CHAPTER 4

BOND
Learning Objectives
 After studying this chapter, student
should be able to:
1. Define bond & discuss the characteristics
and types of bond
2. Explain the advantages and disadvantages
of investing in bond (bondholder)
3. Determine the value of bond
4. Define and calculate the convertible bond
 Long term fixed income securities in
which the issuer (borrower) has agreed
to pay fixed income payment for a
specified period and to repay the fixed
amount of principal (par value=RM1000)
at maturity to bondholder

DEFINITION OF BOND

It is long term written promise to pay a

certain sum of money at a certain time
for a specified rate of interest
 1. Bond Issuer

The parties who interested to

raised funds thru bond
(agrees to pay a fixed amount
of interest on a periodic basis
until a specified maturity date

2 PARTIES INVOLVED

2. Bond holder (investor)

A holder can hold the bond over
the life of bond and regularly
received the interest or can sell
the bond before maturity.
A bond would be expressed in this
way…
 “10% coupon bond maturing in 15 years time
and the coupon or interest is paid every six
months. And the principal would be repaid at
the end of the life of the bond”
– Here it means the bondholder will receive coupons
worth RM100 (10%x1000) every six months from
the company for 15 yrs. At the end of 15th year,
besides the coupon payment, he will also receive
the principal amount of RM1000 as a repayment
to bondholder.
 the relationship between bondholder
and bond issuer is legally binding thru
agreement or contract called
‘bond indenture’ or ‘deed of trust’

Definition:
is a legal agreement between
the firm issuing and the bond trustee
who represent the bond holders
Bond Indenture

The indenture provides:

•specific terms of loan agreement
•the description of the bonds
•the rights of issuing firms & bondholder
•the responsibilities of trustees
 • third party to a bond indenture.
• It can be individual, corporation or
commercial bank whose duties are
to act as a watchdog on behalf of
bondholders

Trustee

Main responsibilities
• to ensure the issuer does not
default on its contractual
obligations such as interest &
principal payments
• if issuer violates the
responsibilities, trustee can take
action of behalf of bondholders
 1. Bond principal

2. Coupon

3. Term of interest payment

4. Bond Maturity
Characteristics of
bond 5. Call Feature

6. Yield to Maturity

7. Current Yield

8. Market Values

9. Sinking Fund
 • also known as issuers
par value/face value of the bond
Bond principal
• The amount that must be repaid to
the bondholder upon maturity
• A typical par value is RM1000

• interest payment paid to the

bondholders
• is fixed throughout the life of the
Coupon
bond
• interest payment
= coupon rate x par value

Term of interest payment annually or semiannually for

fixed number of years
 Bond Maturity
•is the date on which a bond matures
•the principal/par value must be repaid to
the bondholders

• This provision gives the issuing company

the right to call back the bond even before
Call Feature maturity date.
• In most cases, call provision is applied
when interest rate drop
• issuing company will call back high
coupon rate bonds and replace them
with lower coupon bond

• To compensate bondholder for having to retire their bond prematurely,

an amount (call premium) is added to the bonds par value.
The sum of par value plus the call premium = call price
EXAMPLE: The 20 yr bond with par value of RM1,000 per unit called back
in year 2003 at the call premium of 5%.
Thus the call price of each bond would be RM1,000 + 5%(RM1000)
= RM1000 + RM50
= RM1050
 •also known as market interest rate
•discount rate which is also the rate of
Yield to maturity return required by investors when
investing in bond
• changes in market interest rate will
affect the price of bond

Current yield ratio of annual interest payment to

bond’s market price
market value/ present value of the interest &
market price principal payments

Sinking Fund requires the corporation to retire a

certain portion of a debt issue before
its maturity
• this periodic retirement of bonds,
will reduce the risk of the remaining
debt by reducing the amount of debt
still outstanding
 1. Government Bond

2. Private Bonds

Types of
bond

3. Unsecured bonds

4. Other types of bonds

5. Perpetual bond
(fin 312 Apr
10 qs 3a(iii)
 • issued by government
• best known bond because safest
1. Government Bond
(Treasury Bond) • highest quality because guaranteed
by government
• most popular among institutional
investor eg. SOCSO, insurance co.,
banks, EPF
• eg: Malaysian Government Securities
or MGS, T-bills, Malaysian Savings
Bonds

 issued by corporation known

as Private Debt Securities
2. Private Bonds
 Bond issued by government or
corporation could be either
secured of unsecured bonds
 • unsecured long term debt issued by
firms
Debentures • eg: convertibles bonds
• the main concern of the bondholders is
the ability to pay the interest payments
and principal on maturity date

