1/22/2022

To be covered
✓ Definition
C3: BUSINESS AND CORPORATE FINANCE ✓ Types of Bonds
✓ Bond Valuation
• Under valuation
• Over valuation
Topic ✓ Bond Yield
BOND VALUATION AND ANALYSIS • Current Yield
• Yield to Maturity (YTM)
✓ Duration
✓ Convexity
✓ Credit rating
Mr. Mshana: MFA-OG, B.com
✓ Bond Refund Analysis
Accounting Hons, CPA (T), ATEC (II) ✓ QNA Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)

DEFINITION TYPES OF BOND

A Bond
This refers to a financial instrument which is a debt instrument
that attracts interest payment over it’s life and ultimately the
repayment of principle at maturity. OR
Is debt capital market instrument issued by a borrower, who
has to repay to the lender / investor the amount borrowed
along with interest, over a predetermined period of time.
Examples: Exim Bank Bond, NMB Bank Bond
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
There are two main types of Bonds and these are coupon
payment Bond and Zero coupon Bond.
Coupon payment bond
This a regular kind of a bond that attracts interest in form of
cash payment during the life of it. Also called Plain Vanilla,
straight Bond or Bullet bond.
Zero coupon bond
This is a type of Bond which has no coupon payments during
it’s life but only repayment of principle at maturity, normally
repaid at a premium (maturity value exceeds the face value).
Zero coupon bonds are also called deep discount bonds.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)

1
 1/22/2022

BOND VALUATION BOND VALUATION

1. Coupon Payment Bond Example 1 : A coupon Payment bond

The value of a Coupon payment bond is a present value of the future Consider a bond with a coupon rate of 10% and annual
cash flows expected to be derived from the bond, which are the annual coupons. The par value is TAS 1,000 and the bond has 5 years
coupons and the maturity value of the bond.
to maturity. The yield to maturity is 11%.
PV of a Bond= PV of coupon payment + PV of principle (at maturity)
𝟏 − 𝟏 + 𝒚𝒕𝒎 −𝒏 𝑴𝑽 Required: Compute the value of this bond
𝑷𝑽 𝒐𝒇 𝑩𝒐𝒏𝒅 = 𝑪 +
𝒚𝒕𝒎 𝟏 + 𝒚𝒕𝒎 𝒏
YTM= Yield to Maturity Example 2
MV= Maturity value it would be the same as face value if the bond is A 10% Tshs 1.0 billion bond dated January 1, 2014 pays
issued at par
interest semi-annually on June 30 and December 31 0f each
C= Coupon payment (is the interest rate payments in terms of monetary year. It has a maturity 0f 5 years and the market interest rate is
amounts
12 percent. What is the price you will pay for this bond?
Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

BOND VALUATION BOND VALUATION

2. Zero coupon
The value of a zero coupon Bond is a present value of the
future cash flows expected to be derived from the bond which
is a maturity value. Use the same approach of discounting a
single payment except that under this case we discount the
maturity value of a zero coupon bond semi- annually. The
assumption is the interest rate compounds semi-annually.
Example 3 : A zero coupon Bond
GMKES Plc. issues a bond with face value of TAS 10,000
over a period of 5 years.
Required: Compute the value of this bond assuming that it is
a zero coupon Bond and the maturity value is 10,000 with
12% Yield to maturity.

𝑴𝑽
𝑷𝑽 𝒐𝒇 𝑩𝒐𝒏𝒅 = 𝒏𝒙𝟐
𝒚𝒕𝒎
𝟏+ 𝟐

Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

2
 1/22/2022

OVER/UNDER VALUATION OF BONDS BOND YIELDS

The computed present value as per the above formulas is now
compared to the market price of the bonds.
If present value of bond is less than the market price, the
bond is said to be under-valued.
If the computed present value of bond is higher than the
market price then the bond is said to be over-valued
If the present value of the bond is equal to market price the
bond is said to be at par
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
Yield is an important concept in bond investing, as we use it
as a tool to measure the return of one bond as compared to
another. It enables the investor to make informed decisions
about which bond to buy.
1. Current Yield
Current yield is an investment's annual income (interest or
dividends) divided by the current price of the security. This
measure examines the current price of a bond, rather than
looking at its face value. Current yield represents the return
an investor would expect to earn, if the owner purchased
the bond and held it for a year. However, current yield is
not the actual return an investor receives if he holds a bond
until maturity.
Mr. Mshana: MFA-OG, Bcom Accounting
𝑪𝒐𝒖𝒑𝒐𝒏 𝒂𝒎𝒐𝒖𝒏𝒕
. Current Yield =
Hons, CPA (T), ATEC (II)
𝑷𝟎

