bond market

1. Module Title :- Financial Market Analysis
Chapter – Three Bond- Market
Presented by:- Delina Zegeye Yemanebirhan
and
Yohannes Negatu Amenu
Monday 09 may, 2022 @ 10:00 AM
Addis Ababa University School of Commerce:- Department Of Accounting and Finance
for the Program of:- MSc in Corporate Finance Specialty in Investment
Management

2. Chapter – Three Bond- Market

3. Topics to Covered:-
 Definitions of Basic terms
 Sample Bond Certificate
 Types of Bonds
 Risk
 Cost of Bonds to the Issuer
 Bond valuation
 Relationship Between Coupon and Yield
 Coupon Effects on Price Volatility
 Duration
 Bond Rating

4. Definitions of Basic terms
 Bonds are securities that represent a debt owed by the issuer to
the investor.
 A bond is a long-term debt instrument that pays the bondholder a
specified amount of periodic interest rate over a specified period of time.
 Bonds are commonly referred to as loan stock, debt or fixed-
interest securities.
N.B:- The feature that distinguishes a bond from most loans is that a
bond is tradable. Investors can buy and sell bonds without the need
to refer to the original borrower.

5. Definitions of Basic terms (Continued)
 The par, face, or maturity value of the bond is the amount that the issuer must
pay at maturity
 The bond’s principal is the amount borrowed by the company and the amount owed to
the bond holder on the maturity date.
 The bond’s coupon rate is the specified interest rate (or $ amount) that must be periodically
paid and this periodic interest payment is often called the coupon payment.
 Yields are a measure of the returns to be earned on bonds.
 The interest paid on a bond as a percentage of its market price is referred to as
the flat, or running, yield.

6. Definitions of Basic terms (Continued)
 The bond’s maturity date is the time at which a bond becomes due and the principal must be repaid.
 Bond price is the present discounted value of future cash stream generated by a
bond
 Bond valuation is a technique for determining the theoretical fair value of a
particular bond.
N.B:- This rate is usually fixed for the duration of the bond and does not fluctuate with market
interest rates.

7. Definitions of Basic terms (Continued)
 The bond’s current yield is the annual interest (income) divided
by the current price of the security.
 The bond’s yield-to-maturity is the yield (expressed as a
compound rate of return) earned on a bond from the time it is
acquired until the maturity date of the bond.

8. Sample Bond certificate:-

9. Sample Bond certificate:- (Continued)

10. Grand Ethiopian Renaissance Dam Bond

11. Grand Ethiopian Renaissance Dam Bond
(Continued)

12. Types of Bond
1. Treasury Bonds (T-bonds):- are government debt securities
issued by federal government that have an original maturity of
10 to 30 years.
 (T-bonds) have very low interest rates because they have no
default risk.
2. Agency Bonds:- are debt securities issued by a
government-sponsored enterprise.
 The risk on agency bonds is actually very low. They are usually
secured by the loans that are made with the funds raised by the
bond sales.

13. Types of Bond (Continued)
3. Municipal bonds are bonds issued by states, cities, counties and
other governmental entities to raise money to build roads, schools
and a host of other projects for the public good.
 Tax-exempt from federal and possibly state and local income tax.
 There are two in types :- General obligation bond;- do not have
specific assets pledged as security or a specific source of revenue
allocated for their repayment. Instead, they are backed by the “full
faith and credit” of the issuer.

14. Ethiopian case----

15. Types of Bond (Continued)
Revenue bonds:- by contrast, are backed by the cash flow of a
particular revenue-generating project. For example, revenue
bonds may be issued to build a toll bridge, with the tolls being
pledged as repayment.
 There maybe default risk during periods when the economy
is weak.

16. Types of Bond:- (Continued)
4. Corporate Bond:- is debt issued by a company in order for it
to raise capital.
 The interest rate on corporate bonds varies with the level of
risk.
 the risk of default depends on the company’s health, which can be
affected by a number of variables.

17. Types of Bond:- (Continued)
Characteristics of Corporate Bonds
 a Call Provision:- states that the issuer has the right to force the holder to sell
the bond back.
 Conversion Some bonds can be converted into shares of common stock.
Types of Corporate Bonds
 Secured Bonds:- Secured bonds are ones with collateral attached.
 Unsecured Bonds:- Debentures are long-term unsecured bonds that are
backed only by the general creditworthiness of the issuer

18. Risk
Interest rate risk
 Interest rate risk is the risk of that interest rates will change, and therefore, a reduction in the
value/price of a security.
Price risk
 price Risk:- is the risk of Change in price due to changes in interest rates
 Long-term bonds have more price risk than short-term bonds
 Low coupon rate bonds have more price risk than high coupon rate bonds
Longer maturity higher interest rate risk Higher coupon rate
Shorter maturity Lower interest rate risk Lower coupon rate

19. Cost of Bonds to the Issuer
 The longer the bond’s maturity, the higher the interest rate (or cost) to
the firm.
 In addition, the larger the size of the offering, the lower will be the cost
(in % terms) of the bond.
 Also, the greater the risk of the issuing firm, the higher the cost of the
issue.

