Fixed Income Securities

Fixed Income
Securities
By Dakito Alemu (PhD) & Tamirat ACCA

Issues Discussed so far
1) Meaning of Finance
2) Role and components of Financial System
3) Business mathematics
4) Meaning, function and components of MM
5) Capital market and its operations
– Primary markets
– Capital market

Content .. Fixed Income Securities
1) Definition of Bonds & other Fixed Income

Instruments
2) Types of bonds & their buyers & sellers
3) Bond valuation
4) Pricing and the r/p between interest rate & Price
5) Measuring yield sensitivity of a bond using
duration and convexity of bond
6) Credit rating agencies/system, credit spread and
the yield curve By Dakito Alemu (PhD) & Tamirat ACCA
What are fixed Income
Securities?
A fixed income security is a financial:
– obligation to the issuing entity and
– contractual right to investing entity that promises to pay a
specified sum of money at specified future dates.
– The cash flows promised to the buyer/investor of fixed
income securities represent contractual obligations of the
respective issuers.
– The entity promising the payment is called the issuer of the
security
Two categories of fixed income securities:
1) Debt obligations—Bonds
2) Preferred Stock
By Dakito Alemu (PhD) & Tamirat
ACCA
Stocks vs Bonds
Bonds Stocks
● A loan from you to a ● Represent partial
company or ownership
government. ● When a company
● When a company is in
is in danger,
danger, bonds take
precedence. stocks take a back
● Bonds have a specific seat.
maturity date ● Don’t mature
Meaning of a Bond
Is a binding agreement : COVENANT

• My word is my bond (Webster Dictionary)
Bonds are commonly referred to as loan stock, debt or fixed-
interest securities.
It represents a promise by a borrower to pay (IOU) a
lender their principal and usually interest on a loan.
• Is a debt instrument with
1) periodic payments of interest and
2) repayment of principal at maturity
• It is a debt instrument requiring:
– the issuer (borrower) to repay to the investor (lender)
– the amount borrowed plus interest
– over some specified period of time.
Sample Bond certificate
Sample Bond Certificate

ACCA
Grand Ethiopian Renaissance Dam Bond
Grand Ethiopian Renaissance
Dam Bond (Continued)
Sample Share Certificate

ACCA
Bond Characteristics
Par value: is its face value that is returned to
the bondholder at maturity.
– Par value for a bond is typically $1,000 or $100.
Coupon Interest Rate: indicates the percentage of
the par value of the bond that will be paid out
annually in the form of interest.
Term to Maturity: indicates the length of time
until the bond issuer returns the par value to the
bondholder and terminates or redeems the bond.
Factors which determine
Interest Rates
1) The general level of interest rates in the
economy (pure time value of money).
2) The level of risk
3) The duration of a loan
4) The need for the financial intermediaries
to make a profit
5) Size of loan/money
Types of bonds
1) Debentures: a long-term security yielding a fixed rate of
interest, issued by a company and unsecured-US (secured-UK)
against assets.
2) Mortgage bonds: is a bond secured by a lien on real property
(The right to take another's property if an obligation is not discharged).
3) Eurobonds- are bonds issued in a country other than
that of the currency of denomination.
1) Thus bonds issued in US dollars in London/Ethiopia are Eurobonds,
as are Yen bonds issued in New York.
4) Euro bonds- bonds denominated in Euros and issued in the
euro currency area.
• If bonds denominated in Euros would be issued outside the euro currency
area, they would be euro Eurobonds. By Dakito Alemu (PhD) & Tamirat ACCA
5) Zero coupon bonds: allow the issuing firm to issue
bonds at a substantial discount from their face value with
a zero coupon rate.
6) Deep discounted bond: Bond that will pa