BOND YIELDS BOND YIELDS

2. Yield to Maturity Example 4
Yield to maturity is the effective interest rate of the particular bond Mr Scot has purchased bonds of MQD Ltd from the open market at
over the life of it. It is the return that an investor gains by receiving Tshs 1280 per bond. The par value of the bond is Tshs. 1200 @ 12%
the present value of coupons payment, the par value and the capital interest payable annually. The year to maturity is 10 years.
gains in relation to the price that is paid. Required: Compute the YTM (Yield to Maturity) and current yield
YTM is the interest (discount) rate at which the present values of all
the future cash flows equals the bond’s price (the concept is identical Example 5
to IRR). This is sometimes regarded as market rate of interest.
Ruex Ltd issued bonds with maturity of 5 years @12% coupon
There are two approaches to computing yield to maturity which are as payable semi-annually on 1st January 2015. The bonds with par value
follows: of Tshs 1000 are currently trading at Tshs 920. Interest is paid
i. Using trial and error or interpolation method (same as IRR) through direct credit to investor account on 31st March and 30th
ii. Using an approximation formula as follows: September.
𝑪+(
𝑴𝑽−𝑷𝟎
)
Required: Calculate the YTM of the bond and current yield.
YTM = 𝑵
𝑴𝑽+𝑷𝟎
( )
𝟐
Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

3
 1/22/2022

BOND YIELDS DURATION

The relationship between YTM and Coupon Rate This concept relates to the concept of payback period (discounted
payback period), such that it measures the time that the bond will take to
If the YTM is equal to the Coupon rate, the Bond is trading repay it’s cost of purchase.
at par There are two types of duration under bond analysis which are:
If the YTM is lower than the Coupon rate, the Bond is a) Macaulay Duration
trading above par (at Premium) b) Modified Duration
If the YTM is higher than the Coupon rate, the Bond is
trading below par (at Discount) MACAULAY DURATION
This measures the number of years required to recover the true cost
considering the present value of all coupon and principle payments
On the other hand the relationship between YTM and bond received in the future. I.e. the effective (weighted) time period to recover
prices is inverse such that as YTM increases, bond prices investment in bond.
decreases σ 𝑷𝑽 𝑿 𝒕
Macaulay Duration =
Mr. Mshana: MFA-OG, Bcom Accounting
σ 𝑷𝑽
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

DURATION DURATION
MODIFIED DURATION Example 06
This is an extension to Macaulay Duration which measures the sensitivity Diamond Ltd has issued an 8% coupon rate bond with a face value of
of bond prices due changes in interest rate. Tshs 1000, and redeemable after four years. Considering the market
In essence it measures by how much a bond price would change due to interest rate at 10%.
changes in interest rate. Required: what would be the duration of the bond.
This can be computed as follows:
Maculay Duration
Modified Duration =
(𝟏+𝒀𝑻𝑴)
In order to get a change in bond price due to a certain change in YTM
use the below:
%change in p = 𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝒙 %𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒀𝑻𝑴
change in p = 𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝒙 %𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒀𝑻𝑴 x 𝐏𝟎

Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

4

USEFULNESS OF BOND DURATION
• Bond Duration helps investors to quantify the impact of
interest rate risk (interest rate fluctuations) i.e. It predicts
how sharply the market price of a bond will change as a
result of changes in interest rates.
• On the other hand Bond duration helps investors to
immunize themselves against credit risk (default).
• Duration allows bonds of different maturities and coupon
rates to be comparable, making evaluation easier. Interest
rate risk of a portfolio can be managed by making changes in
the duration of the portfolio of bonds.
Note: the higher the duration the more sensitive the bond
price is to the changes in interest rates.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
DURATION GAP
Duration gap is a measure of the difference between entity’s interest
sensitive assets and interest sensitive liabilities. It basically measures the
sensitivity of liabilities and assets due to changes in market interest rate.
Positive Duration Gap
Here the entity’s interest sensitive assets exceeds interest sensitive
liabilities i.e. Assets Duration is more than Liabilities Duration. In this
case if market interest rate increases, the value of Assets will fall more
sharply than the value of liabilities and consequently reducing entity’s
equity.
Negative Duration Gap
Here the entity’s interest sensitive liabilities exceeds interest sensitive
assets i.e. Liabilities Duration is more than Assets Duration. In this case
if market interest rate increases, the value of Liabilities will fall more
sharply than the value of assets and consequently increasing entity’s
equity. Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
1/22/2022
LIMITATION OF DURATION
• One limitation is that duration is only an approximation of
the price sensitivity of a debt instruments, and is only
accurate as a measure of risk for relatively small changes
in relation to the current market price or yield, i.e. it
assumes a linear relationship between changes in interest
rates and prices. This can be resolved by using convexity.
• Another drawback is that duration does not consider
changes in the price of the debt instrument due to a change
in the credit rating or default by the company.
• Additionally, duration also does not consider the fact that
callable bonds/ debentures can be redeemed before their
maturity by the issuer of the bond/ debentures.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
DURATION GAP
Zero Duration gap
Under this circumstance the entity’s interest sensitive assets
equals interest sensitive liabilities i.e. Assets Duration is equal
to Liabilities Duration. In this case if market interest rate
increases, the value of Assets will fall in the same proportion
as the value of liabilities and consequently having no impact
on entity’s equity.
If the company wishes to immunize itself against interest rate
risk (fluctuation of interest rate) then it should maintain a zero
duration gap while observing an optimal weight of interest
sensitive assets and interest sensitive liabilities
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
5

CONVEXITY
Unfortunately, duration has limitations when used as a
measure of interest rate sensitivity. The statistic calculates a
linear relationship between price and yield changes in bonds.
In reality, the relationship between the changes in price and
yield is convex.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
CREDIT RATING
An investment in a company’s equity or debt is accompanied by a
risk. Credit risk is the risk that a borrower will not repay the loan
and default on the borrowing. A company desiring to issue bonds
will need a credit rating.
Many credit rating agencies such as Moody’s, Standard & Poor’s and
Fitch, perform financial research and analysis on commercial and
government entities.
A bond's rating helps a lender to assess that bond's credit
quality compared to other bonds. These agencies rank the
creditworthiness of borrowers using a standardised ratings scale.
These agencies address the possibility that a financial obligation will
not be honoured as promised. Such ratings reflect both the
likelihood of default and the probability of a financial loss suffered
in the event of default.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
1/22/2022
CONVEXITY
• Convexity, which is a measure of the curvature of the
changes in the price of a bond in relation to changes in
interest rates, is used to address this error. Basically, it
measures the change in duration as interest rates
change.
• In general, the higher the coupon, the lower the
convexity - a 5% bond is more sensitive to interest rate
changes than a 10% bond.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
CREDIT RATINGS AND BOND YIELD
Credit ratings affect a bond's yield and the return that
investors expect on the bond.
A highly rated bond usually has a lower yield. This is
because the bond issuer does not have to offer a high
coupon rate in order to attract investors.
A lower rated bond usually has a higher yield. This is
because the investors require an incentive to compensate
for the higher risk associated with the bond.
Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II)
6
 1/22/2022

BOND REFUND
This is when an entity wants to refund/redeem a bond prior to it’s
maturity date. This would be undertaken with the idea of replacing
the same with a debt carrying lower interest rate.
Factors Influencing Bond refund analysis
i. The interest rate scenario – whether rates are expected to fall
further or even out. Further decisions on switching from fixed QUESTIONS AND ANSWERS
rate loans to floating rate loans or vice versa is also critical.
ii. The estimated savings in interest outflow from replacement of
debt (post tax)
iii. Flotation costs that would be incurred on new issue
iv. Tax saving impacts on interest outflow, floatation costs etc.
v. Period between incurring new debt and replacement of old
debt Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

