ACCOUNTING SOLUTIONS LIMITED
THE BOND MARKET
The purpose of this article is to explain the rudiments of the bond market operations
for corporate entities as well as government. The rationale behind this is to give the
general public a fair idea of bonds. So I have tried as much as possible to remove
complex technical issues relating to bonds so that everyone can make informed
argument when it comes to bonds.
Bonds, generally, have been very grey area for public discourse over the years; no
entity from Ghana entered the euro bond market until the Kufuor Government did
so in 2007. Subsequent to that, the Mills Government successfully pursued that path
and the Mahama Government also recently successfully obtained funds from the
bond market. It is therefore imperative that the public is educated on the
operations of the bond market.
Definition of Bond Market
The environment in which the issuance and trading of debt securities occurs is
known as the bond market. The bond market primarily includes government-issued
securities and corporate debt securities and facilitates the transfer of capital from
savers (investors) to the issuers or organizations requiring capital for government
projects, business expansions and sometimes ongoing operations.
In this article I will explain the following issues with respect to the bond market
 The difference between the require rate of return on a bond and the interest
or coupon rate on a bond.
 Role of credit ratings on the bond markets.
 Characteristics of bonds.
 How lenders determine the expected return on bonds which will eventually
determine the interest they will demand on a bond.
 The circumstance under which a bond is likely to be over-subscribed or undersubscribed.
 How the market value of a bond is determined for a bond about to be issued
and for a bond which have already been issued.
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ACCOUNTING SOLUTIONS LIMITED
Interest or coupon rate
This is the actual amount that an investor will receive from the bond. This is
determined on the date the bond is issued. The interest or coupon rate is calculated
as a percentage of the nominal value of the bond (which is usually $100). For
example, a bond with a nominal value of $20m will be made up of 200,000 bonds
($20m / $100). If the bond has an interest or coupon rate of 8% p.a, it implies that
the investor will receive $8 per year for each $100 bond.
Yield or Return of a Bond
The yield on a bond is how much an investor expects to receive with respect to a
bond. The yield on the bond is usually determined by the credit rating (risk of
default) of the bond and the market return of the bond. The yield on the bond and
the coupon rate can be the same (usually on the date of issue of the bond). The
interest rate and the return differ when the bond starts trading. The reasons for the
difference will be explain and illustrated in this article.
Credit Rating
This is a rating based on the risk that a borrower (an organization or government)
would not be able to meet its obligation under the bond agreement, that is the
payment of interest and principal. Credit ratings are determined by credit rating
agencies. The main credit rating agencies are Standard & Poor’s, Moody’s and Fitch.
How credit ratings are determined will be discussed in a later article. The following
credit ratings are available from Fitch and Standard & Poor’s.
Fitch/S&P
Grade
Risk of Default
AAA
Investment
highest quality – zero risk
AA
Investment
high quality – very little risk
A
Investment
strong – minimal risk
BBB
Investment
medium grade –low but clear risk
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ACCOUNTING SOLUTIONS LIMITED
BB
Junk
speculative – marginal
B
Junk
significant risk exposure
CCC
Junk
considerable risk exposure
CC
Junk
highly speculative- very high risk
C
Junk
in default-very high likelihood of failure
Bond Characteristics
i.
ii.
iii.
iv.
v.
vi.
Bonds pay all interest or coupon before principal is paid (redeemed) and
not interest and principal at the same time.
Bonds are usually traded i.e an investor in a bond is not mandated to hold
the investment over the life of the bond but can simply sell the bond to
another investor before maturity.
Most bonds have active market i.e they are bought and sold just like
shares on a stock market.
The principal of bonds are usually not actually paid from the resources of
an organization or government because when the principal is due an
organization or government can raise another bond to repay the old
principal and continue to pay only interest. This is the reason why bonds
are assumed to be irredeemable in financial analysis.
If an organization or government wants to redeem its bond before
maturity, they are redeemed based on market value i.e. the entity will
have to repurchase it in the bond market.
The coupon rate remains unchanged throughout the life of a bond with
the exception of some euro bonds that are issued at a variable rate.
