ABMF2103 Principles of Finance

ACADEMIC YEAR 2021/22

TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS

ABMF 2103 PRINCIPLES OF FINANCE

Tutorial: Chapter 10 (a) Long Term Financing - Bonds

QUESTION 1
i. What are bonds?

A bond is a long-term contract under which the borrower agrees to pay interest
and principal to the bondholder on a specified date.

Bonds are similar to term loans, but generally, they are advertised, offered to the
public and actually sold to many different investors. In fact, when a company sells a
bond, thousands of individual and institutional investors may buy the bond, whereas
in the case of a term loan agreement there is generally only one lender and borrower.

Bonds are long-term debt where the borrower, agrees to pay interest, which is also
known as coupon and principal, to the bondholder on a specified date.

The issuer agrees to pay a fixed amount of coupon at regular intervals, such as
semi-annually or annually, and to pay a fixed amount of principal on the maturity
date.

ii. Discuss the characteristics of bonds.

Firstly, the nominal value is the par of face value. It is also known as the
principal value and is the amount that the issuer agrees to repay to the bondholder at
maturity. However, the bond price is not the same as the principal amount.

Next, the coupon rate is the nominal interest rate that determines the actual
interest that bondholders receive when they own the bond. The nominal interest rate is
based on the par value, which is the principal value, regardless of whether the market
price is high or low. It is paid at regular intervals. It is paid annually, semi-annually, or
quarterly. However, semi-annual is the most popular.

Furthermore, the terms of maturity are the number of years in which the bond
issuer undertakes to satisfy the conditions and obligations of the bond issue. For example,
if the bond is a 5-year bond, the maturity date is 5 years. During this time, the bondholder
receives the promised coupon payment. This also indicates the remaining life of the bond.
At the end of the maturity date, the company will repay the principal, and the bond no
longer exists; all the payment has settled.

Besides that, the yield to maturity is the total return an investor receives from a bond
and is the coupon amount plus the principal, plus the reinvested return. The compounded
rate of return an investor would receive if the bond were purchased at the current market
price and held to maturity. The yield to maturity is the effective and real rate of interest
on a bond investment. The price of a bond is quoted based on its yield

Other than that, the call provision gives the Issuer the right to redeem or call the
bonds from their holders if there is a change in the interest rate environment. The issuer
has the right to call back or cancel the bond before the maturity date. For example, the
issuer is required to give investors a 5% coupon, but the bank rate is now 3%, so the
issuer will pay an additional 2% interest. In most cases, they will choose to cancel the
bond in favour of a bank loan. The investor will receive some compensation in the form
of a call price, but it is lower than the principal value and it is to cover the risk of the
bond being redeemed. Investors will be exposed to the risk of reinvestment as the bonds
are called before their maturity date so they have to find alternative investments.

In addition, a sinking fund is money set aside by the issuer on a regular basis for the
eventual repayment of debt. The purpose of a sinking fund is to ensure that there are
sufficient money to redeem the bond when it matures. For example, the issuer must pay
RM100,000 to the borrower after 10 years, so the issuer will store RM10,000 per year in
an account so that the issuer will have the ability to pay the borrower on the maturity
date.

Lastly, there are restrictive covenants, which also refer to terms and conditions.
Bond covenants contain provisions that place management restrictions and protect and
safeguard bondholders. Some of the more common restrictive covenants include various
limitations on a company's ability to raise debt. For example, ABC does not take out
additional loans until the bonds are repaid.

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QUESTION 2
i. Why bonds are also known as fixed-income securities?
The payment of coupon and principal is stipulated over a period of time.

ii. Discuss the advantages of bonds to both the issuer and investor.

The Issuers

In effect, bonds are a tax deduction for companies for interest payments. The coupon
paid to bondholders is tax-deductible for the issuing company. It can be recorded as an
expense in the profit and loss account and therefore the profit becomes less and the
amount of tax paid is also reduced. For example, the company has a gross profit of
RM50,000 but it has to pay interest of RM5,000 to the borrower and this interest can be
recorded as an expense, so the gross profit minus the expense equals RM45,000. The net
profit is RM45,000.

Next, its earnings per share increase. As a bond is a fixed-income security, in good
times, the surplus available to shareholders, after deducting the interest paid to
bondholders, will be greater as coupon payments are always fixed. When is a good time
for a company to issue bonds to others because there are fixed interest payments. For
example, the interest payment is fixed and if it is a good time the company will earn more
profit because the amount of interest paid on the bond is not the same as the amount of
dividend based on the profit earned by the company.

Lastly, it maintains control of the company. As bondholders are creditors of the

company, they have no control, which also means that they do not have the right to vote
on the management of the company as shareholders do. Therefore, the shareholders of the
company still maintain control of the company. Bondholders are only entitled to interest
and principal payments.

