CHAPTER 5: BOND

BY :
PN AZLIDA BINTI ABDULLAH
 INTRODUCTION TO BOND

 A bond is a long-term promissory note (or debt

security) issued by the borrower, promissing to
pay the holder a stream of interests (coupons) at
specified intervals and its face value at the
redemption date (maturity). The issuer may be
the government or private corporation.
 A debt instrument issued for a period of more
than one year with the purpose of raising capital
by borrowing
 The Federal government, states, cities,
corporations, and many other types of institutions
sell bonds.
 INTRODUCTION TO BOND

 Generally, a bond is a promise to repay the

principal along with interest (coupons) on a
specified date (maturity).
 Some bonds do not pay interest, but all bonds
require a repayment of principal.

 When an investor buys a bond, he/she

becomes a creditor of the issuer.

 However, the buyer does not gain any kind of

ownership rights to the issuer, unlike in the case
of equities.
 INTRODUCTION TO BOND

 On the other hand, a bond holder has a

greater claim on an issuer's income than a
shareholder in the case of financial distress (this
is true for all creditors).

 U.S. Treasury bonds are generally considered

the safest unsecured bonds, since the possibility
of the Treasury defaulting on payments is
almost zero
 INTRODUCTION TO BOND

 The yield from a bond is made up of three

components: coupon interest, capital gains and
interest on interest (if a bond pays no coupon
interest, the only yield will be is capital gains).

 A bond might be sold at above or below par

(the amount paid out at maturity), but the
market price will approach par value as the
bond approaches maturity.
 INTRODUCTION TO BOND

 A riskier bond has to provide a higher payout

to compensate for that additional risk.

 Some bonds are tax-exempt, and these are

typically issued by municipal, county or state
governments, whose interest payments are not
subject to federal income tax, and sometimes
also state or local income tax.
 CHARECTERISTICS OF BOND

1. Face value
 Is the nominal or par value (principal) that will be
returned to the holder at the maturity or
redemption date.
2. Coupon interest rate
 Is the percentage of the face value of the bond
that will be paid out as interest at stated intervals
of times.
3. Maturity date
 Is the length of the time from the date the bond is
issued to the date the bond is redeemed.
 CHARECTERISTICS OF BOND (cont.)

4. Claim
 Bondholders have prior claim to the assets of the
issuing firm before the common stockholders and
preferred stockholders in case of insolvency.
5. Bond ratings
 provide the holders a guideline as to whether the
bonds have a high or low risk. In U.S.A., the three
main rating agencies are the Moody’s, Standard
and Poor’s and Fitch Investor Services. In
Malaysia, we have the Rating Agency of
Malaysia (RAM) and Malaysian Rating
Corporation (MRC).
 CHARECTERISTICS OF BOND (cont.)

6. Sinking Fund Provision

 Some bonds issue have sinking fund provision for
the future retirement of the bonds. Under this
method, profits are appropriated annually to a
sinking fund (a reserve account) and a
corresponding amount is invested in the sinking
fund investment.
7. Call provision
 Some bonds have call provision s which allow the
issuing firm to retire the bonds. Some callable
bonds have a call schedule with varying call
prices at various call dates.
 CHARECTERISTICS OF BOND (cont.)

8. Indenture
 Is a legal contractual agreement between the
issuer and the bond trustee who represents the
holders. The indenture comprises many provision
to protect the bondholders.
 THE RISK OF BOND

 Credit risk
 The issuer unable to pay the interest and
principal at the maturity date

 Interest rate risk

 Incurred when purchase/sell bond before the
maturity period.
 Interest rate increase, the price of bond
decrease.
 Interest rate decrease, the price of bond
increase.
 Who issued the bond?
 Government or company
 Purpose: to generate the capital
 Example: EPF issued bond to cover the deficit
in government budgeting. Another to finance
the infrastructure and development to public.

 Who buy the bond?

 Finance institution
 Discount houses
 Big company
 THE ADVANTAGES & DISADVANTAGES OF
INVESTING IN BONDS

ADVANTAGES :
1. Returns are quite high compared to common
stocks.

2. Tax shield can be obtained from certain issues.

3. Bonds are senior to common stock on claims of

assets of issuer.
 THE ADVANTAGES & DISADVANTAGES OF
INVESTING IN BONDS (cont.)

DISADVANTAGES :
1. Coupons are usually fixed for the life of the
bond.

2. Bond’s returns are exposed to interest rate risk.

3. Most bonds have no voting rights.

 THE ADVANTAGES & DISADVANTAGES OF
ISSUING BONDS

ADVANTAGES :
1. Coupons are usually fixed for the life of the
bond.

