FIXED INCOME SECURITIES

Fixed-income securities have a specified

payment schedule

BOND VALUATION

Dates and amount of interest and p

principal
p p
payments
y
known in advance

Drs. Embun Prowanta, MM, CFP, ERMCP, CSA

Bonds
Bondholders are lending the corporation
money for some stated period of time.
Bonds can be traded in the secondaryy
market.
Price at which a given bond trades is
determined by market conditions and
terms of the bond.

Definition of a Bond
A bond is a legally binding agreement between
a borrower and a lender that specifies the:

Par (face) value

Coupon rate
Yield to Maturity
Maturity Date

The yield to maturity is the required market

interest rate on the bond.

Characteristic of Bonds

How to Value Bonds

Primary Principle:
Value of financial securities = PV of expected future
cash flows

Bond value is, therefore, determined by the

present value of the coupon payments and par
value.
Interest rates are inversely related to present
(i.e., bond) values.

Bonds pay coupon (interest) payments

at fixed intervals and pay the par value
at maturity.

Borrowers (firms) typically make periodic interest

payments to the bondholders.
Coupon & zero coupon

Maturity
Time at which the original principal (Par Value) is repaid
to the bondholder.

C+ FV
...

BOND TYPES

Bond Terminology
Par Value or Face Value
Coupon Interest Rate

Based On Issuer

Federal government securities - T-bonds

Federal agency securities
Municipal securities - General obligation bonds, Revenue bonds

Tax implications
p
for investors

Corporate bonds
Convertible bonds may be exchanged for another asset
Risk that issuer may default on payments

Indenture
Document which details the legal obligation of the
corporation to the bondholders.

Default Risk and Ratings

BOND TYPES
Based on Coupon Payment
Zero Coupon Bonds
Fixed Rate Coupon Bonds
Floating Coupon Bonds

Rating companies
Moodys Investor Service
Standard & Poors

Reverse Floater
Inflation Index Bond

Rating Categories

Based On Collateral :
secured bonds

Investment grade
Speculative grade

Mortgage Bonds
Equipment Trust Bonds

Unsecured bonds :
Debenture Bonds
Subordinate Bonds

Bond Ratings
Moodys and Standard & Poors regularly monitor
corporate financial statements and assign a rating
to the corporations debt
similar to a personal credit report
Investment
Grade

Junk

AAA
AA
A
BBB
BB
B
CCC
CC
C
D

Top Quality

Low Quality
No interest being paid
Currently in Default

RATING SYMBOLS AND DEFINITIONS by PEFINDO

Long Term Debt

Short Term Debt

Capacity and ability of a company

to meet its financial commitments

id

AAA

id

A1

Superior

id

AA

id

A2

Very Strong

id

id

A3

Strong

id

BBB

id

A4

Adequate

id

BB

id

Somewhat Weak

id

Weak

Non-investment

id

CCC

id

Vulnerable

id

id

Default

The ratings from id AA to id B may be modified by the addition of a plus (+) or

minus (-) sign to show relative strength within the rating category.

Protection Against Default

Sinking funds
Subordination of future debt
Dividend restrictions
Collateral

International Bonds
Represent a rapidly growing category
Reflects willingness of borrowers to borrow across
borders

International bond investors face two types of

political risk
Repatriation-of-funds risk
A government may block payments of principal or interest

Sovereign risk
A government may refuse to honor its debts

Foreign Bonds
Categories of foreign bonds
Yankee bonds
Issued by non-U.S. borrowers within the U.S.

Samurai bonds
Yen-denominated
Yen denominated bonds issued in Japan by non
non-Japanese
Japanese
borrowers

Shogun bonds
Non-yen-denominated bonds issued in Japan by nonJapanese borrowers

Bulldog bonds
Issued by non-British borrowers in the U.K.denominated in
pounds

The Bond Indenture

The bond contract between the firm
and the trustee representing the
bondholders.
Lists all of the bonds features:
coupon, par value, maturity, etc.
Lists restrictive provisions which are
designed to protect bondholders.
Describes repayment provisions.

