CHAPTER-4

FIXED INCOME SECURITIES

What is Bond?
• A bond represents a security issued in connection
with a borrowing arrangement.
• A bond obligates the issuer to make specified
payments (regular interest payment and the principal
on maturity date) to the bondholder.
• 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.

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What is Bond?
• 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 as compared with
equity instruments.

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Characteristics of Bond
• Typically, a bond has the following features;
1. The indenture:- it is the formal contract (bond
certificate) between the bondholders and the
corporation that specifies the par value, coupon rate,
and maturity date. .
2. The face value (par value):- The face value of a
bond, or its principal, is price of the bond stated on the
bond certificate that represents the amount the issuer
promises to pay at the time of maturity.
3. The coupon rate:- This is the interest rate payable to
the bondholder.

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Characteristics of Bond
4. The market value:- A bond, which is priced at its
face value, is selling at par. However, in some
situation a bond may not be sold at its face value. If
the issuing company is not doing well financially, its
bonds may sell for less than the par value. In this
case the bond is selling at a discount. If the market
value of the bond is more than the par value then it
is selling at a premium.

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Bond Classification
• Based on form of payment:
− Non-interesting bearing bonds - bonds issued at a discount
and do not pay any interest.
− Regular serial bonds - bonds in which all periodic payment are
equal in amount.
− Deferred-interest bonds - bonds paying interest at a later date;
− Income bonds – bonds that pay no interest unless the issuing
company is profitable.
− Indexed bonds - bonds where the values of principal and the
payout rise with inflation or the value of the underlying
commodity;
− Optional payment bonds – bonds that give the holder the
choice to receive payment on interest or principal or both in the
currency of one or more foreign countries, as well as in
domestic currency.

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Bond Classification
• Based on coupon payment:
− Coupon bonds – bonds with interest coupons
attached;
− Zero-coupon bonds – bonds sold at discount from
its face value and redeemed at maturity for full face
value. These securities provide no interest payments to
holders;
− Floating-rate bonds – debt instruments issued by
large corporations and financial organizations on
which the interest rate is pegged to another rate, often
the Treasury-bill rate, and adjusted periodically at a
specified amount over that rate.

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Bond Classification
• Based on collateral:
1. Unsecured bonds (Debenture) – bonds for
which there is no any specific security set aside or
allocated for repayment of principal;
2. Secured bonds – bonds secured by the pledge of
assets of issuer which is transferred to bondholders
in case the issuer fail to perform the bond.
a) Mortgage bonds – bonds that have as an
underlying security a mortgage
b) Sinking fund bonds – bonds secured by the
deposit of specified amounts.

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Bond Classification
c) Asset-Backed Securities (ABS) – similar to mortgage
bonds, but they are backed by other assets than
mortgage.
d) Guaranteed bonds – bonds which principal or income
or both are guaranteed by another corporation or
parent company in case of default by the issuing
corporation;
e) Participating bonds – bonds which, following the
receipt of a fixed rate of periodic interest, also receive
some of the profit generated by issuing business;
f) Revenue bonds – bonds whose principal and interest
are to be paid solely from earnings (net income).
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Bond Classification
Based on type of circulation:
− Convertible bonds - bonds that give the bond
holder the right to convert them into equity shares
on certain terms.
− Interchangeable bonds – Coupon bonds that
can be converted to the other form of bond or
back to its original form at the request of the
holder paying the service charge for this
conversion.

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Bond Classification
• Based on option (right):
− Callable (redeemable) bonds – bonds that give
the issuer the right to redeem them before
maturity on certain terms.
− Puttable Bonds Puttable - bonds give the
bondholder the right to sell them back to the
issuer before maturity on certain terms.

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Bond Classification
Based on type of issuers:
− Treasury (government) bonds – Issued by federal
(central government). These bonds are of the highest
quality.
− Municipal bonds - bonds issued by governments other
than federal (central) such as county, city, etc.;
− Corporate bonds – Issued by corporations;
a) Industrial bonds – bonds issued by
corporations other than utilities, banks and
railroads.
b) Public utility bonds – high quality debt
instruments issued by public utility firms.

