Lecture 8 Advanced Accounting

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CISI – Financial Products, Markets & Services

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Learning Objectives
1. Know the advantages and disadvantages of investing in
different types of bonds
1. Understand the role of credit rating agencies and the
differences between investment and non-investment
grades
1. 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
1. The advantages for a company of issuing bonds as opposed
to issuing shares
1. The disadvantages and risks of investing in bonds

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Investing in bonds - advantages
Advantages
of investing in
bonds
A regular and certain flow of
income (bonds with a fixed
coupon)
For many bonds (not
all!) they have a fixed
maturity date
A range of income yields to
suit different investment and
tax situations
Relative security of
capital for more highly
rated bonds

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Investing in bonds – Disadvantages/Risks
Disadvantages
and risks of
investing in
bonds
Inflation risk
If inflation rises, the ‘real’ value of
the bond’s coupon and
redemption payment are eroded
Default risk
There is a possibility
that the issuer will not
be able to pay the
coupon or capital
back
Price risk/Market risk
Fluctuations in interest rates
cause bond prices to change
accordingly when they are
traded
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)
Liquidity Risk
The ease with which a
security can be converted
into cash. Some bonds are
more easily sold at a fair
market price than others.
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.

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Price Risk/Market Risk – A closer look
There is an inverse relationship between interest rates and bond prices:
Why?
Its 5% coupon is no longer
attractive, so its resale price
will fall to compensate and
make the return the bond
offers more competitive.
Why?
Its 5% coupon is very
attractive, so its resale price
will rise to compensate and
make the return it offers fall
to more realistic levels.
If interest rates increase, bond prices will decrease
If interest rates decrease, bond prices will increase

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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.
Price Risk/Market Risk – A closer look
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 (£)
Bonds market price
(Price paid to purchase £100 nominal)
X 100
Flat yield (%) =
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

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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 plc, redeemable in 2025, is currently
trading at £100 per £100 nominal.
Flat yield = (£5/£100) x 100
Flat yield = 5%
2. A bond with a coupon of 4%, issued by
ABC plc, redeemable in 2025, is currently
trading at £78 per £100 nominal
Flat yield = (£4/£78) x 100
Flat yield = 5.13%
3. 5% Treasury stock 2028 is currently
priced at £104 per £100 nominal.
Flat yield = 4.81%
Flat yield = (£5/£104) x 100
4. A company issues a bond priced £65
per £100 nominal, paying 2% coupons
half-yearly with redemption in 2024.
5. A bond priced at £110 per £100
nominal, with a variable coupon of 1.5%
above LIBOR has a redemption date of
2016. LIBOR is averaging 1.2%.
Flat yield = (2/65) x 100
Flat yield = 3.08%
Flat yield = (£2.7/£110) x 100
Flat yield = 2.45%

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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 = 3.24%
Flat yield = (£2.75/£85) x 100
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 three most prominent credit rating
agencies that provide these ratings are
Standard & Poor’s; Moody’s; and Fitch Ratings.
The credit risk for most bond issues can be
assessed by looking at independent credit
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.

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Ratings Agencies
Bond Credit Ratings
Credit Risk Moody’s Standard
& Poor’s
Fitch
Ratings
Highest quality
High quality Very strong
Strong
Upper medium grade
Lower medium grade Somewhat
speculative
Low grade Speculative
Medium grade
Poor quality May default
Most speculative
No interest being paid or bankruptcy
petition filed
In default
Aaa AAA
AAA
Aa AA AA
A A
A
Baa BBB BBB
Ba BB BB
B B B
Caa CCC CCC
C CC CC
C D C
C D D
INVESTMENT
GRADE
Offer the greatest
liquidity and
certainty of
repayment
NON-INVESTMENT
GRADE
Also known as
‘High Yield’
The worst rated
are also known as
‘Junk’

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