ACFN 3201

Investment and Portfolio Management

Kebede A.
Ambo University,
Ethiopia
 Introduction

• No business organization can have enough capital for all its operational
needs.
• To meet their operational needs companies do is to borrow money from
lenders.
• well-established companies issues long-term bond to investors and make
money available for their operations.
• Bonds are publicly traded long-term debt securities.
• Bonds are issued in convenient denominations to
investors.
Bonds are exposed to many kinds of risks including:
 interest rate risk,
 purchasing power risk,
 business risk,
 liquidity risk and call risk.
 
 Why bonds?
• Bonds are issued by a variety borrowing companies, government corporations,
states and local governments.
• Bonds are referred to as fixed –income securities because the debt obligations of
the issuer are fixed. (issuer agrees to pay a fixed amount of interest periodically and
to repay a fixed amount of principal at maturity)
• bonds provide investors with two kinds of income:
 1) They provide a generous amount of current income (interest).
 2) They can often be used to generate substantial amounts of capital gains(whenever
market interest rates fall ).
• A basic trading rule in the bond market is that interest rates and bond prices move in
opposite directions.
• When market interest rates rise, bond prices fall, and when market interest rates
drop, bond prices move up.
• Thus, it is possible to buy bonds at low price and to sell them later at a higher price
(capital Gain)
• it is possible to buy bonds at high price and to sell them later at a low price capital
loss,
 Introduction to bond
• Bond is a contract to repay borrowed money with interest (the coupon) at fixed
intervals and repay the principal at a later date, termed maturity.
• Bond is a loan; the issuer is the borrower, the bond holder is the lender, and the
coupon is the interest.
• Bonds provide the borrower with external funds to finance long-term investments.
• Bonds and stocks are both securities,
• The major difference between stock and bond are:
 stock- holders are the owners of the company (i.e., they have an equity stake),
whereas bond-holders are lenders to the issuer.
 bonds usually have a defined term, or maturity, after which the bond is
redeemed, whereas stocks may be outstanding indefinitely.
• An exception is a consol bond, which is perpetuity (i.e., bond with no maturity).
 Types of Bonds
1. Secured bonds and unsecured bonds:
 secured bond is ---secured by the real assets of the issuer.
 unsecured bond -----the name and fame of the issuer is only the security.
2. Perpetual bonds and redeemable bonds:
 Perpetual bonds do not mature or never mature but interest alone would be
paid
 Redeemable bond is redeemed after a specified period of time. The redemption
value is specified by the issuer.
3. Fixed interest rate bonds and floating interest bonds:
 Fixed interest rate bonds-----the interest rate is fixed at the time of issue.
 Floating interest rate bonds-----the interest rates change according to the
prefixed norms
 Types of Bonds……contd
4.Zero Coupon bonds:
 These bonds sell at discount and the face value is repaid at maturity.
 The difference between the purchase cost and face value of the bond is the gain for the
investor.
 the investor does not receive any interest on the bond,
5.Deep discount bonds:
 another form of zero coupon bonds.
 Sell at large discount and mature(repaid) at par value.
 The difference between the maturity value and the issue price is interest maturity period
range from 3 years to 25 years or more.
6.Income Bond:
 interest need be paid only if earned.

7.Tax-Exempt Bonds:
 income from State and Municipal bonds is not subject to the United States Federal income
tax
 Bond Characteristics:
• 1. Bond has a face value. The face value is called par value. The bonds may be issued at par
or at discount.

• 2. The interest rate is fixed. Sometimes it may be variable as in the case of floating rate bond.
Interest is paid semi-annually or annually. The interest rate is known as coupon rate. Interest
rate is specified in certificate.

• 3. The maturity date of bond is usually specified at the issue time except in case of perpetual
bonds.

• 4. The redemption value is also stated in the bonds. The recovery value may be at par value
or at premium.
 
• 5. Bonds are traded in the stock market. When they are traded the market value may be at
par or at premium or at discount. The market value and redemption value need not be the
same.
 
 Relationship between price and a yield of Bond:

• Bond Price:
 The price the investor pays for the bond
 Bond's price will be higher when it pays a coupon (interest) that is higher than
prevailing interest rates.
 when the market interest rates rise, bond prices fall, and when market interest
rates drop, bond prices move up.
 Market interest rates and bond prices move in opposite directions.
• Bond yield:
 The return an investor will receive by holding a bond to maturity.
 The required yield of a bond is usually the yield offered by other bonds that are
currently offered in the market
 Before buying a bond the investor has to calculate the yield of the bond
 Risks in Bonds
1. Business /Financial risk:
 Arises when the issuer will default on interest and/or principal payments.
 a decline in earning power, which reduces a company’s ability to pay interests or dividends
 The stronger the issuer, the less business/financial risk. Example.; government treasury
bills do not have business/financial risk

2. Liquidity Risk:
 The risk that a bond will be difficult to sell it.
 little trading is done in the secondary markets

3. Market risk:
 Arises a change in “market psychology”
 irrespective of any truly fundamental change in earning power security’s price to decline .
 Risks in Bonds…….Cont’d
4. Purchasing power risk:
 Arises with inflation
 A rise in prices, which reduces the buying power of income and principal.
5. Interest rate risk:
 Arises because of price volatility in the bond market.
 When market interest rates rise, bond prices fall, and vice versa.
 a rise in interest rates(market interest rate) is the major cause
6. Call Risk:
 Also called as prepayment risk
 Arises because a bond will be “recalled,” before its scheduled maturity date.
 When there is a big fall in market interest rates bond issuers call for repayment and the
investors have no option to replace a high-yielding bond with a much lower-yielding issue
7. Political risk
 Arises because of price control, wage control, tax increases, changes in tariff and subsidy
policies.
 Rating of Bonds
• The rating is a financial indicator to know the quality of bonds.

• Ratings are the letter grade assigned by credit rating agencies such as
Standard & Poor's, Moody's or Fitch
• Rating scales are---AAA, AA, A, BBB, BB, B, CCC, CC, C, D.

• Anything lower than a BBB rating is considered a speculative or junk bond.

• The rating will give you a clear idea about the quality of the bond.

• Rating is a useful for purchase of a bond.

 Convertible Bonds:

• Convertible bonds are----- bonds which may be exchanged at

the option of then holder for a specified number or amount of
other securities

• Usually the bond is convertible into a fixed number of shares

of common stock.
End of the Chapter