CISI – Financial Products, Markets & Services

Topic – Bonds
(5.4) Investing in bonds

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What do you know?

Attempt the 10 multiple-choice questions about corporate

bonds, which you covered previously

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What do you know?

Answers:
1. C – A commercial paper
2. C – A floating charge
3. D – the lower the cost of borrowing
4. D – They pay coupons plus a quoted margin
5. A - Issued by a domestic company
6. B – LIBOR (London Inter-bank Offered Rate)
7. B – It is a Eurobond
8. D - Foreign
9. A – They provide fixed charges as security
10. D – Higher funding costs

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Learning Objectives

1. Know the advantages and disadvantages of investing in different types

of bonds

2. Understand the role of credit rating agencies and the differences

between investment and non-investment grades

3. Be able to calculate the flat yield of a bond

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Activity – Bonds presentation

Based on everything we have covered about bonds,

In groups you are to prepare and make a 3-minute
presentation on one of either:

1. The advantages of investing in bonds

2. The advantages for a company of issuing bonds as opposed to issuing

shares

3. The disadvantages and risks of investing in bonds

You can only use flipchart paper and the whiteboard as visual aids during your
presentation.

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 Investing in bonds - advantages
A regular and certain flow of
income (bonds with a fixed coupon)

Relative security of capital Advantages of For many bonds (not all!)

for more highly rated bonds investing in they have a fixed maturity
bonds date

A range of income yields to suit

different investment and tax
situations

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Investing in bonds – Disadvantages/Risks
Price risk/Market risk
Inflation risk
Fluctuations in interest rates cause bond
If inflation rises, the ‘real’ value of the
prices to change accordingly when they
bond’s coupon and redemption payment
are traded
are eroded

Liquidity Risk
The ease with which a security
can be converted into cash.
Disadvantages Default risk
Some bonds are more easily sold
and risks of There is a possibility that
at a fair market price than others.
investing in the issuer will not be able
bonds to pay the coupon or
capital back
Exchange rate risk
Bonds denominated in a currency
different from that of the
investor’s home currency are
potentially subject to adverse
exchange rate movements.
Seniority Risk
Some bonds may rank behind more recently issued bonds in terms
of being repaid if the issuer is unable to pay the bond back
(company may go into liquidation) cisi.org
 Price Risk/Market Risk – A closer look
There is an inverse relationship between interest rates and bond prices:

If interest rates increase, bond prices will decrease

If interest rates decrease, bond prices will increase

Why? Why?
Its 5% coupon is no longer Its 5% coupon is very
attractive, so its resale price will attractive, so its resale price will
fall to compensate and make the rise to compensate and make the
return the bond offers more return it offers fall to more
competitive. realistic levels.
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Price Risk/Market Risk – A closer look

Highly rated government bonds are said to have only price risk, as there is
little or no risk that the government will fail to pay the coupons or repay the
capital on the bonds.

However, recent turmoil in government bond markets has resulted from fears that
certain European governments (such as Greece, Ireland and Portugal) may be
unable to meet their obligations on these loans.

The prices of their bonds fell significantly as a result.

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Bond yields
Yields are measures of the return that can be earned on bonds.

1888 US railway company issues a 30-year bond certificate

‘4.4% Pennsylvania Railroad Company 1931’

An investor buys US$1,000 nominal of this bond

How much in coupons does the investor receive annually?

US$44
What is the yield of the bond (at par)?

4.4%
Remember that the coupon reflects the interest rate payable on the nominal or principal
amount
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Bond yields – Flat Yields

An investor may not have paid the par value – they may have paid a different amount to
purchase the bond, so a method of calculating the true return to him or her is needed.

Flat yield

The most straightforward yield is to look at the coupon paid on a bond as a percentage of
its market price – known as the flat or running yield

Annual coupon (£)

Flat yield (%) = X 100
Bonds market price
(Price paid to purchase £100 nominal)

When a bond is kept by the holder from when it is purchased at the nominal value until the
maturity date:

Coupon rate = The yield cisi.org

Activity – Calculating bond yields
Using the worksheets provided, calculate the bond yields for each
example given.