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Bond Classification
• Based on place of circulation:
− Internal bonds - bonds issued by a country
payable in its own currency;
− External bonds - bonds issued by government or
firm for a purchaser outside the nation, usually
denominated in the currency of the purchaser.
The term Eurobond is often applied to these
bonds that are offered outside the country of the
borrower. As the Eurobond market is neither
regulated nor taxed, it offers substantial
advantages for many issuers and investors in
bonds.
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Bond Classification
• Based on quality:
− Gilt-edged bonds – high-grade bonds issued by a
company that has demonstrated its ability to earn a
comfortable profit over a period of years and to
pay its bondholders their interest without
interruption;
− Junk bonds - bonds with low rating, also regarded
as high yield bonds. These bonds are primarily
issued by corporations and also by municipalities.
They have a high risk of default because they are
issued as unsecured and have a low claim on
assets.
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Bond Classification
• Other types of bonds:
− Voting bonds - bonds that give the holder voting
right in corporation management;
− Senior bonds - bonds which having prior claim to
the assets of the debtor upon liquidation;
− Junior bonds – bonds which is subordinated or
secondary to senior bonds.

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Convertible Bold
• Convertible bonds convey option (right) to the holder
of the bond to exchange bond for a fixed number of
shares of common stock, regardless of the market
prices of the securities at the time.
• For example, a bond worth $1000 with a conversion
ratio of 10 allows its holder to convert one bond into
10 shares of common stock. Alternatively, we say the
conversion price in this case is $100: to receive 10
shares of stock, the investor sacrifices bonds with
face value $1,000 or, put another way, $100 of face
value per share.

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Bond Analysis
• An investor before buying bonds must evaluate a wide
range of factors which could influence his/ her
investment results.
• Bond analysis is a careful analysis of factors that
affect investment decision on bonds. It includes both
quantitative and qualitative analysis of a bond.

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Bond Analysis
• An investor in bonds really becomes the creditor of the
issuer of the bonds. Therefore, the most important during
analysis is the assessment of the credibility of the firm.
A. Quantitative analysis
• Quantitative indicators are financial ratios which allows
assessing the financial situation, debt capacity and
credibility of the issuer of the bonds.
• The most important financial ratios for the bond analysis
are:
1. Debt / Equity ratio;
2. Debt / Cash flow ratio;
3. Debt coverage ratio;
4. Cash flow / Debt service ratio.

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Bond Analysis
1. Debt / Equity ratio
• Debt / Equity ratio = DL / SET.
Where,
• DL - long-term debt;
• SET - total stockholders ‘equity.
• Debt/Equity ratio shows the financial leverage of the
firm. The higher level of this ratio is the indicator of
increasing credit risk.

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Bond Analysis
2. Debt / Cash flow ratio = (DL+ LP) / (NI + DC).
Where,
• DL - long-term debt;
• LP - lease payments;
• NI – net income;
• DC – depreciation.
• Debt/ cash flow ratio shows the number of years that a firm
requires to undertake all its long-term liabilities and leasing
contracts using the cash generated by the firm.
• Firms with the low Debt /Cash flow ratio can borrow funds
needed easily at any time. From the other side, firms with the
high Debt /Cash flow ratio could encounter substantial
problems if they would like to borrow.
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Bond Analysis
3. Debt coverage ratio = EBIT / I
Where,
• EBIT - earnings before interest and taxes;
• I - interest expense.
• Debt coverage ratio sometimes is presented as
“Interest turnover” ratio.
• The firm with the higher ratio is assessed as
financially stronger.

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Bond Analysis
4. Cash flow/Debt service ratio = (EBIT+ DC)/ [I + DR (1-Tr) + LP
(1-Tr)
Where,
• EBIT - earnings before interest and taxes;
• I - interest expense.
• DC – depreciation.
• LP - lease payments;
• DR – debt repayment; Tr – corporation tax rate.
• Many credit analysts consider Cash flow/Debt service ratio as
the best measure for evaluation of the firm’s credibility than
Debt coverage ratio for the following reasons:
• It adjusts generated income for non-cash expenses –
depreciation.
• It shows not only ability of the firm to pay interest but also the
ability to repay the debt and to cover leasing payments.

