Investment in Bonds

Definition
A BOND is a financial instrument evidencing presence
of long term obligation created in raising of capital.
The terms of bond transaction are spelt in a bond
indenture which clearly outline the rights, duties and
responsibilities of the parties involved

Bond indenture spells out the term of bond contract.

BOND INDENTURE defines the rights, duties and obligations of both
parties as well as other contract provisions/ covenants
These provisions/ covenant are both affirmative and negative.
• Affirmative covenants include actions that the borrower promises
to perform to ensure timely payment of princincipal and interest.
E.g. maintain certain current ratios, maintaining certain level of
earning assets , to pay interest and principal on timely basis etc
• Negative covenants are certain restrictions and limitation on the
borrower activities such as restrictions of additional borrowing,
paying dividends so long as debt is outstanding, use of existing
asset as further collateral etc
Failure to observe covenants may be considered as technical default.
Features of a bond
A bond should have
• Par /face value – the maturity value of
the bond
• Coupon rate – the rate of paying interest
• Issue date – the date from which first
interest start to accrue
• Term to Maturity - the life of the bond
Classification of bonds.
Bonds may be classified according to
1. Coupon rate
• Fixed rate coupon bond – with fixed
coupon rate
• Floating / variable rate coupon bond –
with a varrying coupon rate that is based
on another base rate
• Zero coupon bond – does not pay
interest in its term to maturity
2. Based on maturity
• redeemable bond – with a finite life
• irredeemable bond – with indefinite life
3. Based on Security
• unsecured (floating charge) – secured by all the assets of
the company
• Secured (fixed charge) – secured by a specific asset of the
company
• subordinate bond – a secured bond that has a secondary
charge to a specific asset
4. Based on Conversion
• non convertible – bond that can be
converted into other financial
instruments (usually equity)
• convertible- bond that are convertible
to shares
• convertible price
• conversion ratio
• another classification of bond
Based on coupon rate structure, we have 0. fixed coupon bond
1. Zero coupon bonds – 0% rate
2. Step-up notes - coupon rate increases over time.
Increase in coupon rates may be done once / several time
during the life of bond as agreed.
3. Deferred coupon bonds – initially, a deferred period exist
when no interest is paid. However after this period,
interest is paid regularly till maturity. The coupons paid are
usually higher compared to those of a similar bond without
deferment period.
4. Floating rate securities – coupon rate is variable .
Reference rate to guide the rate is required e.g.. Assume
interest paid quarterly, reference rate may 3 monthly
average 1 year treasury bills.
coupon rate = reference rate + quoted margin (that
remained fixed during life of bond)
 Sometime a floating rate bond may have a floor and a
cap as minimum and maximum coupon that can accrue
in interest of investor and borrower respectively. A bond
that has both a floor and cap is said to have a collar
5. Inverse floater. A floating rate whose coupon rate
decreases as reference rate increases and vice versa
e.g.. coupon rate = 20% - 2( 5 year TB Yield)
6. Inflation indexed bond – coupon rate linked with inflation
rate
e.g. coupon rate = 5% + annual change in Consumer
Price Index
Pros of bonds
1. cheaper to raise compared to equity
2. considered less risky compared to equity Adobe Acrobat
Document

3. Interest on bonds is tax allowable

4. Bond holders do not having voting rights
5. Bond holders do not cause dilution in control
Cons of bonds
6. Bond creates a legal obligation to pay interest
7. Bond increase financial leverage of the company
8. Usually redeemable which creates an obligation to pay
9. May contain restive covenants increasing agency costs
10. Failure to pay interest cause bond holder to force a company
into liquidation
11. Can only be issued if equity is issued
Bond pricing – traditional method
Bond price = present value of coupon payments + present value of par value

Discount rate should be prevailing market interest rate at date of issue called
EFFECTIVE INTEREST RATE

Bond may be issued at

1. Par value , market rate = coupon rate , bond price = par value
2. Discount , market rate > coupon rate, bond price < par value
3. Premium , market rate < coupon rate, bond price > par value

CLASS ILLUSTRATIONS ON BONDS PRICING

Example
A 8%, 5 years Sh 1000 bond that pay interest
semi annually was issued on 1st January
2010. Compute price if market interest rate is
• 6%
• 8%
• 10%
Valuation of bond.
The Garraty Company has two bond issues
outstanding. Both bonds are 10%, Sh 700,000
bonds. Bond L has a maturity of 15 years, and
Bond S has a maturity of 1 year. Both are annual
bonds
a. What will be the value of each of these bonds
when the going rate of interest is (1) 5%, (2) 8%,
and (3) 12%?
Clean and full price.
• Bond accrue interest throughout, though actual payment is
made every six month (Most commonly)
• Trading of bond may occur at any time. If bond is traded in
between interest payment date, it has some interest accrued.
The seller of the bond will sell the bond with accrued interest
(cum interest) or without interest (ex interest)