Value

Bond Valuation
Bond Price Determinants

Macroeconomic condition
Issuers Industry
Issuer Performance/creditworthy
I
Instrument
SStructure
Rating
Pricing
Covenant

Market Liquidity

Book Value: value of an asset as shown on a

firms balance sheet; historical cost.
Liquidation value: amount that could be
received if an asset were sold individually.
Market value: observed value of an asset in
the marketplace; determined by supply and
demand.
Intrinsic value: economic or fair value of an
asset; the present value of the assets
expected future cash flows.

Valuation

Security Valuation
In general, the intrinsic value of an
asset = the present value of the
stream of expected cash flows
discounted
d
scou ted at a
an app
appropriate
op ate required
equ ed
rate of return.
Can the intrinsic value of an asset
differ from its market value?

V =

t=1

Ct
((1 + k))t

Ct = cash flow to be received at time t.

k = the investors required rate of return.
V = the intrinsic value of the asset.

Bond Concepts

Bond Value ($)

1,372

Bond prices and market interest rates move in

opposite directions.
When coupon rate = YTM, price = par value
When coupon rate > YTM, price > par value
(
(premium
i
b
bond)
d)
When coupon rate < YTM, price < par value
(discount bond)

Ytm = 7%.

1,211

Ytm = 10%.

1,000

837

Ytm = 13%.

775
30

25

20

15

10

Years remaining to Maturity

Bond Valuation

Bond Valuation
Sebuah obligasi memiliki karakteristik : Nilai pari
= Rp 1 miliar, akan jatuh tempo dalam 5 tahun,
Tingkat kupon = 15 % per tahun (annually) dan
yield to maturity adalah sebesar 17 %. Harga
wajar dari obligasi tersebut adalah :
a. Lebih kecil dari Rp 1 M
b. Rp 1 miliar
c. Rp 1,17 miliar
d. Rp 1,68 miliar

BP =

t=1

RpCt
RpFV
+
(1 + Yb)n
(1 + Yb)t

BP = Rp Ct (PVIFA Yb, n) + Rp FV(PVIF Yb, n)

YTM and Bond Value

Using our previous example, now assume that

the required yield is 11%.
How does this change the bonds price?

When the YTM < coupon, the bond

trades at a premium.

1300

Bond Value

Bond Example Revisited

1200

When the YTM = coupon,

coupon the
bond trades at par.

1100

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 10

12 / 31 / 10

1000

1 / 1 / 06

6 / 30 / 06

12 / 31 / 06

800
0

0.01

0.02

0.03

0.04

0.05

0.06
0.07
6 3/8

0.08

0.09

0.1

Discount Rate

When the YTM > coupon, the bond trades at a discount.

PV =

$1,000
$31.875
1
1
+
= $825.69

10
.11 2 (1.055) (1.055)10

Pure Discount Bonds

Pure Discount Bonds

Make no periodic interest payments (coupon rate = 0%)

The entire yield to maturity comes from the difference
between the purchase price and the par value.
Cannot sell for more than par value
Sometimes
S
ti
called
ll d zeroes, d
deep di
discountt b
bonds,
d or
original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips are
good examples of zeroes.

Make no periodic interest payments (coupon rate = 0%)

The entire yield to maturity comes from the difference
between the purchase price and the par value.
Cannot sell for more than par value
Sometimes
S
ti
called
ll d zeroes, d
deep di
discountt b
bonds,
d or
original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips are
good examples of zeroes.

Pure Discount Bonds

Pure Discount Bond: Example

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - todays date
Face value (F)
Discount rate (r)

$0

$0

$0

Find the value of a 30-year zero-coupon bond

with a $1,000 par value and a YTM of 6%.
$0

$F

T 1

$0

$0

$1,000
L

L
T

30

29

Present value of a pure discount bond at time 0:

PV =

PV =

FV
(1 + R )T

Bond Example
Suppose our firm decides to issue 20-year
bonds with a par value of Rp 1 Bio and
annual coupon payments. The return on
other corporate bonds of similar risk is
currently 12%, so we decide to offer a 12%
coupon interest rate.