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Bond Analysis
B. Qualitative analysis
• Qualitative indicators are those which measure the
factors influencing the credibility of the company and
most of which are subjective and not quantifiable in
their nature.
• The following are qualitative indicators:
1. Economic fundamentals – the current economic
climate and the aim of the economic analysis is to
examine how the firm would be able to perform
under the favorable and unfavorable economic
conditions.
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Bond Analysis
2. Market position – shows the market dominance
and overall firm size. The larger firm the stronger is
its credit rating.
3. Management capability - quality of the firm’s
management team. Firms with quality management
have good credit rating.
4. Bond market factors - includes term to maturity,
sector, inflation, supply and demand for credit, and bond
quality.

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Bond Analysis
• Term to maturity - generally term to maturity and the
interest rate (the yield) of the bond are directly related;
thus, the bonds with the longer term to maturity have the
higher yield than the bonds with shorter terms to
maturity.
• Sector - the yields of the bonds vary in various sectors
of the economy; for example, generally the bonds issued
by the utility sector firms generate higher yields to the
investor than bonds in any other sector or government
bonds.
• The level of inflation - the inflation decreases the
purchasing power of the future income. Investors require
the premium to compensate for their exposure related
with the growing inflation. Thus the yield of the bond
changes with the changes in the level of inflation.

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Bond Analysis
• The supply and the demand for the credit - the
interest rate of the price of borrowing money in the
market depend on the supply and demand in the
credit market; When the economy is growing the
demand for the funds is increasing too and the
interest rates generally are growing. Contrary, when
the demand for the credits is low, in the period of
economic crises, the interest rates are also relatively
low.
• Bond quality - the higher the quality of the bond,
the lower the yield. For the bonds with lower quality
(junk bond) the yield is higher.
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Bond Analysis
Bond rating
• Bond rating is the grade given to bonds that indicates
their credit quality (ability to pay a bond's principal
and interest in a timely fashion).
• Private independent rating companies such as
Standard & Poor's, Moody's and Fitch provide these
evaluations.
• The rating of the bond and the yield of the bond are
inversely related: the higher the rating, the lower the
yield of the bond. Bond ratings are expressed as
letters ranging from 'AAA', which is the highest grade,
to 'C' ("junk"), which is the lowest grade.
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Bond Analysis

• Those rated BBB or above (S&P, Fitch) or Baa and above

(Moody’s) are considered investment-grade bonds, whereas
lower-rated bonds are classified as speculative-grade or junk
bonds.

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Bond price (Bond valuation)
• The process of determining security valuation
involves finding the present value of expected future
cash flows using the investor’s required rate of return.
• The value of a bond is equal to the present value of
the cash flows expected from it.
• Bond value = Present value of coupons + Present
value of par value. Thus, determining the value of a
bond requires:
• An estimate of expected cash flows
• An estimate of the required return
• The maturity date of the loan
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Bond price (Bond valuation)
𝑛 𝐶 𝑀
• The value of a bond is: P = σ𝑡 1( 𝑡) + ( 𝑛) ,
= 1+𝑟 1+𝑟
where, n is the number of years to maturity, C is the
annual coupon payment , r is the periodic required
return, M is the maturity value, and t is the time
period when the payment is received.
• Since the stream of annual coupon payments is an
ordinary annuity, we can apply the formula for the
present value of an ordinary annuity to determine
1
1− 𝑛
𝑀
1+𝑟
value of bond. P = C x [ ]+( 𝑛 )
𝑟 1+𝑟