2. Bond’s returns are exposed to interest rate risk.

3. Most bonds have no voting rights.

 Why invest in bond?
 The income is stable
 Less risk compared to share
 The income is higher than fixed deposit and
saving account.
 BOND VALUATION

 Annual compounding
 Bond price = present value of the annuity of
annual interest income + present value of the
bond’s par value

 Vb = ( I x PVIFA i,n) + (PV x PVIF i,n)

 BOND VALUATION

 Where:
◼I = amount of annual interest income
◼PVIFA = present value interest factor annuity
◼PV = par value of the bond
◼PVIF = present value interest factor
◼i = yield on the bond/required rate of return
◼n = years remaining to maturity
 BOND VALUATION

 Example:
 Consider a 20 years bond, 91/2% bond that is
being priced to yield 10%. The par value of
the bond is RM1,000. Determine the value of
bond.
 n = 20 years
 I = 91/2% x RM1,000 = RM95

i = 10%
 PV = RM1,000
 BOND VALUATION

 Solution:
 (RM95 x PVIFA 10%, 20yrs) +
(RM1,000 x PVIF 10%, 20yrs)

= (RM 95 x 8.5136) + (RM1,000 x 0.1486)

= RM808.79 + RM148.60

= RM957.39
 BOND VALUATION

 Semiannual compounding
 In practice, most bonds pay interest every 6
months.

 Bond price = present value of an annuity of

semiannual coupon payments + present value
of the bond’s par value
 BOND VALUATION

 Vb = ( I/m x PVIFA i,n) + (PV x PVIF i,n)

 Where:
◼I = amount of semiannual interest income
◼PVIFA = present value interest factor annuity
◼PV = par value of the bond
◼PVIF = present value interest factor
◼i = yield on the bond/required rate of return
◼n = years remaining to maturity
◼m = time coupon is being paid in a year
 BOND VALUATION

 Example:
 Consider a 20 years bond, 91/2% bond that is
being priced to yield 10%. The par value of the
bond is RM1,000. Determine the value of bond if
interest income is semiannually.
 n = 20 years x 2 = 40 yrs
 I = 91/2% x RM1,000 = RM95/2 =RM47.50

i = 10%/2 = 5%
 PV = RM1,000
 BOND VALUATION

 Solution:
 (RM47.50 x PVIFA 5%, 40yrs) +
(RM1,000 x PVIF 5%, 40yrs)

= (RM 47.50 x 17.1591) + (RM1,000 x 0.1420)

= RM815.06 + RM142

= RM957.06
 BOND VALUATION

 Exercise 1:
Determine the value of a 20 years bond, with 9%
coupon to yield at 12%. The bond was issued 5
years ago. The interest payment is paid annually.

 Exercise 2:
Assuming the yield of the bond is 12%. The interest
payment or the coupon rate is 10% and to be paid
annually for ten years. Calculate the value of
bond.
 BOND VALUATION

 Exercise 3:
Using semiannual compounding, a 15 year zero-
coupon bond that has a par value of RM1,000 and
a required rate of return of 8%. Determine the
value of the bond.

 Exercise 4:
Would you pay RM920 for the bond if the
required rate of return for securities in the same
risk class of 10%. The bond has 5 years remaining
and the interest is paid annually.
 BOND VALUATION

 Exercise 5:
Using semiannual compounding, the par value is
RM1,000, find the prices of the following bonds:

i). A 10 ½%, 15 years bond priced to yield at 8%

ii). A 7%, 10 years bond priced to yield at 8%

iii). A 12%, 20 years bond priced to yield at 10%

 BOND VALUATION

 Exercise 6:
Syarikat Trend menerbitkan bon yang mempunyai kadar kupon
10% setahun dan nilai par bon ialah RM100,000. Tempoh matang
bon ini adalah selama 5 tahun dari sekarang. Kadar pulangan yang
diperlukan oleh pelabur ialah 8% setahun. Jika faedah dibayar
setiap setengah tahun, berapakah
i). Nilai intrinsik bon tersebut sekarang
ii). Nilai bon pada akhir tahun ke – 2
iii). Nilai bon pada akhir awal tahun ke – 4
iv). Berdasarkan jawapan (i) di atas, jika harga pasaran bon ini
pada masa sekarang adalah sebanyak RM110,000, apakah
keputusan yang wajar diambil oleh pelabur.
 BOND VALUATION

 Exercise 7:
Syarikat Jasa Bakti telah mengeluarkan bon sebagai sumber
pembiayaan operasinya. Bon tersebut mempunyai tarikh matang 12
tahun dan kadar kuponnya 10% setahun dibayar secara tahunan.
Nilai muka bon adalah RM1000.

i). Jika kadar pulangan perlu pelabur adalah 12%, kirakan nilai
bon tersebut.
ii). Sekiranya kupon dibayar setiap setengah tahun, adakah nilai
bon masih sama?. Andaikan kadar pulangan perlu pelabur
masih 12%
 BOND VALUATION

 Exercise 8:
Syarikat AMZ baru sahaja menerbitkan bon yang mempunyai
maklumat seperti berikut:
Nilai kupon : RM80 setahun
Nilai par : RM1000
Kadar diskaun : 10%
Tempoh matang : 3 tahun
Anda dikehendaki untuk menilai bon tersebut jika:
i). Kupon dibayar setiap akhir tahun
ii). Kupon dibayar setiap setengah tahun
 BOND VALUATION

 Exercise 9:
An investment broker has approach En. Aidi and presented the
following information regarding 2 bonds:
a). Hijrah Bond was issued 8 years ago with 12 years to maturity and
a coupon rate of 6.5%. It is currently selling at RM850.
b). Islah Bond was issued last week with 30 years to maturity and a
coupon rate of 12%. It is currently selling at RM1,100.