•the claims on subordinated debentures

are made only after the claims on the
Subordinated secured bond and unsubordinated
3. Unsecured debentures have been satisfied
debentures
Bond

• *Bond that are

not backed by an
asset or collateral • normally issued by firm’s facing financial
difficulties
• Coupon rate are • the holder of income bond are entitled to
higher than interest payments when there are
secured bond earnings available to make such payments
Income
• if company failed, does not lead to firm’s
bond
bankruptcy
 Mortgage
•usually secured by real estate or
building, which are higher value than the
bond value of mortgage bond issued

• secured by stock and/or bonds owned

by the issuer
• the market value of collateral is usually
collateral 25% - 35% greater than bond value
Secured
trust bond
Bond

• *bonds that are • use to finance the purchase of aircraft,

backed by assets trains, ships, boats and truck
or collateral • purchase of assets done by trustee who
 it usually has a later leases the assets to the firms
priority claim on • when the firms have made the final
specific assets in lease payments, the firm will receive the
the event of equipment
title to the asset
bankruptcy trust
certificates
 FIRST MORTGAGE BOND
bondholders have the
priority claim of property
or assets

SECOND MORTGAGE BOND

claims are made only after
the claims on the first
mortgage bonds have
6 Types of
been satisfied
Mortgage bond

CLOSED-END MORTGAGE
BOND
prohibits the firms from
issuing any more bonds of
the same priority on the
property being pledged
Cont’d OPEN-END MORTGAGE
BOND
•allows the company to issue
additional bonds of the
same priority on the same property
that has been earlier pledged

LIMITED OPEN-END
MORTGAGE BONDS
•it sets a limit on the amount of new
6 Types of bonds that can be issued with
Mortgage bond equal property

BLANKET MORTGAGE BOND

•covers all real properties such as
buildings and equipment owned by
the corporation
 EUROBONDS
•issued by international borrower & sold to the
investors in countries with currencies other than
the currency in which the bond is denominated
eg: dollar denominated bond issued by U.S Corp.
sold in European countries

JUNKBONDS
•low grade bond rated below BBB
Other Types also called high yield securities because high risk
Of bond of default faced by bondholders
•issued to finance mergers, takeovers, restructure
or firm reorganization

ZERO COUPON BONDS

sold at a large discount from par
investor return comes from the gain in value
(par value – purchase price)
main attraction: buy low, receive full face value
at maturity
Rating the bond
 Why are bonds rated?
- to provide the potential investor an
objective form of risk analysis and
evaluation on the quality of bond and
the issuer of bond
 Who are the rating agency?
1. RAM Rating Services Berhad
2. Malaysian Rating Corporation Berhad
Types of bond rating
Investment
Grade Bond

 AAA Highest
 AA
 A
 BBB
 BB
 B
 C
 D Lowest Below Investment
Grade Bond
How do rating agency rate the
bonds?
 Purpose of rating – to measure the ability of
the issuer to pay the interest payments during
the specified periods & principal upon
maturity
 By collecting the data pertaining to the
company in respects to its operations,
financial performance and its prospects
 Data collected will be analyzed before rate is
determined
Implications of bond’s rating on
expected return by investors
 The yield/expected rate of return on BB
rating bonds and below is higher –
investor perceived high risk
 Thus the issuer would have to pay
higher interest payments for lower rating
bonds in order to sell the bond
  Provide steady stream of income in
the form of interest
 Risk is minimized because o interest
is paid every year and principal is
paid at maturity
 Bondholder have a priority claim on
income and assets as compared to
Advantages of common stock holder; lesser risk
Investing Bond  Bondholder is guaranteed of receiving
the principal despite changes in the
price
 Bondholder can sue the company
since they are creditors to company
due to nonpayment of interest and
principal
  Return is fixed, limited to fixed
interest payment

 Bondholder is not the owner but just

a lender; thus don’t have voting
rights
Disadvantages of
Investing Bond
 Bond is not good hedge against
inflation because of fixed return

 Difficult to resell because most

investors invest in common shares
and there is no formal secondary
market for bonds
  Market interest rate