How lenders determine the expected return of bonds
The return on the bond is simply how much investors are expecting from a bond. In
determining the return of a bond, an investor will first identify the credit rating of
the bond; this is usually done with the help of credit rating agencies. The credit
rating of a bond is then compared with the return of identical bonds with similar
credit rating and duration. Credit ratings of bonds, returns and duration in the
bond market can be obtained from credit rating agencies.
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ACCOUNTING SOLUTIONS LIMITED
If the bond is a corporate bond the expected return is made up of the return on
government bonds with the same duration as that of the corporate bond plus a
default risk premium which is determining by how much returns identical corporate
bond (with the same credit rating and duration) investors are receiving above the
return from government bonds with the same duration. This can simply be put in a
mathematical formula as
Return = Return on Government Bond + Default risk premium
Corporate Bonds (which has already been issued)
Illustration
Ashgold Company, has $100m bond already in issue. The bond carries a coupon rate
of 5% p.a. The bond is redeemable in four (4) year time at its nominal value.
Ashgold is rated AA
The following information has been provided. The return on government bonds via
Bank of Ghana website is:
1 year 3.54%
(This implies the government pays 3.5% interest p.a for a one
year bond.)
2 years 4.01%
(this implies the government pay 4.01% interest p.a) for a 2 year
bond)
3 years 4.70%
e.t.c
4 years
5.60% e.t.c
Extracts from credit rating Agencies Website (in basis points)
Rating
1 year
2 year
3 year
4 year
AAA
5
18
29
40
AA
16
30
42
50
A
26
39
50
60
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ACCOUNTING SOLUTIONS LIMITED
Basis points (100 basis points are equal to 1%)
Require
i.
ii.
What is the return on the bond now?
What will be the return on the bond if Ashgold credit rating is
downgraded to A
Will the coupon rate change if Ashgold is downgraded to A
What is the current market value of Ashgold bond
What will be the market value of Ashgold bond if the credit rating is
downgraded to A.
iii.
iv.
v.
Solutions
i.
The current return on Ahsgold bond
Return = 5.6% + 50 basis points = 6.10%
ii.
If the credit rating of Ashgold is downgraded to A
Return = 5.6% + 60 basis point = 6.2%
iii.
If the credit rating of Ashgold is downgraded to A the coupon rate will still
remain 5% p.a
iv.
The market value of the bond can be estimated by identifying the interest
and principal that will be received over the remaining life of the bond and
taking out the return require by the investor(discounting using the require
rate of return) to arrive at the current market value of the bond
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ACCOUNTING SOLUTIONS LIMITED
Year
1
2
3
4
Interest
5
5
5
5
Principal
100
Cash flows
5
5
5
105
Discount factor 6.1%
0.94
0.89
0.84
0.79
Present values
4.7
4.5
4.2
83
Total present values (market value) = $96.4
The current market value of the bond in the bond market will be $96.4 for each
$100 of the bond. This means that if an investor wants to sell the bond now every
$100 of the bond can only be sold for $96.4. This is because similar bonds are
providing a return of 6.1% whiles Ashgold is paying only 5% interest.
v.
If Ashgold credit rating is downgraded to A, the market value of Ashgold
bond will fall further as investors will perceive an additional risk and
require a higher return 6.2% (return being provided by bonds with a
duration of 4 years and an A credit rating). The investors will now
discount interest and principal that is been expected from Ashgold bond
by 6.2%. this can be illustrated as follows:
Year
1
2
3
4
Interest
5
5
5
5
Principal
100
Cash flows
5
5
5
105
Discount factor 6.2%
0.942
0.887
0.835
0.786
Present values
4.71
4.43
4.17
82.5
Total present market value = $95.8
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ACCOUNTING SOLUTIONS LIMITED
This shows that if the risk of default of a bond increases resulting in a downgraded
credit rating, the market value of the bond (how much the bond can be sold before
maturity) reduces. The investor will have to decide whether to sell the bond and
avoid future risk of default or hold the bond to maturity and take the risk. The
opposite i.e if the credit rating of a bond improves, investors will now require a
lower return as shown by the credit rating data and hence the market value of the
bond will increase. This will happen because the market will now discount the same
interest and principal from Ashgold bond using a lower return.
