CHAPTER THREE

FIXED INCOME
SECURITIES

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 BOND BASICS
• Bond is a debt instrument issued for a period of more than one year
with the purpose of raising capital by borrowing.
• So bonds are long-term debt or funded debt, issued by corporations,
and governments and their agencies to finance operations or special
projects.
• Corporations pay back interest and principal from earnings, whereas
governments pay from taxes, or revenues from special projects.
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Most individual bonds have five features when they are issued: issue
size, issue date, maturity date, maturity value, and coupon.
1. Issue size – is the number of bonds issued multiplied by the face
value. For example, if an entity issues two million bonds with a
1,000 Birr price, the issue size is 2 billion Birr.
2. Issue date – The issue date is simply the date on which a bond is
issued and begins to accrue interest. For example, if bond is issued
on January 1st then the bond issuer will have to pay coupon/interest
from that day to the bond holders.

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3. Maturity date – the date on which an investor can expect to have
his or her principal repaid.
4. Maturity value – the amount of money the issuer will pay the
holder of a bond at the maturity date.
5. Coupon – The coupon rate is the periodic interest payment that the
issuer makes during the life of the bond.
– For instance, if a bond with a 100,000 Birr maturity value offers a
coupon of 14%, the investor can expect to receive 14,000 Birr each
year until the bond matures.

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 How are bonds different from stocks?
• Bonds are considered debt investments.
• On the other hand, a stock purchase is considered an equity
investment because the investor (also known as the stockholder)
becomes a part owner of the corporation.
• While bonds generally don’t provide an opportunity to share in the
profits of the corporation, the stockholder is entitled to receive a
portion of the profits and may also be given voting rights.

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• Bondholders earn interest while stockholders typically receive
dividends.
• Because bondholders are creditors rather than part owners, if a
corporation goes bankrupt, bondholders have a higher claim on assets
than stockholders.
– This provides added security to the bond investor – but does not completely
eliminate risk.

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 Benefits of Investing in Bonds
1. Income predictability
2. Safety
3. Diversification and
4. Choice

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 Risks of Bond Investing
1. The risk of default (also known as credit risk)
– An issuer of debt is said to be in default when the issuer is unable to repay
the principle or interest as scheduled.
– Most of the time government bonds have virtually no risk of default.
– Corporate bonds are more exposed to default risk because companies cannot
raise taxes when there is a cash shortfall or take advantage of other options
available to governments.

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Price risk
– If you sell your bonds prior to their maturity, their price or market value may
be lower than the price at which you bought them.
Demand and supply
– The availability of bonds and the demand for them also affects the price of
bonds.
– As demand increases, prices raise, all other factors remaining the same.
– Also, as the supply of bonds decline, prices generally also rise.
– Similarly, when demand falls or supply increases, prices fall and yield to
maturity declines.

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 Pricing of Bonds
• The price or value of a bond is determined by discounting the bond's
expected cash flows to the present using the appropriate discount
rate.
• The price of the bond should equal the present value of its expected
cash flows.
• The coupons and principal repayment of 1,000 Birr are known and
the present value, or price, can be determined by discounting these
future payments from the issuer at an appropriate required yield, r,
for the issue.

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This relationship is expressed for coupon bond by the following
formula:

Where,
C = the annual coupon payment,
i = the required return on the bond, and
n = Number of compounding in a year.

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Example-1- If a 1,000 Birr face value bond paying 15% coupon is maturing in 10 years
and the interest rate is 12%. How much should you pay for this bond?
Face Value Coupon rate Maturing time Interest rate
1,000 15% 10 years 12%
Given:
– The annual coupon payment (C)= 1,000 x 0.15 = 150
– The required return on the bond (i)= 0.12
– Number of compounding in a year (n)= 10

= 1,169.50
So, an investor should pay maximum 1,169.50 Birr for this bond.

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Example 3.2: If a 12% semi-annual bond maturing in 10 years is
selling in the market for 750 Birr when the market interest rate is 16%.
Should you buy this bond at 750 Birr?
Face Value Coupon rate Maturing Interest rate
1,000 Annual 12% or 6% 10 years or 20 semi- Annual 16% or semi-
semi-annual annual annual 8%

Given:
– The annual coupon payment (C)= 1,000 x 0.06 = 60
– The required return on the bond (i)= 0.08
– Number of compounding in a year (n)= 20

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Solution:

PV of Bond = 803.63
Yes, we should buy the bond because its intrinsic value 803.63 Birr is
higher than the market price of 750 Birr.

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Exercise:
Assume that you wish to purchase a bond with a 30-year maturity, an annual
coupon rate of 10 percent, a face value of Birr 1,000, and semiannual interest
payments. If you require a 9 percent nominal yield to maturity on this investment,
what is the maximum price you should be willing to pay for the bond?
Given:
– The annual coupon payment (C)= 1,000 x 0.05 = 50
– The required return on the bond (i)= 0.045
– Number of compounding in a year (n)= 60

= Birr 1,103.19

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Exercise 2: You intend to purchase a 10-year, Br 1,000 face value bond
that pays interest of Birr 60 every 6 months. If your nominal annual
required rate of return is 10 percent with semiannual compounding,
how much should you be willing to pay for this bond?
Given:
– The annual coupon payment (C)= 1,000 x 0.06 = 60
– The required return on the bond (i)= 0.05
– Number of compounding in a year (n)= 20

Birr 1,124.62

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Discount and premium bonds
• A bond whose market price is less than its par value is selling at a
discount. It is called discount bond.
• If the market price is more than the par value, the bond is selling at a
premium. It is called premium bond.