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Exercise
• To illustrate, consider a 10-year, 12% coupon bond
with a par value of $1000. Let us assume that the
required yield on this bond is 13%. The value of the
bond is: $945.73
• Consider a bond, maturing in 10 years and having a
coupon rate of 8%. The par value is $1,000. Investors
consider 10 percent to be an appropriate required rate
of return in view of the risk level associated with this
bond. The annual interest payment is $80(8% *
$1,000). The present value of this bond is: $877.11
• Assume the same data as in the above example except
the interest is paid semiannually. The value of the
bond becomes $875.38
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Bond price (Bond valuation)
• Most of the bonds pay interest semi-annually. To
value such bonds, the bond valuation equation has to
be modified along the following lines:
• The annual interest payment, C, must be divided by two to
obtain the semi-annual interest payment
• The number of years to maturity must be multiplied by
two to get the number of half-yearly periods
• The discount rate has to be divided by two to get the
discount rate applicable to half-yearly periods.
• As an illustration, consider an 8 year, 12% coupon
bond with a par value of $100 on which interest is
payable semi-annually. The required return on this
bond is 14%. The value of the bond is: $90.55
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Bond price (Bond valuation)
• If the bond pays interest on quarterly basis, the bond
valuation equation has to be modified along the
following lines:
• The annual interest payment, C, must be divided by four to
obtain the quarter interest payment
• The number of years to maturity must be multiplied by
four to get the number of periods
• The discount rate has to be divided by four to get the
discount rate applicable to the three months.
• At a higher interest rate, the present value of the
payments to be received by the bond holder is lower.
Therefore, the bond price will fall as market interest
rates rise.
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Bond Yield
• Bonds are generally traded on the basis of their
prices. However, they are usually not compared in
terms of prices because of significant variations in
cash flow patterns and other features. Instead, they
are typically compared in terms of yields.
• There are three widely used measures of the yield:
• Current Yield
• Yield-to-Maturity
• Yield- to- Call

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Bond Yield
1. Current yield (CY)
• Current yield (CY) is the return that should be applied
on market price to result the coupon payment.
• It has a limited application because it measures only
the interest return of the bond. It does not consider
the capital gain (or loss) that an investor will realize if
the bond is purchased at a discount (or premium) and
held till maturity. It also ignores the time value of
money. Hence it is an incomplete and simplistic
measure of yield.
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Bond Yield
𝐶
• Current yield (CY) is estimated using formula: ,
𝑃
Where: C – annual coupon payment of the bond; P -
current market price of the bond.
• For example, the current yield of a 10 year, 12 percent
coupon bond with a par value of $1000 and selling
for $950 is 12.63%.
Current yield = 120/950 = 0.1263 or 12.63%.

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Bond Yield
2. Yield- to- Maturity (YTM)
• Yield-to-maturity is discount rate which equalizes
present value of the future cash flows of the bond to
its current market price (value).
• Yield- to- Maturity (YTM) is the most important and
widely used measure of the bonds because it
considers the current coupon income as well as the
capital gain or loss the investor will realize by holding
the bond to maturity. In addition, it takes into account
the time value of money.
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Bond Yield
• Then YTM of the bond is calculated from this
equation:
𝑛 𝐶 𝑀
P = σ𝑡 1( 𝑡 )+( 𝑛 )
= 1+𝑌𝑇𝑀 1+𝑌𝑇𝑀
• Where: P - current market price of the bond; n -
number of periods until maturity of the bond; C -
coupon payment each period; YTM - yield-to-
maturity of the bond; M – Maturity (face) value of
the bond.

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Bond Yield
• The computation of YTM requires a trial and error
procedure. To illustrate this, consider a $1000 par
value bond, carrying a coupon rate of 9%, and
maturing after 8 years. The bond is currently selling
for $800. What is the YTM on this bond?
1
1 − 1+𝑌𝑇𝑀 8 1000
800 = 90∗[ ]+( )
8
𝑌𝑇𝑀 1+𝑌𝑇𝑀
• Let us begin with a discount rate of 12%. Putting a
value of 12% for YTM we find the value of the bond
$851.1.

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Bond Yield
• Since this value is greater than $800, we have to try a
higher value for YTM. Let us try YTM = 14% . This
makes the value of the bond $768.1 Since this value is
less than $800, we try a lower value for YTM Let us
try YTM = 13%. This makes the value of the bond
$808.
• Thus YTM lies between 13% and 14%. Using a linear
interpolation, we find that YTM is equal to 13.2%:
808 − 800
13% + (14% – 13%)
808 −768.1

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Bond Yield
• If you are not inclined to follow the trial-and-error
approach described above, you can employ the following
formula to find the approximate YTM on a bond:
𝑀 −𝑃
𝑐+
• YTM ~ 𝑛
, where YTM is the yield to maturity, C
0.4𝑀 + 0.6𝑃
is the annual interest payment, M is the maturity value of
the bond, P is the present price of the bond, and n is the
years to maturity
• To illustrate the use of this formula, let us consider the
bond discussed above. The approximate YTM of the
90 +(1000 −800)/8
bond works out to 13.1% : YTM =
0.4 𝑥 1000 +(0.6 𝑥 800)

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Bond Yield
3. 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. 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.