interest below market rate
7) Floating rate notes (FRNs). These are corporate
bonds where the coupon can be adjusted at pre determined
intervals.
8) Junk bonds: are high-risk debt with very low
ratings.
– Junk bonds are also called high-yield bonds for the high interest rates
they pay the investor.
Callable bonds can be redeemed at the
issuer’s discretion prior to the specified maturity
(redemption) date.
Put-able bonds can be sold back
(returned) to the issuer on specified dates at the
holder’s discretion, prior to the redemption date.
Convertible bonds. These are usually
corporate bonds, issued with the option for holders to
convert into some other asset on specified terms at a
future date.
Example
United Bank issues 2,000 convertible bonds at the start of 2008.
The bonds have a 3-year term, and are issued at par with a face
value of Br. 1000 per bond, giving total proceeds of Br.
2,000,000.
Interest is payable annually in arrears at a nominal annual
interest rate of 6%.
Each bond is convertible at any time up to maturity into 250
common share.
The market interest rate on similar bond without conversion
right was 9% and the risk-free annual interest rate for 3-year tem is 5%.
At he issue date, the market price of one common share is Br. 3. The dividend expected over the 3-year term of
the bonds amount to 14c per share at the end of each year.
– What is the value of the equity component in the

bond?
Solution
PV of the principal (Br. 2m/1.09)3………….. 1,544,000
PV of interest (Br. 0.12m (1-(1.09)3)/.09………303,720
Total liability Component…………………….1,847,720
Add: Equity component (balancing figure)….…152,280
Total proceed of the bond issue…..Br. 2,000,000
The split b/n the liability and equity component remains the
same throughout the term of the instrument, even if there
are changes in the likelihood of the option being exercised.
– Since it is impossible to predict how the bondholder will behave
– the issuer continue to have an obligation to make future payments
until conversion.

Bond indenture/Contract
Bond indenture: a legal and binding contract between a

bond issuer and the bondholders
The bond indenture/contract describes the details of a
bond issue:
1) Description of the loan (interest rate,
maturity date)
2) Terms of repayment
3) Collateral
4) Default provisions
Debt Markets

Debt Markets
Debt markets are used by both firms and
governments to
– raise funds for long-term purposes, though most
investment by firms is financed by retained profits.
Bonds are long-term borrowing instruments for
the issuer.
– Major issuers of bonds are governments (Treasury
bonds in US, Ethiopia) and firms, which issue corporate
bonds/debenture

Bond Market
Primary markets for bonds, i.e. the markets in which newly issued
instruments are bought,
– Art 49 (1248/21) ―Primary Market‖ means a market
facilitated by underwriters in which new capital is
created or raised by selling newly issued stocks, bonds,
notes, and other financial instruments;
Secondary markets, in which existing or second hand instruments
are traded.
– Art 61/ ―Secondary Market‖ means market or markets where investors
buy previously issued securities from other investors as opposed to the
primary market, where investors buy new securities directly from the
issuer or an intermediary;
BOND
VALUATION

What is Bond Valuation?
Is a technique for determining the
theoretical fair value of a particular bond.
Bond valuation includes calculating the
present value of a:
1) Bond's future interest payments, also
known as its cash flow, and
2) Bond's value upon maturity, also known
as its face value or par value.
Who should value a bond?
Is the process of determining the fair
value or fair price of a bond.
An investor as well as the issuer uses bond
valuation to determine what rate of return (Price)
is required for a bond investment to be worthwhile.
Note
– The debt is normally valued gross of debt because we do
not know the tax position of each investor.
Types of Bond Prices
Clean price (Ex- interest)- the price of a

bond ignoring any interest which may have
accrued since the last coupon payment.
Dirty price (Cum- interest)- the price of
a bond, including any accrued interest.
Quoted prices are usually clean prices
whereas the price to be paid is the dirty
price.
Approaches of Bond valuation
1) Book value : is the value of an asset as shown on

a firm’s balance sheet.
2) Liquidation value is the dollar sum that could be
realized if an asset were sold individually and not
as part of a going concern.
3) The intrinsic/Discounted Model of an asset, also
called the fair value ——is the present value of the asset’s
expected future cash flows. Theoretical
• This value is the amount an investor should be willing to pay,
given the amount, timing, and riskiness of future cash flows.
Current Yield, Capital Gain Yield and Yield to
Maturity (YTM)
The theoretical fair value of a bond is calculated by discounting the future value
of its coupon payments by an appropriate discount rate (YTM).
Annual coupon payment

Current yield (CY) 
Current price
Change in price
Capital gains yield (CGY) 
Beginning price
 Expected  Expected
Expected totalreturn  YT M  
 CY    CGY 
   
YTM of Discounted Bond
For a discount bond, the yield to maturity
(YTM) is greater than the current yield
• A bond that is issued for less than its par (or face) value, or
a bond currently trading for less than its par value in the
secondary market.
For a premium bond, the yield to maturity is less than

the current yield
– A premium bond is a bond trading above its par value;
• a bond trades at a premium when it offers a coupon
rate higher than prevailing interest rates
Test Your Understanding
Consider a bond with a 15 10% annual coupon rate,
years to maturity and a par value

of $1,000. The current price is
$800.
–Will the yield to maturity be
more or less than current yield?