FV
$1,000
=
= $174.11
(1 + R)T (1.06)30

Bond Example

120

120

120

...

1000
120

...

20

What would be a fair price for these bonds?

Bond Example

Bond Example

Mathematical Solution:

Mathematical Solution:

BP = PMT (PVIFA k, n ) + FV (PVIF k, n )

BP = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 )

BP = PMT

BP = PMT

1-

1
(1 + i)n
i

1-

+ FV / (1 + i)n

BP =

120 1 -

1
(1 + i)n
i

+ FV / (1 + i)n

1
(1.12 )20 +
.12

1000/ (1.12) 20

= Rp 1 Bio

Bond Example

Note:
Note:
If the coupon
p rate = discount rate,
rate,
the bond will sell for par value.
value.

Suppose interest rates fall

immediately after we issue the
bonds. The required return on
bonds of similar risk drops to 10%.
10%
What would happen to the bonds
intrinsic value?

Bond Example
Mathematical Solution:
BP = PMT (PVIFA k, n ) + FV (PVIF k, n )
BP = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )
BP = PMT

1-

1
(1 + i)n
i

+ FV / (1 + i)n

1
(1.10 )20 + 1000/ (1.10)
.10
PV = Rp 1,170 Bio
PV =

120 1 -

20

Note:
If the coupon rate > discount rate,
the bond will
ill sell for a premium.
premi m

Bond Example

Bond Example
Mathematical Solution:

Suppose interest rates rise

immediately after we issue the
bonds. The required return on
bonds of similar risk rises to 14%.

BP = PMT (PVIFA k, n ) + FV (PVIF k, n )

BP = 120 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
BP = PMT

What would happen to the bonds

intrinsic value?

BP =

1-

120 1 -

1
(1 + i)n
i

+ FV / (1 + i)n

1
(1.14 )20 + 1000/ (1.14)

20

= 867,54 M

.14

10

Note:
If the coupon rate < discount rate,
the bond will sell for a discount.

Suppose
p
are
coupons
semi-annual

Bond Example
Mathematical Solution:
BP = PMT (PVIFA k, n ) + FV (PVIF k, n )
BP = 60 (PVIFA .07, 40 ) + 1000 (PVIF .07, 40 )
BP = PMT

1-

1
(1 + i)n
i

+ FV / (1 + i)n

1
(1.07 )40 + 1000 / (1.07)
.07
BP = Rp 866,68 M

BP =

60 1 -

40

Sebuah obligasi dengan dengan nilai nominal

$1,000, waktu jatuh tempo 5 tahun,
membayar kupon 10% per tahun dan
memiliki yield to maturity sebesar 8%. Jika
yield to maturity tidak berubah, 1 tahun dari
sekarang harga obligasi tersebut akan :
a. Lebih mahal
b. Lebih murah
c. Tidak berubah
d. Tidak bisa ditentukan

11

Conditions Required to Earn a

Bonds Expected YTM

A bonds computed YTM will only actually be

earned if:
The bond is held to maturity
The bond issuer does not default in the timing or
amount of scheduled payments
All the cash flows are immediately reinvested to
earn the bonds YTM

Yield To Maturity
The expected rate of return on a
bond.
The rate of return investors earn on a
bond if they hold it to maturity.
maturity

P0 =

t=1

$Ct

(1 + kb)t

$M
(1 + kb)n

YTM Example

YTM Example

Mathematical Solution:
Suppose we paid $898.90 for a
$1,000 par 10% coupon bond
with 8 years to maturity and
semi annual coupon payments.
semi-annual
payments

BP = PMT (PVIFA k, n ) + FV (PVIF k, n )

898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF
BP = PMT

What is our yield to maturity?