A Bond About to be issued
If a company decides to issue a new bond, an investor will decided to subscribe for
the bond or not after comparing the terms of the new bond with the returns of
similar bonds which are already in issue. This is because bonds are traded activity
and an investor can purchase an already existing bond or purchase a new bond.
A new bond would be fully subscribed if it pays a return equal to similar existing
bonds or a slightly better return than existing bond. If a new bond pays a very high
interest compared with a return of similar existing bonds, the new bond would be
over-subscribed (investors will rush for the new bond) If a new bond pays interest
below the return of similar existing bond, the new bond would be under-subscribed.
This can be illustrated as follows
Abrante company ltd is about to issue to $50m 3 years bonds with a coupon rate of
4% p.a. The bond will be redeemable at par in 3 years. The Bond is rated AA
Solutions
Using the earlier information provided by bank of Ghana and Credit rating Agency,
first comparing with similar bonds already in issue, the expected return each year on
the bond is as follows
Years
1
3.54 + 0.16 =
3.7%
2
4.01 + 0.30 =
4.31%
3
4.70 + 0.42 =
5.12%
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ACCOUNTING SOLUTIONS LIMITED
This implies that interest from the bond for first year will be discounted at 3.7% p.a.
Interest from the bond for the second year would be discounted at 4.31% and
interest from the bond in 3 years’ time would be discounted at 5.12%. The present
value of the bond which is the same as its theoretical market value would be
estimated as
Year
interest
principal
cash flows
D.F
PV
1
4
-
4
4/1.037
3.86
2
4
-
4
4/1.0431 2
3.68
3
4
104
104
104/1.0512 3
89.53
97.07
The theoretical market value of each $100 of the new bond will be $97.07. If the
bond is issued under the current terms, the bond will be undersubscribed because no
investor will pay $100 for a bond worth $97.07.
The company would be required to increase the interest rate or agree to pay
premium on the redemption of the bond. The expected return that investors will
require on this bond can be estimated by simply calculating the IRR of the bond.
This is simply done by undertaking a try and error to identify the return that if used
to discount the current interest and principal, the present value of the bond would
be $97.07. This can be illustrated as follows.
$
D.F (4%)
PV
D.F10%
Now (year zero) MV
(97.07)
1
Y1-Y3
interest
4.00
Year 3
principal
100
(97.07)
1
(97.07)
2.755
11.02
2.487
9.95
0.888
88.80
2.75
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0.701
PV
75.10
12.02
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ACCOUNTING SOLUTIONS LIMITED
IRR = 4 + 2.75
x 6%
14.77
= 4% + 1.1% = 5.1%
This illustration shows that similar bonds which are already in issue are providing a
return of 5.1%. An interest of 4% is lower than expected hence the bond should be
issued at a discount or interest rate is increased to 5.1% or slightly above or a
premium is offered on redemption, else the bond will be under – subscribed.
Government bonds
The situation of corporate bond is the same with government bonds expect that the
return of government bonds based on credit rating is provided by credit rating
agencies as a percentage of the nominal value of the bond.
Illustration
The following credit ratings of government bonds have been obtained from S&P
website.
S&P rating
1 year
3 year
5 year
AAA
3.60
3.72
3.95
AA+
3.75
3.89
4.15
AA
3.95
4.11
4.40
AA -
4.33
4.60
4.95
Required
i.
What is the return of a three year French government euro bond if a
French government is rated AA+
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ii.
iii.
What is the return of a five year Nigerian government euro bond if the
Nigerian government bond is rated A –
What will be the return on a one year Ghana government euro bond if
the Ghana government bond is rated AA
Answer
i.
ii.
iii.
The French government bond will have a market return of 3.89% p.a
The five year Nigerian government bond will have a return of 4.95% p.a
The Ghana government one year bond will have a return of 3.95% p.a
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