‭BOND‬

‭A‬ ‭bond‬ ‭is‬ ‭a‬ ‭security‬ ‭(so‬ ‭tradable)‬ ‭instrument‬ ‭that‬ ‭evidences‬ ‭a‬‭company's‬‭debt.‬‭The‬‭instrument‬
‭can‬ ‭be‬ ‭in‬ ‭paper‬ ‭or‬ ‭electronic‬ ‭form.‬ ‭A‬ ‭bond‬ ‭usually‬ ‭pays‬ ‭a‬ ‭fixed‬ ‭rate‬ ‭of‬‭interest‬‭and‬‭it‬‭may‬‭be‬
‭secured‬ ‭or‬ ‭unsecured.‬ ‭If‬ ‭quoted,‬ ‭it‬ ‭will‬ ‭trade‬ ‭on‬ ‭an‬ ‭exchange‬ ‭at‬ ‭a‬ ‭price‬ ‭determined‬ ‭by‬ ‭that‬
‭market.‬

‭IRREDEEMABLE DEBT‬

‭The‬‭market‬‭value‬‭of‬‭any‬‭bond‬‭should‬‭equal‬‭the‬‭present‬‭value‬‭of‬‭the‬‭future‬‭payments‬‭to‬‭investors‬
‭discounted‬‭at‬‭their‬‭required‬‭return.‬‭In‬‭the‬‭case‬‭of‬‭irredeemable‬‭bonds‬‭there‬‭will‬‭be‬‭a‬‭fixed‬‭annual‬
‭payment of coupon interest into perpetuity, with no repayment of principal.‬

‭MV=‭___‬
i‬
‭K‭d‬ ‬
‭i - Annual Interest Payment starting in one year's time‬
‭K‬‭d‬ ‭- Bondholder’s required return, expressed as a decimal​‬

‭ OTE:‬
N
‭Kd is usually pre-tax.‬
‭To find post-tax, multiply with (1-t)‬

‭REDEEMABLE DEBT‬

‭The‬ ‭market‬ ‭value‬ ‭of‬ ‭a‬ ‭redeemable‬ ‭bond‬ ‭should‬ ‭equal‬ ‭the‬ ‭present‬ ‭value‬ ‭of‬ ‭the‬ ‭coupon‬‭interest‬
‭(paid‬ ‭each‬ ‭year‬ ‭until‬ ‭maturity)‬ ‭and‬ ‭the‬ ‭redemption‬ ‭price‬ ‭(paid‬ ‭at‬ ‭maturity),‬ ‭discounted‬ ‭at‬ ‭the‬
‭investors'‬‭required‬‭rate‬‭of‬‭return.‬‭The‬‭bondholder’s‬‭required‬‭return‬‭on‬‭a‬‭redeemable‬‭bond‬‭is‬‭also‬
‭referred to as its Yield to Maturity or Gross Redemption Yield.‬

‭MV = PV of future interest and redemption receipts, discounted at investors’ required returns​‬

‭MV - market price of the debenture now (year 0) ​‬

‭Q1)‬ ‭12%‬ ‭redeemable‬ ‭debt‬ ‭with‬ ‭5‬ ‭years‬ ‭to‬ ‭redemption(at‬ ‭par).‬ ‭Current‬ ‭MV‬ ‭of‬ ‭debt‬ ‭is‬
‭$107.59. Tax at 30%‬

‭Solution:‬

‭ 2)‬ ‭A‬ ‭company‬ ‭has‬ ‭in‬ ‭issue‬ ‭10%‬ ‭irredeemable‬ ‭debt‬ ‭quoted‬ ‭at‬ ‭$80‬ ‭ex-interest.‬ ‭The‬
Q
‭corporation tax rate is 30%‬
‭(a) What is the return required by the debt providers (the pre-tax cost of debt)?‬
‭(b) What is the post-tax cost of debt to the company?‬
‭Solution:‬
‭ 3)‬ ‭A‬ ‭company‬ ‭has‬ ‭irredeemable‬ ‭loan‬ ‭notes‬ ‭currently‬ ‭trading‬ ‭at‬ ‭$50‬ ‭exinterest.‬ ‭The‬
Q
‭coupon rate is 8% and the rate of corporation tax is 30%.‬
‭(a) What is the return required by the debt providers (the pre-tax cost of debt)?‬
‭(b) What is the post-tax cost of debt to the company?‬