1-

1
(1 + i)n
i

1
898.90 = 50 1 - (1 + i )16

k, 16 )

+ FV / (1 + i)n
solve using trial and error

1000 / (1 + i) 16

12

YTM Approximation Formula

Bond Prices and Yields

Prices and Yields (required rates of return) have
an inverse relationship
When yields get very high the value of the bond
will be veryy low
When yields approach zero, the value of the
bond approaches the sum of the cash flows

FV - BP
n

YTM =
FV

+
2

BP

Bonds Risk

Prices and Yield

Price

Credit Risk / default risk

Interest Rate Risk
Liquidity Risk
Call Risk

Yield

13

Accrued Interest

Accrued Interest
Accrued interest calculation:

Bonds pay coupon payments periodically

Annually, semi-annually, quarterly, etc.

When a bond is purchased on a day

between its scheduled interest payment,

buyer must pay seller for accrued interest

Interest that has been earned but not yet paid

by issuer

Zero Coupon Bonds

No coupon interest payments.
The bond holders return is
determined entirely by the price
discount.

Accrued
=
Interest
Calculation

( Coupon Payment )

# of days since last coupon payment

# of days between scheduled coupon payment dates

Thus,
Th the
h actuall price
i for
f a bond
b d is
i the
h bonds
b d clean
l
price plus the accrued interest

Known as the bonds invoice price, full price or dirty price

U.S. newspapers quote clean prices

But buyers must pay the dirty price, which is always higher
if bond is between coupon payment dates
However, difference is not substantial

Zero Example
Suppose you pay $508 for a zero
coupon bond that has 10 years
left to maturity.
What
Wh is
i your yield
i ld to maturity?
i ?

14

Zero Example

PV = -508

Suppose you pay $508 for a zero

coupon bond that has 10 years
left to maturity.
What
Wh is
i your yield
i ld to maturity?
i ?

-$508

$1000

Zero Example

FV = 1000

Mathematical Solution:
PV = FV (PVIF i, n )
508 = 1000 (PVIF i, 10 )
.508
508 = (PVIF i, 10 ) [use
[
PVIF table]
bl ]

10

PV = FV /(1 + i) 10
508 = 1000 /(1 + i)10
1.9685 = (1 + i)10
i = 7%

10

Yield to Maturity Example

950 =
20

t =1

35 1000
+
T
t
(1+ r ) (1+ r )

10 yr Maturity

Coupon Rate = 7%

Price = $950

Yield Measures
Bond Equivalent Yield
7.72% = 3.86% x 2
Effective Annual Yield
(1 0386)2 - 1 = 7.88%
(1.0386)
7 88%
Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %

Solve for r = semiannual rate

r = 3.8635%

15

Realized Yield versus YTM

Reinvestment Assumptions
Holding Period Return
Changes in rates affects returns
p p
payments
y
Reinvestment of coupon
Change in price of the bond

Other Measures of Bonds Yields

Current yieldevery non-zero bond has a positive
current yield
Current Yield =

Annual coupon $ interest

Current price of bond

Investors desiring high investment cash flows are

interested in a bonds current yield

Other Measures of Bonds Yields

Yield-to-call (YTC)
A bond issuer may call a bond before
its original maturity date
Need to calculate the bonds YTC
Similar to YTM, except replace T as the timeto-call rather than time-to-maturity

Holding-Period Return:
Single Period
HPR = [ I + ( P0 - P1 )]

/ P0

where
I = interest payment
P1 = price in one period
P0 = purchase price

16

Holding-Period Example
CR = 8%
YTM = 8% N=10 years
Semiannual Compounding P0 = $1000
In six months the rate falls to 7%
P1 = $1068.55
$1068 55
HPR = [40 + ( 1068.55 - 1000)] / 1000
HPR = 10.85% (semiannual)

Suppose the bond was issued 20

years ago and now has 10 years
to maturity. What yield to
maturity remained at 10%, or at
13%, or at 7%?

At maturity, the value of any bond must

equal its par value.
The value of a premium bond would
decrease to $1,000.
$ ,
The value of a discount bond would
increase to $1,000.
A par bond stays at $1,000 if Ytm remains
constant.

17