 Coupon rate
Factors affecting
the Price and YTM
of Bond  Forces of demand and
supply

 Rating
Relationship between the required of return (k)
and value of bond

k = coupon interest rate sell at par

k > coupon interest rate sell at discount

k < coupon interest rate sell at premium

Bond Valuation / Price of bond (Intrinsic
value) (Vb)

Vb = Coupon Payment (PVIFA k/m , nxm ) + Principal (PVIF k/m , nxm)

m

Where,
Vb = intrinsic value/price of bond
Coupon Payment = coupon rate x par value
m = how many time the coupon payment is paid in a year
k = required rate of return / yield to
maturity
n = years remaining to maturity
Illustration 1
 ABC Corp. planned to raise funds by issuing a
10-year maturity bond. The coupon rate was
10% to be paid annually and the required rate of
return is 12%. Find the price or value of bond.
Vb = Coupon Payment / m (PVIFAk/m,nxm) + Principal
(PVIFk/m,nxm)
= RM100 (PVIFA12%,10) + RM1000(PVIF12%,10)
= RM100 (5.6502) + RM1000 (0.3220)
= RM565.02 + RM322
= RM887.02
Illustration 2
 Determined the value of 20 year’s bond
with 9 1/2% coupon to yield at 10%

Illustration 3
 Determine the value of a 20 year bond,
with 9% coupon paid semiannually to yield
at interest rate10%.
Illustration 4
 Determine the value of a 20 year bond, with 9%
coupon to yield at 12%. The bond was issued 5
years ago
 n = 20 – 5 = 15 years
 Vb = Coupon Payment / m (PVIFAk/m,nxm) + Principal
(PVIFk/m,nxm)
= RM90 (PVIFA12%,15) + RM1000((PVIF12%,15)
= RM90 (6.8109) + RM1000 (0.1827)
= RM612.98 + RM182.70
= RM795.68
Yield to Maturity

YTM = rate of return required = discount rate (k)

 YTM is rate of return required by the investors

 It is the rate of return the bondholders would earn if they
buy the bond at specified prices and hold it until maturity

YTM (k) = coupon rate, the bond will sell at par

YTM (k) > coupon rate, the bond will sell at discount

YTM (k) < coupon rate, the bond will sell at premium
Yield to Maturity (%)
 Formula = CP/m + (PV – MP)
nxm
PV + MP
2

CP = annual coupon payment

PV = Par value (RM 1000)
m = how many times the coupon payment is paid in a
year
n = Years remaining to maturity
MP = Market price
Illustration 5
 Bond AAA was issued 6 years ago with
10 years maturity and coupon rate of 10
%. It is currently selling at RM900.
Calculate YTM.
Illustration 6
 a) What would be the YTM on bond with
RM1,000 maturity value, 12% coupon
and market price of RM920
 b) Would you pay RM920 for the bond if
the required rate of return for securities in
the same risk class was 10%.
The bond has 5 years remaining to
maturity and the interest is paid annually.
Yield to Call (YTC)
 Interest rate that will make the present
value of the bond’s interest payments
and call price equal to its current market
price.
C.Rate =14%
0 5 10

MP=RM1050 RV=RM1080 PV=RM1000

Yield to Call (YTC)
Formula = CP/m + (RV – MP)
nxm

RV + MP
2
CP = annual coupon payment
RV = Redemption Value
m = how many times the coupon payment is
paid in a year
n = Years remaining to be called
MP = Market price
Illustration 7
 A 10-year bond with a face value of
RM1,000 and coupon rate of 14% is
selling for RM1,050. The bond issuer
may call back the bonds after 5 years at
RM1,080. Find yield to call for the bond
investors.
 Answer : 13.71%
 Current Yield (%)
• Indicate the return of the bond holder will get in terms of the
current market price.