‭Q4)‬ ‭A‬ ‭company‬ ‭has‬ ‭in‬ ‭issue‬ ‭12%‬ ‭redeemable‬ ‭loan‬ ‭notes‬ ‭with‬ ‭5‬ ‭years‬ ‭the‬ ‭redemption.‬
‭Redemption‬ ‭will‬ ‭be‬ ‭at‬ ‭par.‬ ‭The‬ ‭investors‬ ‭require‬ ‭a‬‭return‬‭of10%.‬‭What‬‭is‬‭the‬‭MV‬‭of‬‭the‬
‭loan notes?‬
‭Q5)‬‭A‬‭company‬‭has‬‭in‬‭issue‬‭12%‬‭redeemable‬‭debt‬‭with‬‭5‬‭years‬‭to‬‭redemption.‬‭Redemption‬
‭is‬‭at‬‭par.‬‭The‬‭current‬‭market‬‭value‬‭of‬‭the‬‭debt‬‭is‬‭$107.59.‬‭The‬‭corporation‬‭tax‬‭rate‬‭is‬‭30%.‬
‭What is the return required by the debt providers (pre-tax cost of debt)?‬
‭YIELD TO MATURITY‬

‭YTM‬‭is‬‭yield‬‭to‬‭maturity‬‭which‬‭means‬‭the‬‭total‬‭return‬‭you‬‭expect‬‭from‬‭your‬‭investment‬‭in‬‭bonds‬
‭if the same is held till maturity.‬

‭COUPON RATE‬

‭It is the annual amount of interest that the owner of the bond will receive.‬

‭CURRENT YIELD‬

‭It‬‭is‬‭a‬‭measure‬‭of‬‭an‬‭investor’s‬‭return‬‭in‬‭the‬‭next‬‭year,‬‭from‬‭the‬‭bond‬‭invested.‬‭It‬‭tests‬‭how‬‭much‬
‭return an investor can earn from the coupon payments given the bond’s market price.‬

‭Current Yield =‬ ‭Annual Coupon Payment‬

‭Current Bond Price‬

‭Point of Difference​‬ ‭Current Yield​‬ ‭Yield to Maturity​‬

‭Measures​‬ ‭Income from the bond​‬ ‭Total return from the bond​‬
‭Horizon​‬ ‭One year​‬ ‭Until Maturity​‬
‭Investor focus​​‬ ‭Income‬ ‭Overall Performance‬
‭ ith short-term goals and‬
W ‭ ho wants to invest for a‬
W
‭Suits investors​‬ ‭want to earn additional‬ ‭long term​‬
‭income​‬

‭YIELD TO CALL‬

‭It‬ ‭refers‬ ‭to‬ ‭the‬ ‭return‬ ‭that‬ ‭a‬ ‭bondholder‬ ‭is‬ ‭expected‬ ‭to‬ ‭receive‬ ‭if‬ ‭the‬ ‭bond‬ ‭is‬ ‭held‬ ‭until‬ ‭the‬
‭call/exercise‬‭date,‬‭which‬‭takes‬‭place‬‭much‬‭before‬‭the‬‭scheduled‬‭maturity‬‭date.‬ ‭It‬‭does‬‭not‬‭apply‬
‭to‬ ‭all‬ ‭fixed-income‬ ‭securities,‬ ‭but‬ ‭only‬ ‭to‬ ‭callable‬ ‭bonds.‬ ‭Callable‬ ‭bonds‬ ‭are‬ ‭debt‬ ‭instruments‬
‭that‬ ‭let‬ ‭bond‬ ‭issuers‬ ‭repurchase‬ ‭them‬ ‭on‬ ‭the‬ ‭call‬ ‭date‬ ‭at‬ ‭a‬ ‭predetermined‬ ‭price,‬ ‭known‬ ‭as‬
‭call/strike price.‬

