MBA 3rd semester FM01 Notes

1. Bonds
Welcome

2. Learning
What is a Bond ?
Definitions
Types of Bonds-
Callability/Putability &
Convertibility
Bond Analysis- The
Risk Perspective

3. What is a Bond-?
A debt investment in which an investor loans money to
an entity (corporate or governmental) that borrows the
funds for a defined period of time at a fixed/
floating interest rate. Bonds are used by companies,
municipalities, states and governments to finance a
variety of projects and activities. Bonds are commonly
referred to as fixed-income securities.
Bonds pay fixed /floating coupon (interest) payments at
fixed intervals (usually every 6 months) and pay the par
value at maturity.

4. Definitions
Par or Face Value -
The amount of money that is paid to the
bondholders at maturity. It also generally
represents the amount of money borrowed by the
bond issuer.
Coupon Rate -
The coupon rate, which is generally fixed,
determines the periodic coupon or interest
payments. It is expressed as a percentage of the
bond's face value. It also represents the interest
cost of the bond to the issuer.

5. Definitions
Coupon Payments -
The coupon payments represent the periodic interest
payments from the bond issuer to the bondholder. The
annual coupon payment is calculated by multiplying the
coupon rate by the bond's face value. Since most bonds pay
interest semiannually, generally one half of the annual
coupon is paid to the bondholders every six months.
Maturity Date -
The maturity date represents the date on which the bond
matures, i.e., the date on which the face value is repaid. The
last coupon payment is also paid on the maturity date.

6. Definitions
Original Maturity -
The time from when the bond was issued until its maturity
date.
Remaining Maturity -
The time currently remaining until the maturity date.
Call Date -
For bonds which are callable, i.e., bonds which can be
redeemed by the issuer prior to maturity, the call date
represents the earliest date at which the bond can be called.

7. Definitions
Call Price -
The amount of money the issuer has to pay to call
a callable bond (there is a premium for calling the
bond early). When a bond first becomes callable, i.
e., on the call date, the call price is often set to
equal the face value plus one year's interest.
Required Return -
The rate of return that investors currently require
on a bond.

8. Definitions
Yield to Maturity -
YTM is the measure of a bonds rate of return that
considers both interest income and capital gain
and loss
It is the bonds, Internal or required rate of return
This required rate of return can be calculated when
the current price and cash flows[ Interest and par
value] associated with the bond are known

9. Definitions
Market Value- A Bond may be traded ina stock
exchange. The price at which it is currently sold
or bought is referred to as the market value.
Market value may be different from the Par value
or the maturity Value.
Redemption Value-At the end of maturity the
borrowed sum must be refunded. The amount of
money paid at the time of maturity is referred to
as redemption value. Normally bonds are
redeemable at par, but they can also be
redeemed at premium or discount.

10. Current Yield
YTM is not the same as CY
Current yield is the annual interest divided
by the bonds current value
Current yield only considers the annual
interest and ignores any capital gain or
loss

11. Call ability of Bonds
A bond that can be redeemed by the issuer prior
to its maturity. Usually a premium is paid to the
bond owner when the bond is called.
Also known as a "redeemable bond".
The main cause of a call is a decline in interest
rates. If interest rates have declined since a
company first issued the bonds, it will likely want
to refinance this debt at a lower rate of interest.
The company will call its current bonds and
reissue them at a lower rate of interest.

12. Call ability of bonds
The call premium is somewhat of a penalty paid
by the issuer to the bondholders for the early
redemption
Call Provision-A provision on a bond or other
fixed-income instrument that allows the original
issuer to repurchase and retire the bonds. If
there is a call provision in place, it will typically
come with a time window under which the bond
can be called, and a specific price to be paid to
bondholders and any accrued interest are
defined

13. Putability of Bonds
PUT Provisions-The opposite of a callable
bond, a bond with a put provision allows
the bondholder to redeem the bond at par
value with the issuer at a specified point
before maturity. Investors might choose to
do this if interest rates increase after the
bond was issued. The bond will restrict
the dates when this can be done. These
bonds are quite rare.

14. Types of Bonds
Zeros-Bonds that pay only PAR value at maturity
and no coupon payments.
Euro Bonds-Bonds denominated in one currency
and sold in another currency.
Example - suppose Disney decides to sell $1,
000 bonds in France. These are U.S.
denominated bonds trading in a foreign country.
Why do this?
If borrowing rates are lower in France

15. Zero Coupon Bond-IDBI[1992]
Also called Deep Discount bonds, Zero Interest
Bonds
They are issued at a discount to the face value ,
hence the name, deep discount bonds
Do Not carry a rate of Interest. It provides for a
payment of a lump sum amount at a future date
in exchange for the current price of the bond
The difference between the face value and the
purchase price of the Bond is the YTM for the
investor.