Relationship between Bond Price, Yield-
to Maturity, and Coupon Rate
When coupon rate = YTM, price = par

value.
When coupon rate > YTM, price > par
value (premium bond)
When coupon rate < YTM, price < par
value (discount bond)
ACCA
Example:- Current Yield
What is the current yield and the yield to
maturity on a $1,000 face value discount
bond maturing in 1 year , the coupon
rate is10% and selling for a price of
$800?
Solution:-
CY= I/P = 1000*0.1/800 = 12.5%
Bond Valuation (Continued)
Basic Valuation Model:

PVIF-Present Value Interest Factor
Basic Valuation Model:
PVIF-Present Value Interest Factor
Bond valuation- Discounted
Model
Is the process of determining the fair value of a bond is based
on the present value of expected future cash flows.
When valuing debt we assume that
– Market price = Discounted cash flows of the debt
The value of a bond is the present value of the expected
cash flows on the bond, discounted at an interest rate
(investors required rate of return…CAPM) that is
appropriate to the riskiness of that bond.
• It is the intrinsic value or the fair value of the bond.
• As interest rates rise, the price of a bond will decrease and vice
versa.
Bond Valuation-Discounted Model
Generally, value of financial asset is

affected by three elements:
1) The amount and timing of the asset's
expected cash flows
2) The riskiness of these cash flows
3) The investor's required rate (YTM) of
return for undertaking the investment

Types of Bond/Debt
1) IRREDEEMABLE BOND
2) REDEEMABLE BOND

1) Valuation of Debt –
Irredeemable Bond
Irredeemable debt is debt that is never repaid.
The company does not intend to repay the principal but to pay
interest forever, the interest is paid in perpetuity.
The holder of this debt will simply receive interest each year for ever
(unless they choose to sell it on the stock exchange, in which case the
purchase will continue to receive the interest).
The market value of irredeemable debt can be expressed as a
formula as follows:
Market Value =I/kd

– where:
– I = the interest p.a. on £100 nominal
– kd= the investors required rate of return
Q PLC has in issue $1,000,000 6%

irredeemable debentures.
Investors currently require a return of
12% p.a..
What will be the market value of the
debt?
Solution
Market value = 6p.a *(1/0.12)

= $50 p.c. ex. int.
Ex-Interest Price : When the interest accrued from the last due date
of interest to the date of transaction is not included in the price
quoted, it is called
Ex-interest price or
Real Price.
Cum-Interest Price : When the interest accrued from the last due
date of interest to the date of transaction is included in the price
quoted, it is called Cum-Interest price which is the total amount
paid for the purchase of debentures.
By Dakito Alemu (PhD) & Tamira
ACCA
Valuation of Preference shares
Similar to irredeemable debt, the income stream

is the fixed percentage dividend received in
perpetuity.
The formula is therefore: P0= D/ Kp
where:
– D = the constant annual preference dividend
– P0 = ex-div market value of the share
– Kp = cost of the preference share.
Tosca- A firm has in issue $1 11%

preference shares.
The required return of preference
shareholders is 12%.
Required:
What is the value of a preference
share?
Solution
PO= 11*(1/0.12)
$92

2) Valuation of Debt –
Redeemable Bond
In practice, debt is not irredeemable but
redeemable which means that the company
will repay the borrowing at some specified
date in the future.
The valuation of redeemable debt is the
one place where there is no formula and
where we have no choice but to use first
principles.
Bond valuation formula
– Coupon t .is coupon payment at end of time‖ t‖

– r is the period discount rate (IRR/YTM/RRR).
– N is the number of periods remaining.

Example 1
A bond pays a coupon of 4% every six months, and
100 birr will be repaid at maturity.
– There are two years to maturity and the next
coupon is due in six months.
The redemption yield (yield to maturity or
IRR/RRR) on similar bonds is 6% per year.
What is the selling price/intrinsic value of the bond?