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Bond Yield
• YTC can be calculated similar to YTM as 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
𝑛 𝐶 𝑃𝐶
equation: P = σ𝑡 1( 𝑡 + 𝑛) Where: P -
= 1+𝑌𝑇𝐶 1+𝑌𝑇𝐶
current market price of the callable bond; n - number
of periods to call of the bond; C - coupon payment
each period before the call of the bond; YTC - yield-
to-call of the bond; Pc - call price of the bond.

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Bond Investment Decision
• 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.

44
Bond Investment Decision
• Intrinsic value of the bond can be calculated from
𝑛 𝐶 𝑀
this equation: : σ𝑡 1( 𝑡) + ( 𝑛)
= 1+𝑟 1+𝑟
• Where: r – required rate of return; n - number of
periods until maturity of the bond; C - coupon
payment of each period; M - 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
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Bond Investment Decision
• An asset is said to over-valuated if the market price of the
asset is grater than its intrinsic value. On the contrary, an
asset is under-valuated if the market price is lower than its
intrinsic value.
• Approach-1:
• If YTM > r - decision to buy or to keep the bond as it is under
valuated;
• If YTM < r - decision to sell the bond as it is over valuated;
• If YTM = r - bond is valuated at the same range as in the
market and its current market price shows the intrinsic value.
• Approach-2:
• If P < V - decision to buy or to keep the bond as it is under
valuated;
• If P > V - 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.

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Exercise
• Assume that $1,000 par value, 10% coupon rate, 5
years bond is being sold at $950 per bond in the
market.
• Calculate current yield of the bond
• Calculate yield to maturity of the bond
• Calculate yield to call of the bond assuming the bond will
be called back after three years.
• Calculate intrinsic value of the bond if other bonds in the
market with similar risk exposure earn 8% return

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Bond Risk
• Bonds are subject to diverse risks, such as interest rate
risk, inflation risk, real interest rate risk, default risk,
call risk, liquidity risk, and reinvestment risk
• Interest Rate Risk - interest rates tend to vary over
time, causing fluctuations in bond prices. A rise in
interest rates will depress the market prices of
outstanding bonds whereas a fall in interest rates will
push the market prices up.

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Bond Risk
• The longer the maturity of the bond, the greater the
sensitivity of price to fluctuations in the interest rate.
• If you buy the bond at par with an 8% coupon rate,
and market rates subsequently rise, then you suffer a
loss: You have tied up your money earning 8% when
alternative investments offer higher returns. The
longer the period for which your money is tied up, the
greater the loss, and correspondingly the greater the
drop in the bond price.

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Bond Risk
• Inflation Risk - when the inflation is higher than
expected, the borrower gains at the expense of the
lender and vice versa.
• The impact of a change in inflation rate is similar to
that of a change in interest rate. This means that
inflation risk is greater for long-term bonds. Hence, in
a period of volatile inflation rates, investors will be
reluctant to buy such bonds. During such times,
floating rate bonds and shorter-maturity bonds
become more popular.

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Bond Risk
• Default Risk - is the risk that a borrower may not pay
interest and/or principal on time. Other things being
equal, bonds which carry a higher default risk (lower
credit rating) trade at a higher yield to maturity. Put
differently, they sell at a lower price compared to
government securities which are considered free from
default risk.
• Call Risk - a bond may have a call provision that gives
the issuer the option to redeem the bond before its
maturity. The issuer would generally exercise the call
option when interest rates decline. As opposed to issuers
callable bond exposes the investors to call risk since
bonds are typically called for prepayment after interest
rates have fallen, and investors will not find comparable
investment vehicles.

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-END-

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