Question 02
Question 1
You have working with MAISARA Co. as a financial and investment analyst. MAISARA
A five year bond of Makumbusho Company has a 10% coupon payable annually. The Co is considering an investment in Benson Co.’s bonds. The company plans to hold the
bond face value is TZS. 1,000,000 and its Yield to Maturity (YTM) is estimated at 10%. bonds for only one year before selling them in the secondary market. Benson Co’ bonds
The management of Makumbusho Co. expects market interest rates to increase from are redeemable at a 2 percent premium in five years. Additional details of Benson’s
the current 10% to 12% thus pulling down the value of the bond. You are a financial bonds are as given below:
analyst and have been approached by the Board of Directors of Makumbusho
Bond Par Value TZS 10,000,000
Company to explain the theoretical implication of changes in market rates on bond
prices. The board has also once heard of the concept of Duration. They would also like Coupon Rate (payment on annual basis) 10%
to learn its relation to maturity. Yield to Maturity 10%
Required: Modified duration at the Current Yield to Maturity 3.79 Years
i. Calculate and comment on the current price of Makumbusho Company’s bond MAISARA Co considers duration of the bond to be a key factor when making
ii. Prepare a brief report for Makumbusho company’s Board which describes the investment decisions. The company investment in bonds is primarily motivated by
usefulness of duration and calculate Duration of the bond realization of capital gains.
iii. Change in bond price both in percentage and in TZS should the market interest Required:
rate increase from 10% to 12% as per management forecast 1. Estimate the Macaulay duration and the market price of MAISARA Co.’s bond
2. Estimate the new bond price and the capital gain or loss upon selling the bond one
year later if the interest rate decreases from 10% to 8% using the Duration Rule.
Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) 3. Comment on the relationship between ‘bond
Hons, CPA (T), price’ and ‘market interest rate
ATEC (II)

7
 1/22/2022

QUESTION 03 QUESTION 04
ABE has surplus cash which can be invested for at least five years. The Algorithmic Ltd has issued a bond which is redeemable after five years at a
company has consulted you to help them choose an investment that gives the coupon rate of 9% and a face value of TAS 100 million.
shortest recovery period. The company presented the information on two (a) Given that the Gross Redemption Yield (GRY) is at 10%, determine the
types of bonds as follows; following:
(i) Macaulay Duration of the bond,
Bond Redemption Nominal Redemption Coupon Rate Price TAS
Value TAS value
(ii) Modified Duration.

A redeemable in 1,000 At par 7.00 950

5 years (b) Explain two (2) benefits and limitations of duration to investors.
B redeemable in 1,000 At 5% 7.50 1,010
(c) Discuss the impact on duration of:
6 years premium (i) Longer dated bonds,
(ii) Lower coupon bonds, and
Required: (iii) Lower yields.
Use Macaulay Duration method to advise ABE on the best Bond option
to select for their investment.

Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)

QUESTION 05
National Social Security Fund bought building materials on loan from a United
Kingdom Company for its Ubungo apartments and will be paying GBP 1000 for each
of the next five years. The managing Director Dr Mzee asked the Director of THE END
Investment Mr Bajaji to create a bond portfolio so as to reduce cash outflow impact
Mr Bajaji created a bond portfolio on only two available Euro – sterling bonds, a one
year bond with a 6% coupon and a four year bond with 8% coupon. The Euro – sterling
interest rate is currently 10%
Required
i. Determine the correct amount of each bond Mr Bajaji should buy to immunize the
portfolio from interest rate risk BE EVER BLESSED BEYOND MEASURES!!
ii. Show how the value of the assets and liabilities would change if the discount rate
falls to 9.5% or Rises to 10.5% and in each case explain what you observe from
your computation
iii. Comment on the underlying assumptions for the above immunization strategy to
work
Mr. Mshana: MFA-OG, Bcom Accounting Mr. Mshana: MFA-OG, Bcom Accounting
Hons, CPA (T), ATEC (II) Hons, CPA (T), ATEC (II)