundle of income-generating debt assets, such as mortgages or auto loans.

CDOs can be excellent financial tools when used responsibly and for their intended purpose.
From the standpoint of the banks who sell CDOs, the sale of these instruments gives them more
funds to lend to other customers, and takes the risk of default off of the bank.

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