16. Example-Zero Coupon Bonds
A company may issue a pure discount
Bond of Rs 1000 face value at Rs 520
today for a period of 5 years
PV = CFt / (1+r)t
PV= 520
CF= Face Value = Rs 1000
T= Maturity= 5 years
Yield/r= 14%

17. Types of Bonds
Security
Collateral – secured by financial securities
Mortgage – secured by real property, normally
land or buildings
Debentures – unsecured
Notes – unsecured debt with original maturity
less than 10 years

18. Convertibility of Bonds
Many corporate bonds are convertible
bonds
These bonds can be exchanged for some
specified amount of common or preferred
stock in the issuing company.
At the time of issue, the terms of
conversion will be outlined, including the
times, prices, and conditions under which
it can occur

19. Convertibility of Bonds
Most convertible bonds are also callable.
This means, in effect, that the company
can force bondholders to convert their
bonds into stock (called "forced
conversion").
Convertibility affects the performance of
the bond in certain ways

20. Convertibility of Bonds
First and foremost, convertible bonds tend to
have lower interest rates than non-convertibles
because they also accrue value as the price of
the underlying stock rises
Therefore, convertible bonds offer some of the
benefits of both stocks and bonds
Convertibles earn interest even when the stock is
trading down or sideways, but when the stock
prices rises, the value of the convertible
increases.

21. Convertibility of Bonds
Convertibles, therefore, can offer
protection against a decline in stock price.

22. The Bond Indenture
Contract between the company and the
bondholders and includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if
applicable
Call provisions
Restrictive covenants if any-Capital Structure,
asset sales etc.

23. Bond Analysis
The Risk Perspective

24. Bond Analysis-The Risk
Perspective
Inflation Rate Risk
Interest Rate Risk
Price Risk
Reinvestment Rate Risk
Call Risk
Marketability Risk
Credit Risk

25. Inflation Rate Risk
Necessity to adjust the rate of interest for
price changes.

26. Example
Suppose you lend Rs. 100 today for a
promise to be repaid Rs. 105 at the end of
a year. The Rate of interest is 5 %,
However assume that prices over the next
year are assumed to rise 6 %, your money
has appreciated in Value by 5 %, but the
inflation rate is 6 % means that you have
actually suffered a loss of 1 %, ur interest
rate should have matched the inflation rate
therefore to cover this risk of loss of
purchasing power.

27. Interest Rate Risk
Price Risk
Change in price due to changes in
interest rates
Long-term bonds have more price risk
than short-term bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which
cash flows can be reinvested

28. Price Risk
Bond prices are inversely related to
interest rates, so if interest rates increase,
the price of the bond will decrease
The interest rate on a bond is set at the
time it is issued. Generally, the coupon will
reflect interest rates at the time of
issuance.

29. Price Risk
However, if interest rates increase, people will be
unwilling to purchase the bonds in the secondary
market at the earlier rate
For example, if the coupon is set at 6% and
interest rates in the market are at 7%, the interest
rate on the bond is well below what you could
get from a different investment. Therefore, the
price of the bond will decrease For this reason, it
can be risky to buy long-term bonds during
periods of low interest rates.

30. Reinvestment Risk
A drop in the interest rates causes a decline in
the expected income from investing interim
coupon payments
Example: Suppose you purchase a bond @ 8 %-
Par Value- Rs. 1000 today, the semi annual
coupon that you obtain shall be Rs.40, you can
reinvest the same @ 8 % if the interest rates
have not declined, but if the interest rates during
such period decline to @ 6%, the reinvestment
income will decline from Rs.1.60[ Rs.40*.04] to
Rs.1.20[Rs. 40 *0.03]

31. Bond prices fall with
a
rise in interest rates
and rise with a fall in
interest rates

32. Credit Risk
Just as individuals occasionally default on
their loans or mortgages, some
organizations that issue bonds
occasionally default on their obligations.
If this is the case, the remaining value of
your investment can be lost.
Government Bonds carry a lower credit
risk than corporate bonds

33. Credit Risk
Definitely the return is much more in a
corporate bond as compared to a
government bond
There are Bond investment agencies that
evaluate the quality of the bonds and rank
them in categories according to the
relative probability of default, this helps
the investor in assessing the credit risk-
AAA is the best,, D - Bonds that have been
defaulted.

34. Ratings given by credit agencies for Bonds
Agency Highest
Safety
High
Safety
Moderate
Safety
Inadequate
Safety
High Risk
CRISIL AAA AA BBB BB B
CARE LAAA LAA LBBB LBB LB

35. Call Risk
When a bond is issued, it will be either callable
or non-callable
A callable bond is one in which the company can
require the bondholder to sell the bond back to
the company. Buying back outstanding bonds is
called "redeeming" or "calling".
When issued, the bond will explain when it can
be redeemed and what the price will be.
When a bond first becomes callable, i.e., on the call date, the
call price is often set to equal the face value plus one year's
interest.

36. Call Risk
A company will often call a bond if it is paying a
higher coupon than the current market interest
rates
Basically, the company can reissue the same
bonds at a lower interest rate, saving them some
amount on all the coupon payments; this
process is called "refunding
callable bonds will carry something called call
protection. This means that there is some period
of time during which the bond cannot be called.

37. Marketability Risk
Bonds are mostly not traded in secondary
markets, especially low rated bonds and
are therefore subject to Marketability Risk
For these Bonds the investor may have to
lose substantially while selling them as
the buyers expect a higher premium.