20. Bond Valuation
 Bond valuation is the process of determining the fair price, or value, of a bond.
 The theoretical fair value of a bond is calculated by discounting the future value of
its coupon payments by an appropriate discount rate.
1. Current Yield





















CGY
Expect ed
CY
Expect ed
YT M
ret urn
t ot al
Expect ed
price
Beginning
price
in
Change
(CGY)
yield
gains
Capit al
price
Current
payment
coupon
Annual
(CY)
yield
Current

21. Bond Valuation (Continued)
Example:- Current Yield
What is the current yield and the yield to maturity on a $1,000
face value discount bond maturing in 1 year , the coupon rate
is10% and selling for a price of $800?
Solution:-
 CY= I/P = 1000*0.1/800 = 12.5%
 YTM = F-P/P
= $1000-$800 / $800
= 25%

22. Bond Valuation (Continued)
Basic Valuation Model:
PVIF-Present Value Interest Factor

23. Bond Valuation (Continued)
Basic Valuation Model:
PVIF-Present Value Interest Factor

24. Bond Valuation (Continued)
 Bond Value = PV(coupons) + PV(par)
 Bond Value = PV(annuity) + PV(lump sum)
Where k= yield to maturity
n
n
2
2
1
1
k)
(1
CF
...
k)
(1
CF
k)
(1
CF
Value








25. Bond Valuation (Continued)
Example:- Bond Price
Suppose a bond that has a 10% annual coupon and a face value of $1000.
There are 20 years to maturity and the yield to maturity is 8%. What is the
price of this bond?
Solution: Using the formula: I(1- 1/(1+r) n/r + FV/(1+r)n
BV = PV of annuity + PV of lump sum
BV = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
BV = 981.81 + 214.55 = 1196.36

26. Bond Valuation (Continued)
Exercise:-
A10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par,
January 1, 2010, Issue Paying Annual Interest and the
required rate of return is a. 12% b.10% c. 8%. Find the
value of the bond for each required rate of return.
Solution a. BV 887
b. BV 1,000
c. BV 1,134

27. Bond Valuation (Continued)
 Basic Bond Valuation:- Formula
BV= I (1-(1+i) -n/i + FV(1+i) -n
Where,
BV= Bond Value
I= Periodic Interest Payment
i= r/m
m= interest payment period
n= m*t
t=maturity Period

28. Bond Valuation (Continued)
Exercise:- Semiannual Payment bond
The bonds have a 10% coupon rate, a $1,000 par value
(maturity value), and mature in two years. Assume
semiannual compounding and that market rates of
interest are 12%.

29. Bond Valuation (Continued)
Solution:-
Given= Fv= 1,000, t= 2 years , r= 12%, m=2(semiannual), i=r/m=0.12/2= 0.06
n= m*t= 2*2 =4, I = FV*cupon rate/2= 1000*0.1/2 = 50
Require= Calculate the value of Bond (BV)
Solution= BV= I(1-(1+i) -n)/i + FV(1+i) -n
50(1-(1+0.06) -4/ 0.06 + 1000(1+0.06)-4
173.25 + 792
965.35

30. Relationship Between Coupon and Yield
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
 Why? The discount provides yield above coupon rate
 Price below par value, called a discount bond
If YTM < coupon rate, then par value < bond price
 Why? Higher coupon rate causes value above par
 Price above par value, called a premium bond

31. Bond Values and Changes in Interest
Rates
 The value of the bond declines as the market interest rate (discount rate) increases.
0.0
200.0
400.0
600.0
800.0
1000.0
1200.0
0% 5% 10% 15% 20% 25% 30%
Interest Rate
Bond
Value

32. Coupon Effects on Price Volatility
 Bond Duration and Interest Rate Sensitivity
 The amount of bond price volatility depends on three basic factors:
 length of time to maturity (Duration)
 risk
 amount of coupon interest paid by the bond
 First, the longer the term to maturity, the greater is a bond’s volatility
 Second, the riskier a bond, the more variable the required return will be, resulting in
greater price volatility.

33. Coupon Effects on Price Volatility (Continued)
 Finally, the amount of coupon interest also impacts a bond’s price volatility.
 Specifically, the lower the coupon, the greater will be the bond’s volatility, because it will be
longer before the investor receives a significant portion of the cash flow from his or her
investment.
Summary:-
 The longer the maturity of a bond, the higher will be its sensitivity to the interest
rate changes. Similarly, the price of a bond with low coupon rate will be more
sensitive to the interest rate changes.
 However, the bond’s price sensitivity can be more accurately estimated by its
duration. A bond’s duration is measured as the weighted average of times to
each cash flow (interest payment or repayment of principal).

34. Bond Rating
Credit Rating Agencies

35. Bond Rating (Continued)
 A credit rating is a measurement by independent party of a
person or business entity's ability to repay a financial
obligation based on income and past repayment histories
 There are more than 70 agencies throughout the world, and
preferred agencies vary from country to country.
 The three most prominent credit rating agencies are:
 Standard & Poor’s (S&P)
 Moody’s, and
 Fitch Ratings.

36. Bond Rating (Continued)
 The bond rating agencies look at specific factors that focus on an entity's capacity
to meet its financial commitments by looking at:
 The strength of the issuer's balance sheet.
 The issuer's ability to make its debt payments.
 The condition of the issuer's operations.
 The future economic outlook for the issuer.

37. Bond Rating (Continued)

38. Bond Rating (Continued)

39. Bond Rating (Continued)

40. Bond Rating (Continued)
 Which bonds provide high yield AAA or CCC? Why?
 What is the advantage for the company that scored a better
rating?

41. Bond Rating (Continued)

42. Bond Rating (Continued)
According to trading economics, Standard & Poor's
credit rating for Ethiopia stands at CCC . Moody's
credit rating for Ethiopia was last set at Caa2. Fitch's
credit rating for Ethiopia was last reported at CCC.