Formula:
Coupon Amount/Payment *
Current Price

* Coupon rate x par value

Convertible Bond

A bond issue that can be

exchanged for a specified
*Definition number of shares of
common stocks
  Par value
Convertible bond usually issued as
debentures or long term unsecured
corporate debt
Par value = RM1000 same as ordinary
bond

 Convertibility – the bond may be

converted into a certain number of
shares of the issuing company’s
FEATURES OF common stock
CONVERTIBLE
BOND  Conversion period – bond holder can
convert at any time subject to
conversion period

 Conversion ratio – refers to how many

shares you get if you convert your
bond into stocks
Conversion Ratio (shares)
 refers to how many shares you get if you
convert your bond into stocks

 Conversion ratio = Par Value

Conversion price

Illustration 7
Par value is RM1,000 and conversion price
is RM25. Calculate the conversion ratio
 Conversion Price (RM)
 Is the stated price per share at which the convertible
bond can be traded for common stock
 # of shares that you will received depend on the
conversion price
 The lower the conversion price = more shares received
 The higher the conversion price = lesser shares
received
 Formula:
Par Value or % at premium x MPCS

Conversion Ratio
Illustration 8

Par value is RM1,000. Conversion

ratio = 40 shares. Find the conversion
price.
 Conversion Value (RM)

 Market value of the stock that would be received if

the convertible bonds were converted

Formula:
 conversion ratio x current market price of stock
Illustration 9
 Comestika Industries, has an outstanding
convertible bonds of RM1000 that is
convertible to common stock at RM20 per
share. The conversion ratio is 50 shares
(RM1000/RM20). Find the conversion value if
the current mkt price is RM24. Is it advisable
for the investor to convert its bond into
c/stock?
Illustration 10
 Find the conversion value when the stock is
selling at RM30, RM35, RM40, RM45,RM 50,
RM55. Assume conversion ratio is 25 shares.
Conversion price should be RM40 per share
(RM 1000/25). At what level of market prices
would the exercise of converting bond benefit
bond issuer and bond holder
Conversion Premium (RM)
 Market value of convertible bond exceeds the
conversion value
 Indicates the profit that the issuer will receive if the
bondholder convert their bonds into common stock
Method 1
Using Market Price (if market price of bond given)
Current Market Price of convertible bond - Conversion Value

Method 2
Using Par Value (if market price of bond is not given)
Par Value – Conversion Value
Illustration 11 (using market price)
 Market price of Jaya Bersatu
convertible bond is RM880. The
conversion ratio is 20 shares. The
market price of Jaya Bersatu share is
RM35. Find the conversion premium
Illustration 12 (using par value)
 The par value of Putra bhd convertible
bond is RM1,000. Conversion value is
RM750. Find the conversion premium
(RM)
Conversion Premium Per Share (RM)

Formula:

Conversion Premium Per share

= Conversion Price – Market price of common stock
Illustration 13
The conversion price for Metra Bhd
convertible bond is RM40. The market
price of Metra Bhd common stock is
currently at RM30. Find the conversion
premium per share
 Conversion Premium in %
Conversion Premium in % - Method 1
Conversion Premium in % = Conversion premium in (RM) x 100%

Conversion Value

Conversion Premium in % - Method 2

Conversion Premium in %
= Conversion Price – Market Price of Common Stock x 100%

Market Price of Common Stock

Illustration 14 (by using Method 1)

Given par value = RM1000

Conversion Value = RM750
Find the conversion premium in %
Illustration 15 (by using Method 2)

Conversion Price = RM40

Market price of common stock = RM30
Find conversion premium (%)
Number of shares to be issued
Method 1) : # of shares to be issued
Total Value of Convertible Bond (financing needed)
Conversion Price

*(if financing needed/additional financing given in question)

Method 2) : # of shares to be issued

Number of bond issued x conversion ratio

*(If number of bond issued given in question)

TOTAL NUMBER OF SHARES TO BE ISSUED :

Existing # of shares outstanding + # of shares to be issued
EPS
 Serves as an indicator of a company’s
profitability.
 Means that the portion of a company’s
profit allocated to each outstanding share
of common stock – earning per share of
common stock
 Formula:
EPS = Net income available for common stock
Number of outstanding shares
PE ratio
 Means how much investors are willing to
pay per ringgit of earnings
 If PE ratio = 20 times, means that investors
are willing to pay RM20 for every RM of
earnings that the company generates
 Formula:
PE Ratio = MP of common stock
EPS
Effect on EPS
1. New EBIT = % increase x Current EBIT
2. Interest = % of interest (coupon rate) x Value of
convertible bond
3. EBT = New EBIT – Interest
4. Tax = % of Tax x EBT
5. NIAC = EBT – Tax
6. EPS = Net income available for common stock
Number of outstanding shares
Effect on EPS

Before After Full After 60%

Conversion Conversion Conversion
EBIT
(-) Interest 0 40% x interest
b4 conversion
EBT
(-) Tax
NIAC
EPS