To investors

Firstly, investors receive a fixed return each year, so they do not have to worry about
reduced or unstable interest payments. Bonds are fixed income securities and investors
who buy them can expect a steady return because the interest payments are fixed. This is
a good option for those who want a stable payment but do not want to take the risk.

Next, it is less risky for investors because bondholders are able to have priority over
shareholders in the assets of the company in the event of liquidation or bankruptcy.

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QUESTION 3
Discuss the disadvantages of bonds to both the issuer and investor.
The issuer

Firstly, the debt must be paid. Regardless of whether the company has a good or
bad year, it must pay fixed interest charges. Failure to meet these payment requirements
could result in bankruptcy proceedings for the bondholders.

Secondly, bonds increase the risk due to financial leverage, which means
increased use of debt. Bonds are classified as long-term debt, usually more than seven
years, and some can even be maintained until the death of the investor, and the issuance
of such securities increases a company's financial leverage. The company may not be able
to make regular payments and this can also affect shareholders who will not receive
dividends.

Lastly, there are restrictions on the issuing company. To protect themselves,

bondholders may impose certain restrictions or covenants on the issuing company to
prevent it from failing to meet its obligations. For example, ABC does not take out
additional loans until the bonds have been repaid.

The investor

Firstly, fixed interest payments. If the issuing company has good earnings,
bondholders do not enjoy additional earnings. Regardless of how high the profits are, the
investor receives only a fixed payment.

Secondly, the actual interest payment is reduced. As bondholders receive fixed

interest payments, they may suffer losses in times of high inflation. The value of the
currency will decrease year on year. For example, RM50 in 2018 can be used to buy a
power bank, RM50 in 2019 can buy a low-quality power bank and RM50 in 2020 is only
enough to buy a cable.

The returns are then even lower. Since the risk is low, the return is also low.

Finally, there is the risk of reinvestment of redeemable bonds. The interest

received on the reinvested money might not be as high as expected

QUESTION 4
Discuss the following types of bonds:

Government bonds are bonds issued by governments that are denominated in their
own currency. They are often referred to as risk-free bonds and have a maturity of three
years or more. It carries no risk, is unlikely to go bust and the investors get all the coupon

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and principal payments back at the end. For example, Malaysian Government Securities
(MGS), Khazanah Bonds, Bon Simpanan Merdeka 2009 are issued to Malaysian citizens
over the age of 56.

Next is the convertible bond. It is a bond that can be converted into ordinary shares
at a fixed price, at the option of the bondholder. The conversion rate is the number of
shares that an investor can convert into. For example, if the par value of the bond is
RM1,000 and the conversion rate is 25, then the bond that the investor converts into
shares would be RM40 per share. The current market price per share is RM45 and the
investor can sell at a profit. Convertible bonds have low coupon rates, but they offer
investors the opportunity to earn capital gains.

A zero-coupon bond is a bond that does not pay annual interest, where the issuer
pays principal only at the end of the maturity date but sells it at a discount to its face
value, thus providing compensation to investors in the form of capital appreciation. A
zero-coupon bond is bought at a price below its face value and repaid at face value at
maturity. It does not pay interest at regular intervals, or has what is known as a "coupon",
as it does not pay any interest, hence the name zero coupon bond. When the bond
matures, its investors receive its face value. Examples of zero-coupon bonds include
Treasury bills

Junk bonds are bonds rated 'BB' or lower because of their high risk of default. It is
also referred to as a "high yield bond" or "speculative bond". These are usually purchased
for speculative purposes. Junk bonds usually have interest rates three to four percentage
points higher than safer government-issued bonds. But high risk, high reward, so if the
company goes bust, the investor takes the risk. Take on debt securities of companies with
credit ratings below investment grade. They are low-rated, high-yield, speculative
instruments issued mainly by companies and are often used to finance restructuring,
mergers and acquisitions.

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QUESTION 5
i. What are bond ratings
 Bond ratings are grades that are assigned to bond issues by the credit rating
agencies.
 Conducted financial analysis to designate investment quality.
 Ratings basically point to the default risk of an issue. Higher ratings mean that
issues are investment grade.
 Lower rating means that issues are in the junk category and more speculative.
 The higher the rating, the lower the default risk and, hence, the lower the yield
of an obligation
 A lower rating means that the investor must assume more of the default risk
and has to be compensated with a higher yield.

ii. Why are bond ratings important to investors

 Agency ratings can be used as a viable guideline in measuring the

creditworthiness of the issuer and the issuer’s default risk.
 These ratings are objective and reliable because they are done by an independent
party.
 Investors are able to make comparison among bonds in terms of risk and return.

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