‭YIELD TO PUT‬

‭It‬ ‭refers‬ ‭to‬ ‭the‬ ‭return‬ ‭that‬ ‭a‬ ‭bondholder‬ ‭is‬ ‭expected‬ ‭to‬ ‭receive‬ ‭if‬ ‭the‬ ‭bond‬ ‭is‬ ‭held‬ ‭until‬ ‭the‬
‭call/exercise‬‭date,‬‭which‬‭takes‬‭place‬‭much‬‭before‬‭the‬‭scheduled‬‭maturity‬‭date.‬‭It‬‭does‬‭not‬‭apply‬
‭to‬ ‭all‬ ‭fixed-income‬ ‭securities,‬ ‭but‬ ‭only‬ ‭to‬ ‭puttable‬ ‭bonds.‬ ‭Puttable‬ ‭bonds‬ ‭are‬ ‭debt‬ ‭instruments‬
‭that let bondholders sell them on the put date at a predetermined price, known as put/strike price.‬

‭RISK FACED WHILE INVESTING IN A BOND‬

‭BUSINESS RISK‬

‭The‬‭volatility‬‭of‬‭operating‬‭profit‬‭or,‬‭more‬‭specifically,‬‭operating‬‭cash‬‭flows‬‭due‬‭to‬‭the‬‭nature‬‭of‬
‭the‬ ‭industry,‬ ‭country‬ ‭and‬ ‭level‬ ‭of‬ ‭operational‬ ‭gearing‬ ‭(i.e.‬ ‭proportion‬ ‭of‬ ‭fixed‬ ‭to‬ ‭variable‬
‭operating costs).‬

‭SYSTEMATIC RISK‬

‭Systematic‬ ‭risk‬ ‭refers‬ ‭to‬ ‭the‬ ‭risk‬ ‭inherent‬ ‭to‬ ‭the‬ ‭entire‬ ‭market‬ ‭or‬ ‭market‬ ‭segment.‬ ‭Systematic‬
‭risk,‬‭also‬‭known‬‭as‬‭undiversifiable‬‭risk,‬‭volatility‬‭risk,‬‭or‬‭market‬‭risk,‬‭affects‬‭the‬‭overall‬‭market,‬
‭not just a particular stock or industry.‬

‭UNSYSTEMATIC RISK‬

‭Unsystematic‬ ‭risk‬ ‭is‬ ‭a‬ ‭risk‬ ‭specific‬ ‭to‬ ‭a‬ ‭company‬ ‭or‬ ‭industry.‬ ‭It‬‭is‬‭also‬‭known‬‭as‬‭diversifiable‬
‭risk‬

‭PRICE RISK​:‬

‭Price‬‭risk‬‭is‬‭the‬‭risk‬‭of‬‭a‬‭decline‬‭in‬‭the‬‭value‬‭of‬‭a‬‭security‬‭or‬‭an‬‭investment‬‭portfolio‬‭excluding‬‭a‬
‭downturn‬ ‭in‬ ‭the‬ ‭market,‬ ‭due‬ ‭to‬ ‭multiple‬ ‭factors.​‬ ‭Factors‬ ‭that‬ ‭affect‬ ‭price‬‭risk‬‭include‬‭earnings‬
‭volatility, poor business management, and price changes.​‬