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• Yield on the bond
• The return of a bond is largely determined by its interest rate, which,
in turn, is determined by the prevailing interest rate and the
creditworthiness of the issuer, assessed by credit rating companies.
• A higher credit rating allows the issuer to sell its bonds for a higher
price, i.e. at a lower interest rate.
• Nominal yield, or the coupon rate, is the stated interest rate of the
bond, which is a percentage of par values.
• The coupon is usually paid semiannually. Thus, a bond that pays 14%
interest pays 140 Birr per year in 2 semi-annual payments of 70 Birr.

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• Bonds trading in the secondary market will usually have prices that
are less or more than par value, thus yielding an interest rate that
differs from the nominal yield, called the current yield, or current
return.
• So the price of bonds moves in the opposite direction of interest
rates.

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• Current Yield:
• Because current bond prices fluctuate, an investor can pay more or
less than the par value for a bond.
• Current yield measure looks at the current price of a bond instead of
its face value and
• It represents the return an investor would expect if he or she
purchased the bond and held it for a year.
• This measure is not an accurate reflection of the actual return that an
investor will receive in all cases because bond prices are constantly
changing due to market factors.

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Current Yield Formula

• Example: If a bond is paying 14% annual coupon having value of

1,000 Birr which is now selling in the market for 880 Birr, what is the
current yield of this bond?

• Recall that if the market price of a bond goes down, the current yield
will go up. Using the above example, if the current bond price goes
down to 700 Birr instead 880 Birr, the current yield would be:
140/700 = 20%.

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• Yield to Maturity:
• The yield-to-maturity, or true yield, of a bond that is held to
maturity will have to account for the gain or loss that occurs when
the par value is repaid.
• The yield to maturity generally will yield an interest rate comparable
to newly issued bonds with the same credit rating. The following
formula provides an approximation of YTM.

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• Example: If a 1,000 Birr face value with 12% annual coupon with
maturity of 6 years is now trading for 900 Birr and assuming that the
investors buys it for 900 Birr and hold it until maturity. YTM is
calculated as follows:

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Example 2: The price of a bond is 920 Birr with a face value of 1,000
Birr which is the face value of many bonds. Assume that the annual
coupons are 100 Birr, which is a 10% coupon rate, and that there are 10
years remaining until maturity.
What is the YTM of this bond?

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Example 3: If a 1,000 Birr face value bond paying 15% coupon
whereas it is maturing in 10 years and the interest rate is 12%. If it is
trading for 1,150 Birr, what is the current yield and YTM?

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Example 4: If a 12% annual bond having 1,000 Birr face value
maturing in 10 years is selling in the market for 750 Birr when the
market interest rate is 16%. What is the current yield and YTM of this
bond?

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Example 5: A corporate bond has a face value of $1,000, and pays a
$50 coupon every six months (i.e., the bond has a 10 percent
semiannual coupon). The bond matures in 12 years and sells at a price
of $1,080. What is the bond’s nominal yield to maturity?

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 Bond rating:
Agencies ratings are an integral part of the bond market because most
corporate and municipal bonds are rated by one or more of the rating
agencies.
There are three major rating agencies:
(1) Fitch Investors Service,
(2) Moody’s, and
(3) Standard and Poor’s (S and P)

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• Bond ratings provide the fundamental analysis for thousands of
issues.
• The rating agencies analyze the issuing organization and the specific
issue to determine the probability of default and inform the market of
their analyses through their ratings.
• The agencies assign letter ratings depicting what they view as the risk
of default of an obligation.
• The letter ratings range from AAA (Aaa) to D.
• Table below describes the various ratings assigned by the major
services.

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 FITC MOO S & P DEFINITION
H DY’S
AAA Aaa AAA The highest rating assigned to a debt instrument,
High indicating an extremely strong capacity to pay principal
grade and interest. Bonds in this category are often referred to
as gilt edge securities.
AA Aa AA High-quality bonds by all standards with strong
capacity to pay principal and interest. These bonds are
rated lower primarily because the margins of protection
are less strong than those for Aaa and AAA bonds.
A A A These bonds possess many favorable investment
Medi attributes, but elements may suggest a susceptibility to
um impairment given adverse economic changes.
grade BBB Baa BBB Bonds are regarded as having adequate capacity to pay
principal and interest, but certain protective elements
may be lacking in the event of adverse economic
conditions that could lead to a weakened capacity for
payment.

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 FITCH MOODY’ S AND P DEFINITION
S
BB Ba BB Bonds regarded as having only moderate protection
Speculative of principal and interest payments during both good
and bad times
B B B Bonds that generally lack characteristics of other
desirable investments. Assurance of interest and
principal payments over any long period of time may
be small.
CCC Caa CCC Poor-quality issues that may be in default or in
danger of default.
Default CC Ca CC Highly speculative issues that are often in default or
possess other marked shortcomings.
C The lowest-rated class of bonds. These issues can be
regarded as extremely poor in investment quality.
C C Rating given to income bonds on which no interest is
being paid
DDD, D Issues in default with principal or interest payments in
arrears. Such, bonds are extremely speculative and
should be valued only on the basis of their value in
liquidation or reorganization.

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 End of
Chapter 3
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