Solution
– An interest rate of 6% p.a.

indicates a rate of 3% per six
month period.
– P = 4/(1.03) + 4/(1.03)2 + 4/(1.03)3
+4/(1.03)4+ 100/(1.03)4
– P = 3.88 + 3.77 + 3.66 + 3.55 +
88.85 = 103.71 Birr
CREDIT RATING
AGENCIES/SYSTEM
BOND RISKS

Types of Bond Risks
Risks on a bond are the

following
1) Interest rate risk
2) Price risks
3) Default risk

1) Interest Rate Risk
Interest rate risk is the chance of

loss because of changing interest
rates
The relationship between bond prices
and interest rates is inverse
– If market interest rates rise, the market price
of bonds will fall (Malkiel’s theorems)
– Bonds with Longer term to maturity have
more interest rate risk (Malkiel’s theorems)
3 factors that affect bond
prices
1) Interest rates: In general, when
interest rates rise, bond. They use
the money to run their operations.
2) Inflation: In general, when
inflation. This means a dollar can
buy fewer goods over time. ...
3) Credit ratings: Credit rating.
What Determines the Price Volatility for Bonds
Interest rate risk

Interest rate risk is the risk of that interest rates will change,
and therefore, a reduction in the value/price of a security.
Price risk
Price Risk:- is the risk of Change in price due to changes in interest
rates
Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon rate
bonds
Longer maturity higher interest rate risk
Shorter maturity Lower interest rate risk
Longer maturity higher interest rate risk Higher coupon rate
Shorter maturity Lower interest rate risk Lower coupon rate
3) Default Risk
Default risk/credit risk measures the

likelihood that a firm will be unable to pay
the principal and interest on a bond. Market
index setters
– Standard & Poor’s Corporation (S&P 500),
– Dow Jones Industrial Average (DJIA’s 30)
– Fitch and
– Moody’s Investor Service are the leading advisory
services monitoring default risk
BOND
RATING
What are Bond Ratings?
Is a letter-based credit scoring scheme used to judge the
quality and creditworthiness of a bond.
Is a grade given to bonds that indicates their credit
quality.
– The higher the rating the less likely an issuer will default.
Credit ratings or credit scores are based on substantial
due diligence conducted by the rating agencies who must
take a balanced and objective view of the borrower's
financial situation and capacity to service/repay the debt.
Is an opinion of the ability of issuer to honor their
financial obligation to make coupon or principle
payments.
ACCA
Bond Rating
Credit Rating Agencies
Who issues bond ratings?
Moody’s Investor Services
• 1909 – John Moody published a book of Railroad Investments that
included concise analysis of their relative investment quality.
Standard & Poor’s Corporation

• 1860 – Henry Varnum Poor began supplying European investors with
financial information on their holdings in the developing infrastructure of
America
Fitch Ratings
• 1913 – John Knowles Finch published “Fitch Bond Book” and other
books on financial markets. Fitch is credited with introducing the AAA
through D rating system now used

ACCA
Comparison of Bond Ratings

ACCA
ACCA
ACCA
Bond Ratings – Investment Quality
High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very strong
Medium Grade
– Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
– Moody’s Baa and S&P BBB – capacity to pay is adequate,
adverse conditions will have more impact on the firm’s
ability to pay
ACCA 7-71
Bond Ratings - Speculative
Low Grade
– Moody’s Ba and B
– S&P BB and B
– Considered possible that the capacity to pay will
deteriorate.
Very Low Grade
– Moody’s C (and below) and S&P C (and below)
• income bonds with no interest being paid, or
• in default with principal and interest in arrears
By Dakito Alemu (PhD) & Tamirat ACCA 7-72

Default Risk (cont’d)
Investment grade bonds are bonds

rated BBB (medium grade) or above
Junk bonds are rated below BBB
–The lower the grade of a bond, the
higher its yield to maturity