Assuming both bonds are in the same risk class, which bonds should
En. Aidi buy? Assume that his required rate of return is 16% and
both bonds pay RM1,000 at maturity. Show your relevant
calculation.
 YIELD TO MATURITY (YTM)

 Is the rate of return by the investors or the discount

rate
 The bondholders would earn (the rate of return) if
they buy the bond at specified prices and hold it
until maturity.
 When YTM = coupon rate , the bond will sell at PV
 When YTM > coupon rate, the bond will sell at
discount.
 When YTM < coupon rate, the bond will sell at
premium
 YIELD TO MATURITY (YTM)

YTM = I/m + PV - MP
nxm
Method 1: Using Formula
(PV + MP) / 2

Where:
I = Coupon payment (interest income)
PV = Par value
MP = Market price
m = Time coupon is being paid in a year
n = years remaining to maturity
 YIELD TO MATURITY (YTM)

 Example 1:
You are given the following information regarding
to bond AAA. Bond AAA was issued 6 years ago
with 10 years maturity period. A coupon rate is
10% and paid annually. The selling price at
RM900. Calculate the yield on this bond.
 YIELD TO MATURITY (YTM)

 Solution 1:
I = RM1000 x 10% = RM100
n = 10 – 6 = 4 years
MP = RM900
PV = RM1000

YTM = I/m + PV - MP
nxm
(PV + MP) / 2
 YIELD TO MATURITY (YTM)

 Solution 1:
YTM = I/m + PV - MP
nxm
(PV + MP) / 2
= (100 /1) + (1000 – 900)/4
(1000 + 900 ) /2
= 125 / 950
= 0.1316
= 13.16%
 YIELD TO MATURITY (YTM)

 Exercise 1:
What would be the yield to maturity on bond with
RM1000 maturity value, a 12% coupon rate and a
market price of RM920? The bond has 6 years
remaining to maturity.
 YIELD TO MATURITY (YTM)

Method 2:
Trial & Error Vb = ( I/m x PVIFA i,n) + (PV x PVIF i,n)

Where:
I = Coupon payment (interest income)
m = Time coupon is being paid in a year
n = years remaining to maturity
i = YTM (kadar pulangan dijangka)
 YIELD TO MATURITY (YTM)

 Example : (Annual compounding)

The current market price of the bond is RM809.50.
the amount of annual interest income is 7.5% and
the par value of the bond is RM1000. The number
of years to maturity is 15 years.

**Note: the yield on this bond has to be more than

7.5%. Through trial and error, we might start with
a discount rate above the bond’s coupon, such as
8% or 9% or 10% until we get the price of bond
(exactly or nearest answer)
 YIELD TO MATURITY (YTM)

 Solution 1:
MP= RM809.50
I = 7.5% x RM1000 = RM75
n = 15 years
Try 10%:
Bond price = ( I x PVIFA i,n) + (PV x PVIF i,n)
RM809.50 = (75 x PVIFA, 10, 15) + (1000 x PVIF 10, 15 )
= (75 x 7.6061) + (1000 x 0.2394)
= RM570.46 + RM239.40
= RM809.86
 YIELD TO MATURITY (YTM)

 Solution 1:
 The computed price of RM809.45 is reasonably close to
the bond’s current market price of RM809.50.
 As a result, the 10% rate represents the yield-to-maturity
on this bond
 In this case, if you were to pay RM809.50 for the bond
and hold it to maturity, you would expect to earn a yield
of 10%.
 YIELD TO MATURITY (YTM)

 Example : (Semiannual compounding)

The current market price of the bond is RM809.50.
the amount of annual interest income is 7.5% and
the par value of the bond is RM1000. The number
of years to maturity is 15 years.
 YIELD TO MATURITY (YTM)

 Solution 1:
MP= RM809.50
I = 7.5% x RM1000 = RM75/2 = RM37.50
n = 15 years x 2 = 30 yrs
Try 10%, so: 10%/2 = 5%

Bond price = ( I x PVIFA i,n) + (PV x PVIF i,n)

RM809.50 = (75 x PVIFA, 5, 30) + (1000 x PVIF 5, 30 )
= (37.5 x 15.3725) + (1000 x 0.2314)
= RM576.49 + RM231.40
= RM807.89
 YIELD TO MATURITY (YTM)

 Exercise 1 :
A bond is currently selling in the market for
RM1098.62. it has a coupon of 9% and a 20
years maturity. Using annual compounding,
calculate the YTM?