‭INTEREST RATE RISK‬

‭Interest‬‭rate‬‭risk‬‭is‬‭the‬‭potential‬‭that‬‭a‬‭change‬‭in‬‭overall‬‭interest‬‭rates‬‭will‬‭reduce‬‭the‬‭value‬‭of‬‭a‬
‭bond‬‭or‬‭other‬‭fixed-rate‬‭investment.‬‭As‬‭interest‬‭rates‬‭rise‬‭bond‬‭prices‬‭fall,‬‭and‬‭vice‬‭versa.‬‭Interest‬
‭rate‬ ‭risk‬‭can‬‭be‬‭reduced‬‭through‬‭diversification‬‭of‬‭bond‬‭maturities‬‭or‬‭hedged‬‭using‬‭interest‬‭rate‬
‭derivatives.‬
‭An exposure to interest rate risk arises in the following situations:​‬
 ‭●‬ ‭An‬ ‭organization‬ ‭is‬ ‭expecting‬ ‭some‬ ‭income‬ ‭in‬ ‭the‬ ‭future,‬ ‭and‬ ‭the‬ ‭amount‬ ‭of‬ ‭income‬
‭received will depend on the interest rate at that time.​‬
‭●‬ ‭An‬‭organization‬‭is‬‭expecting‬‭to‬‭make‬‭some‬‭payment‬‭in‬‭the‬‭future,‬‭and‬‭the‬‭amount‬‭of‬‭the‬
‭payment will depend on the interest rate at the time.​‬
‭●‬ ‭The‬‭organization‬‭has‬‭an‬‭asset‬‭whose‬‭market‬‭value‬‭changes‬‭whenever‬‭market‬‭interest‬‭rates‬
‭change.‬
‭GAP ANALYSIS​‬
‭The‬‭degree‬‭to‬‭which‬‭a‬‭firm‬‭is‬‭exposed‬‭to‬‭interest‬‭rate‬‭risk‬‭can‬‭be‬‭identified‬‭through‬‭gap‬‭analysis.‬
‭This‬‭uses‬‭the‬‭principle‬‭of‬‭grouping‬‭together‬‭assets‬‭and‬‭liabilities‬‭that‬‭are‬‭affected‬‭by‬‭interest‬‭rate‬
‭changes according to their maturity dates.​‬
‭●‬ ‭A‬‭negative‬‭gap‬‭occurs‬‭when‬‭IRSL‬‭>‬‭IRSA‬‭matures‬‭at‬‭the‬‭same‬‭time.‬‭This‬‭results‬‭in‬‭a‬‭net‬
‭exposure if interest rates rise by the time of maturity​‬
‭●‬ ‭A‬ ‭positive‬ ‭gap‬ ‭occurs‬ ‭is‬ ‭the‬ ‭IRSL‬ ‭<‬ ‭IRSA‬ ‭.‬ ‭In‬ ‭this‬ ‭situation,‬ ‭the‬ ‭firm‬ ‭will‬‭lose‬‭out‬‭if‬
‭interest rates fall by maturity.​‬

‭DEFAULT RISK‬
‭Default‬ ‭risk‬ ‭refers‬ ‭to‬ ‭the‬ ‭likelihood‬ ‭that‬ ‭a‬ ‭borrower‬ ‭won't‬ ‭be‬ ‭able‬ ‭to‬ ‭make‬ ‭their‬ ‭required‬‭debt‬
‭payments‬ ‭to‬ ‭a‬ ‭lender.‬ ‭A‬ ‭higher‬ ‭level‬ ‭of‬ ‭default‬ ‭risk‬ ‭typically‬ ‭requires‬ ‭the‬ ‭borrower‬ ‭to‬ ‭pay‬ ‭a‬
‭higher‬ ‭interest‬ ‭rate.‬ ‭Factors‬ ‭causing‬ ‭Default‬ ‭risk‬ ‭include:​‬ ‭Debtor’s‬ ‭financial‬ ‭health​,‬ ‭Economic‬
‭cycle and industry conditions​, Political factors​, Foreign exchange exposure​.‬