The steps involved in credit rating
process are explained below:
1) Receipt of the Request.
2) Assignment to Analytical Team.
3) Obtaining Information.
4) Plant Visits and Meeting with Management.
5) Presentation of Findings.
6) Rating Committee Meeting.
7) Communication of Decision.
8) Dissemination of the Public.
ACCA
Specific Rating Factors
o The strength of the issuer's balance sheet.
o The issuer's ability to make its debt
payments.
o The condition of the issuer's operations.
o The future economic outlook for the issuer.
o Current business conditions, including
profit margins and earnings growth
(corporations)
ACCA
ACCA
ACCA
2021 Ethiopia’s Credit Rating
According to trading economics,
– Standard & Poor's credit rating for Ethiopia stands at CCC .
– Moody's credit rating for Ethiopia was last set at Caa2.
– Fitch's credit rating for Ethiopia was last reported at CCC.
In general, a credit rating is used by sovereign wealth
funds, pension funds and other investors to gauge the
credit worthiness of Ethiopia thus having a big impact on
the country's borrowing costs.
– In 2020, the national debt of Ethiopia amounted to
around 42.79 billion U.S. dollars.
This page includes the government debt credit rating for
Ethiopia as reported by major credit rating agencies.
Agency Rating Outlook Date
S&P CCC Negative Nov 10 2021
Moody's Caa2 Negative Oct 20 2021
S&P CCC+ Negative Sep 24 2021
Moody's Caa1 Under review May 17 2021
Moody's B2 Under review Mar 10 2021
S&P B- Negative watch Feb 12 2021
Fitch CCC n/a Feb 09 2021
Moody's B2 Negative Aug 07 2020
Moody's B2 Under review May 07 2020
S&P B Negative Apr 10 2020
Fitch B Negative Oct 01 2019
Moody's B1 Negative Sep 20 2019
S&P B Stable May 09 2014
Moody's B1 Stable May 09 2014
Fitch B Stable May 09 2014
ACCA
Global Credit Ranking for Emerging Market Countries

ACCA
ACCA
ACCA
The end!

ACCA

Fixed Income Securities

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Fixed Income

By Dakito Alemu (PhD) & Tamirat ACCA

By Dakito Alemu (PhD) & Tamirat ACCA

1) Definition of Bonds & other Fixed Income

Is a binding agreement : COVENANT

By Dakito Alemu (PhD) & Tamirat

By Dakito Alemu (PhD) & Tamirat

6) Deep discounted bond: Bond that will pa

– What is the value of the equity component in the

By Dakito Alemu (PhD) & Tamirat ACCA

Bond indenture: a legal and binding contract between a

By Dakito Alemu (PhD) & Tamirat ACCA

By Dakito Alemu (PhD) & Tamirat ACCA

By Dakito Alemu (PhD) & Tamirat ACCA

Clean price (Ex- interest)- the price of a

1) Book value : is the value of an asset as shown on

Annual coupon payment

For a premium bond, the yield to maturity is less than

Consider a bond with a 15 10% annual coupon rate,

years to maturity and a par value

By Dakito Alemu (PhD) & Tamirat ACCA

When coupon rate = YTM, price = par

Basic Valuation Model:

Generally, value of financial asset is

By Dakito Alemu (PhD) & Tamirat ACCA

By Dakito Alemu (PhD) & Tamirat ACCA

Market Value =I/kd

Q PLC has in issue $1,000,000 6%

Market value = 6p.a *(1/0.12)

Similar to irredeemable debt, the income stream

Tosca- A firm has in issue $1 11%

By Dakito Alemu (PhD) & Tamirat ACCA

– Coupon t .is coupon payment at end of time‖ t‖

By Dakito Alemu (PhD) & Tamirat ACCA

What is the selling price/intrinsic value of the bond?

By Dakito Alemu (PhD) & Tamirat ACCA

– An interest rate of 6% p.a.

By Dakito Alemu (PhD) & Tamirat ACCA

Risks on a bond are the

By Dakito Alemu (PhD) & Tamirat ACCA

Interest rate risk is the chance of

Interest rate risk

Default risk/credit risk measures the

Standard & Poor’s Corporation

By Dakito Alemu (PhD) & Tamirat ACCA

By Dakito Alemu (PhD) & Tamirat

By Dakito Alemu (PhD) & Tamirat ACCA 7-72

Investment grade bonds are bonds

By Dakito Alemu (PhD) & Tamirat ACCA

By Dakito Alemu (PhD) & Tamirat

By Dakito Alemu (PhD) & Tamirat

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