1. A bond with a coupon of 5%, issued by XYZ 4. A company issues a bond priced £65 per £100
plc, redeemable in 2015, is currently trading at nominal, paying 2% coupons half-yearly with
£100 per £100 nominal. redemption in 2024.
Flat yield = (2/65) x 100
Flat yield = (£5/£100) x 100
Flat yield = 3.08%
Flat yield = 5%

2. A bond with a coupon of 4%, issued by ABC 5. A bond priced at £110 per £100 nominal,
plc, redeemable in 2025, is currently trading at £78 with a variable coupon of 1.5% above LIBOR
per £100 nominal has a redemption date of 2016. LIBOR is
averaging 1.2%.
Flat yield = (£4/£78) x 100
Flat yield = (£2.7/£110) x 100
Flat yield = 5.13%
Flat yield = 2.45%
3. 5% Treasury stock 2028 is currently priced at
£104 per £100 nominal.
Flat yield = (£5/£104) x 100
Flat yield = 4.81%
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Activity – Calculating bond yields
Using the worksheets provided,
calculate the bond yields for each
example given.
6.
a) 2.75% Apple Loan 2030 is
trading at £130 per £100 nominal.
What is the flat yield?
Flat yield = (£2.75/£130) x 100
Flat yield = 2.16%
b) Interest rates fall to 2.25% and
the same bond is now trading at
£140 per £100 nominal. What is
the flat yield?
Flat yield = (£2.75/£140) x 100
Flat yield = 1.96%
c) Interest rates rise to 3.15% and the
same bond is now trading for £85 per
£100 nominal. What is the flat yield?
Flat yield = (£2.75/£85) x 100
Flat yield = 3.24%
Relationship between bond prices and bond yields
If the price of the bond goes up from the nominal value, the
yield decreases.
If the price of the bond goes down from the nominal value,
the yield increases
Remember…..
Bond price when issued = £100 per £100 nominal.
If bond price when traded is below £100 per £100 nominal,
the bond price has decreased, therefore the yield will be
higher than the coupon rate
If bond price when traded is above £100 per £100 nominal,
the bond price has increased, therefore the yield will be
lower than the coupon rate
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Rating Agencies
We’ve seen examples where security in the form of a
fixed charge, floating charge or third party guarantee
over a bond does not exist.

The credit risk for most bond issues can be assessed by

looking at independent credit ratings

The three most prominent credit rating agencies that

provide these ratings are Standard & Poor’s; Moody’s;
and Fitch Ratings.

Bonds will be assessed and given a credit rating when

they are first issued and then re-assessed if
circumstances change, so that their rating can be
upgraded or downgraded with a consequent effect on their
price. cisi.org
 Ratings Agencies
Bond Credit Ratings
Credit Risk Moody’s Standard Fitch
& Poor’s Ratings
Highest quality Aaa AAA AAA INVESTMENT
High quality Very strong Aa AA AA GRADE
Offer the greatest
Upper medium grade Strong A A A liquidity and
Medium grade Baa BBB BBB certainty of
Somewhat repayment
Lower medium grade Ba BB BB
speculative
Low grade Speculative B B B NON-INVESTMENT
Poor quality May default GRADE
Caa CCC CCC
Also known as
Most speculative C CC CC ‘High Yield’
No interest being paid or bankruptcy petition The worst rated
filed C D C are also known as
In default ‘Junk’
C D D

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Grading bonds Exercise

1. Moody’s rates a bond ‘Baa’. What INVESTMENT GRADE

grade would it be rated as?
2. Standard & Poor’s rates a bond ‘BBB’. What grade INVESTMENT GRADE
would it be rated as?
3. Fitch Ratings rates a bond ‘BB’ What grade would NON-INVESTMENT GRADE
it be rated as?
4. An issuer is ‘in default’. What rating would ‘C’ rating
Moody’s give to their bonds?
5. What is the highest rating Fitch Ratings will offer ‘AAA’ rating
on bonds?
6. What rating does Standard & Poor’s offer for a bond ‘B’ rating
considered to be ‘low grade’?
7. What rating does Moody’s offer for a bond ‘Aa’ rating
considered to be ‘high quality’?
8. What rating does Fitch Ratings offer for a bond ‘CCC’ rating
considered to be ‘Poor quality’? cisi.org