• Assuming the bond is traded cum interest, The price to be

paid is the true value of bond itself as at particular date ( clean
price ) plus accrued interest
Full price (sometimes dirty price) = clean price + accrued
interest
Example
1. A 10%, 5 years Sh 1000 bond that pay interest
semi annually was traded at Sh 1037 on 1st April
2012. the bond was issued on 1st January 2010.
Compute clean and full price.
2. Compute the full price and clean price today
(15th September 2011) of a 10%, 2 year sh
100,000 bond issued on 1st January 2011 and
pay interest semi-annually every six months.
yield rate is 12%.
2. Suppose Hillard Manufacturing sold an issue of bonds
with a 10-year maturity, a $1,000 par value, a 10%
coupon rate, and semiannual interest payments.
a. Two years after the bonds were issued, the going rate
of interest on bonds such as these fell to 6%. At what
price would the bonds sell?
b. Suppose that, 2 years after the initial offering, the going
interest rate had risen to 12%. At what price would the
bonds sell?
c. Suppose, as in part a, that interest rates fell to 6% 2
years after the issue date. Suppose further that the
interest rate remained at 6% for the next 8 years. What
would happen to the price of the bonds over time?
Multiple valuation approach.
Tradition approach of valuation of bond assume the same market rate
prevails all through hence only one discount rate is used for all cash
flows.
Arbitrage free valuation uses concept of spot rate where each cash
flows is discounted with the “same period” spot rate. This approach is
an application of discussed earlier.
Theoretical spot rate
Recall ;spot rate is yield rate of on the run zero coupon bond – that rate
that discount terminal cash flow to the current price .
Theoretical spot rate are spot rates computed to reflect what would be
arbitrage free yield rates on various strips. Bootstrapping is the
process of getting theoretical treasury spot rate.
Illustration 1.
Assume a 10%, 2 year, Ksh 100,000 treasury bond currently
trading at traditional price valuation to yield 11%. Following
spot rate prevails.
Six month treasury spot rate 6.00%
Twelve month treasury spot rate 7.50%
Eighteen month treasury spot rate 9.00%
Twenty-four treasury spot rate 10.00%
Compute the value of bond using
(i) Traditional valuation approach
(ii) Multiple valuation approach
Bonds return
Bond returns are in three forms
• interest
• capital gains
• reinvestment returns
Illustration
1. A 10% Sh 4 million 2 year bond was issued on 1st January
2010. interest is paid semi – annually. Market interest rate at
date of issue was 16%. Compute the bond issue price and
the total return generated by bond investor.
2. A 15% sh 6 million 6 years bond is priced to yield 12%.
Compute the yield to be earned by investor.
List of risk exposures to bond investors
1. Interest rate risk
2. Call and prepayment risk
3. Reinvestment risk
4. Credit risk
5. Liquidity risk
6. Exchange risk
7. Volatility risk
8. Inflation risk
9. Event risk
10. Sovereign risk
Provision for paying off bonds
Definitions
• Non amortizing bond – only interest is paid throughout bond’s
life. Par value is paid on maturity
• Amortising bond – periodic payment include both interest and
part of principal amount
1. Call provision – gives the issuer the right (but not obligation)
to retire all or part of bond prior to maturity date.
Usually after issue of bond, there is a period in which the
bond can’t be called (call protection period ) after which the
bond is callable (currently callable)
Call price may be fixed in advance, based on previously
agreed call scheduled, a single price irrespective of when the
call is made or mark-whole premium ( a formula is set on how
to compute premium on call). Bonds are usually called at a
premium
a. Non refundable bonds. – non refundable provision
prevents early redemption of bond from certain sources
usually proceeds from a lower coupon bond. Thus a bond
may be callable (allowing earlier redemption) but non
refundable (meaning bond can’t be recalled using proceeds
of low coupon bond). A bond may be non refundable for its
entire life meaning it can’t be refinancing.
2. Prepayment provisions – give the issuer the right to
acceralete payment of principal. These provisions are
contained in amortising bonds and mortgages
a. Sinking fund provision – requires issuer to retire a
specified portion of the issue each year (through periodic
cash payment to a trustee that equal par value of
redeemable amount or delivering to trustee purchased
bond – in open market – which upon retirement / resell will
equal to par value of redeemable ). This provision reduces
credit risk of redeemable bond.
3. Conversion privilege – the bond holder may be
granted a right to convert the bond for a given
number of shares. (Note exchangeable bond can be
exchanged with shares of other company)
4. Put provision- give the bond holder the right to sell
the bond to issuer at specified dates and specified
prices prior to maturity.
5. open market buying especially if quoted in a
market
6. discounting back to the issuer – if such provisions
have been made
7. normal retirement upon maturity.
Rights / Options granted to issuers include
i) The right to call the bond
ii) Right to prepay principal above scheduled
amounts
iii) A cap on a floater

Rights / Options to bond holders include

iv) Conversion privilege
v) Put provision
vi) Floor on a floater
Bond rating
The primary question in bond rating is whether the company can be able to
service its debt in a timely manner over the life of given issue

Bond rating provides a fundamental analysis about the issue especially

with regard to default risk.

Bond rating has a direct impact on marketability and effective interest rates
paid.

Three major rating agency are

1. Fitch Microsoft Office
Word 97 - 2003 Document
2. Moody’s
3. Standard and Poor’s