INVESTMENT ON BONDS

Learning Objectives
By the end of this lesson, students will be able to:
1. Identify investment bonds and their key characteristics.
2. Understand the key concepts and types of bonds in the financial market.
3. Apply strategies for analyzing bonds and making sound investment decisions.

Lesson Outline
I. Introduction to Bonds
• What is a Bond?
A bond is a fixed-income security that represents a loan made by an investor to a borrower (typically corporate or
governmental). Bonds are used by companies, municipalities, and governments to finance projects and operations.
• A bond is like a loan that you give to a company or government. They borrow your money and promise to pay it back after a
set time. While they hold your money, they pay you interest. This interest is called a coupon payment.
Example:
Imagine your friend borrows ₱1,000 from you for one year and agrees to pay you ₱50 as interest. At the end of the year, your
friend pays you back the ₱1,000 and adds ₱50. That’s basically how a bond works!
Key Features of Bonds:
1. Principal/Face Value: The amount the bondholder will receive at maturity.
2. Coupon Rate: The interest rate paid on the bond's face value.
3. Maturity Date: The date when the bond's principal will be repaid.
4. Issuer: The entity borrowing the funds (e.g., government or corporation).
5. Yield: The return on investment from the bond, calculated based on its purchase price and coupon payments.
Types of Bonds:
6. Government Bonds: Issued by national governments, e.g., Treasury Bonds in the US or Retail Treasury Bonds in
the Philippines.
7. Corporate Bonds: Issued by companies to fund business activities.
8. Municipal Bonds: Issued by local governments or municipalities.
9. Convertible Bonds: Bonds that can be converted into a specified number of shares of the issuing company.
II. Bond Analysis
A. Credit Risk Analysis

• Credit risk refers to the possibility that a bond issuer might fail to meet its payment obligations. Analyzing credit risk helps
investors decide whether to invest in a bond.
1. Credit Ratings: Understand ratings provided by agencies
International Credit Rating Agencies:
1. Fitch Ratings: A global leader in credit rating and research.
2. Moody's Investors Service: Another major global credit rating agency.
3. Standard & Poor's Global Ratings: A leading provider of credit ratings, indices, and research.
Local Credit Rating Agency:

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 1. Philippine Rating Services Corporation (PhilRatings): A local credit rating agency that assesses the creditworthiness
of Philippine corporations and government entities.

Ratings
o Investment-grade bonds (AAA to BBB).
Example: A company with an AAA rating is considered very low risk, so its bonds are likely to pay reliable interest
and principal
o High-yield or junk bonds (BB or lower).
Example: A company-rated BB is considered riskier, meaning there’s a higher chance of default but often a higher
return to compensate for the risk.
Remember
• If a government issues a bond rated AAA, it’s highly secure and may yield a 3% annual return. Conversely, a smaller
company with a B rating might offer an 8% return because of higher default risk.
2. Issuer Financial Health: Examine the issuer's financial statements, profitability, and debt levels.
Examining the issuer's financial statements is crucial for assessing credit risk. Factors to consider include:
• Profitability: Is the company earning enough to cover its debt payments?
Example: A company with consistently high net income is more reliable.
• Debt Levels: How much debt does the company have compared to its equity?
Example: A company with $500M debt and $50M equity might struggle, indicating higher risk.
B. Interest Rate Sensitivity
Interest rate sensitivity is the degree to which a bond’s price changes in response to interest rate fluctuations.
Relationship between bond prices and interest rates:
o When interest rates rise, bond prices fall.
o When interest rates fall, bond prices rise.
Bond prices and interest rates move inversely:
• When interest rates rise, new bonds offer higher yields, so existing bonds with lower yields become less attractive, and their
prices fall.
Example: A bond with a fixed 3% coupon becomes less appealing if new bonds offer 5%. Its price will drop to attract buyers.
• When interest rates fall, existing bonds with higher fixed coupons become more attractive, and their prices rise.
Example: A 3% bond becomes valuable if new bonds offer only 1%.
Duration and Convexity:
o Duration measures the bond’s sensitivity to interest rate changes.
o Convexity refines the measurement by accounting for changes in duration as rates shift.
These metrics measure a bond’s sensitivity to interest rate changes and help refine risk assessment.
• Duration: A measure of a bond's sensitivity to changes in interest rates.
- Duration estimates how much a bond’s price will change for a 1% change in interest rates.
Example: A bond with a duration of 5 years would lose approximately 5% of its price if interest rates rise by 1%. Conversely,
its price will increase by 5% if rates fall by 1%.

• Convexity: A measure of the curvature of a bond's price-yield curve. It measures how that sensitivity changes as interest
rates change.
- Convexity adjusts duration to account for non-linear price changes as interest rates shift. Bonds with higher convexity
experience less dramatic price drops when rates rise and larger price gains when rates fall.
Example: If a bond has positive convexity, it might lose only 4.8% (instead of 5%) when rates rise by 1%.
Example Combining Both:
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Suppose a bond has a duration of 7 and positive convexity.
• If rates rise by 1%, the price might decrease by 6.9% instead of 7%.
• If rates fall by 1%, the price might increase by 7.1%.
By analyzing these factors, investors can estimate the bond's performance under different interest rate scenarios.
Example:
10-year Philippine Government Bond (PGB) with:
• Face Value: Php1,000
• Coupon Rate: 5%
• Current Market Price: Php950
Computation for Duration:
The duration of a bond (7 years in your example) estimates how much the bond's price will change in response to a 1% change in
interest rates. The formula for estimating the price change is:
%Price Change = −Duration×%Change in Interest Rate
Calculating the New Bond Price
Current Market Price = Php950
Price Decrease = 7% of Php950 = 950×0.07=Php66.50
New Bond Price = Php950 - Php66.50 = Php883.50
Example Scenario (Year-by-Year):
• Year 0 (Purchase Year):
o Market Price: Php950
o Interest Rate: Assume it's 5% (initial rate at purchase).
• Year 1:
o Interest Rates rise to 6%. Use a 1% increase to calculate price change:
▪ New Price = Php950 - Php66.50 = Php883.50
• Year 2:
o Interest Rates rise further to 7%. Another 1% increase applies:
▪ Price Drop = 7% of Php883.50 = Php61.85
▪ New Price = Php883.50 - Php61.85 = Php821.65
Convexity:
The formula for price change becomes:
%Price Change = −Duration×%Change in Interest Rate+1/2×Convexity× (%Change in Interest Rate)2
• Practical Example:
A bond with:
o Duration = 7 years
o Convexity = 0.5
o Interest rate change = +2%
Without convexity:
%Price Change=−7×0.02=−14%
With convexity:
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 %Price Change=−14%+1/2×0.5×(0.02)
%Price Change=−14%+0.0001=−13.9%
The price decrease is slightly less than estimated by duration alone.

C. Yield Analysis
• Current Yield: Annual income (coupon payment) received from a bond divided by the bond's current market price. It
measures the immediate return on your investment, assuming the bond's price remains constant.

Formula:
Current Yield = (Annual Coupon Payment / Current Market Price) * 100%

Example Scenario:
Bond: A 10-year Philippine Government Bond (PGB) with a face value of Php1,000.
Annual Coupon Rate: 5%
Current Market Price: Php950
Calculation:
Annual Coupon Payment = 5% * Php1,000 = Php50
Current Yield = (Php50 / Php950) * 100% = 5.26%
Interpretation: If you buy this PGB at its current market price of Php950, you'll earn a 5.26% annual return based on the
annual coupon payment.

• Yield to Maturity (YTM): The total return anticipated on a bond if held until maturity. It considers the bond's current price, its
face value, the coupon rate, and the time remaining until maturity. It provides a more comprehensive view of the bond's
potential return, accounting for both the periodic interest payments and the capital gain or loss at maturity.
Scenario:
Same PGB as current yield scenario example:
Face Value: Php1,000
Annual Coupon Rate: 5%
Current Market Price: Php950
Years to Maturity: 10
Calculation:
YTM is more complex to calculate manually and often requires financial calculators or software. However, you can use online
tools or consult with a financial advisor to estimate it.
Interpretation: The YTM considers not only the annual coupon payments but also the capital gain or loss you'll realize when
the bond matures. If the YTM is higher than the current yield, it suggests that the bond is undervalued and offers a potential
for capital appreciation in addition to the regular interest income.

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Key Differences of Current Yield and YTM

III. Decision-Making for Bond Investment

Factors to Consider:
1. Risk Tolerance: Match bond choices with your risk profile.
o Risk-averse investors may prefer government bonds.
o Risk-tolerant investors might choose high-yield corporate bonds.
2. Investment Goals:
o For income generation: Focus on bonds with high coupon rates.
o For diversification: Choose bonds with different maturities and issuers.
3. Economic Environment:
o Inflation and interest rate trends impact bond yields and prices.

Practical Example:
• Case Study: Investing in Philippine Retail Treasury Bonds (RTBs).
o Assess the coupon rate, maturity, and benefits such as tax incentives for RTBs.
o Analyze how government stability supports low credit risk.

IV. Strategies for Investing in Bonds

1. Laddering Strategy:
o Invest in bonds with different maturities to reduce reinvestment risk.
2. Barbell Strategy:
o Combine short-term bonds for flexibility and long-term bonds for higher yields.
3. Diversification:
o Spread investments across different issuers, sectors, and regions to mitigate risks.
4. Active vs. Passive Bond Investment:
o Active Strategy: Actively trading bonds to capitalize on interest rate changes.
o Passive Strategy: Holding bonds until maturity to secure a steady income.

V. Key Concepts and Summary

• Key Points:
o Bonds are a low-risk investment option offering regular income.
o Thorough bond analysis is crucial to identify creditworthiness and risks.
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 o Various strategies like laddering and diversification can optimize bond investment.
• Interactive Activity:
o Have students assess two sample bonds (e.g., a government bond and a corporate bond).
o Let them calculate YTM, compare risks, and recommend an investment decision based on risk tolerance and market
conditions.

Assessment and Homework

• Quiz Questions:
1. What is the relationship between bond prices and interest rates?
2. Explain the difference between a government bond and a corporate bond.
• Homework Assignment:
o Research the current bond offerings in the Philippine market. Select one bond, perform an analysis (credit risk, yield,
and duration), and recommend whether to invest.

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E d i t e d b y J u l i e t J a n e O . O l l a m i n a – M B M M ( C A R )