Paper 2.6 Fixed Income Dealing

CHARTERED INSTITUTE OF STOCKBROKERS September 2018 Specialised Certification Examination Paper 2.6 Fixed Income Dealing 2

Question 2 - Fixed Income Valuation and Analysis 2a) i) Why are many bonds callable? ii) What is the disadvantage to the investor of a callable bond? iii) What does the investor receive in exchange for a bond being callable? iv) How are bond valuation calculations affected if bonds are callable? (4 marks) Solution 2a) i) Many bonds are callable to give the issuer the option of calling the bond in and refunding (reissuing) the bond if interest rates decline. The objective is to reduce interest cost. ii) The disadvantage to the investor is that the investor will not receive that long stream of constant income that the bondholder would have received with a noncallable bond. iii) In return, the yields on callable bonds are usually slightly higher than the yields on noncallable bonds of equivalent risk. iv) The bond valuation calculation should include the call price rather than the par value as the final amount received. Also, only the cash flows until the first call should be discounted. The result is that the investor should be looking at yield to first call, not yield to maturity, for callable bonds. (1 mark for each point) 2b) Given the data in the table below, calculate the price of a 10% coupon corporate bond maturing in 2 years, having face value of 100 Period Years to Maturity Spot Rate (%) Corporate Spread (%) 1 0.5 10.00 1.00 2 1.0 10.40 1.00 3 1.5 10.60 1.00 4 2.0 11.00 1.00 Solution to Question 2b) (4 marks) Price = 2c) Consider the following bonds: Bond 1: AA-rated, pays a coupon of 9%, matures in 7 years. Bond 2: BB-rated, pays a coupon of 9%, matures in 12 years. Bond 3: BB-rated, pays a coupon of 9%, matures in 7 years. Bond 4: AA-rated, pays a coupon of 9%, matures in 12 years. (4 marks) Required a) Determine whether Bond 1 or Bond 3 has more potential for price fluctuation and give a reason why. b) Determine whether Bond 2 or Bond 4 has more potential for price fluctuation and give a reason why. c) Determine whether Bond 1 or Bond 4 has more potential for price fluctuation and give a reason why. d) Determine whether Bond 2 or Bond 3 has more potential for price fluctuation and give a reason why. Solution 2c) a) Bond 3 has more potential for price fluctuation because it has a lower rating. b) Bond 2 has more potential for price fluctuation because it has a lower rating. c) Bond 4 has more potential for price fluctuation because it has a longer maturity. d) Bond 2 has more potential for price fluctuation because it has a longer maturity. (4 marks) 3

Question 3 - Financial Accounting and Financial Statement Analysis 3a) When Schemers Limited started facing problems it was, among other things, recording revenue in advance of the sale of the goods. How does such an accounting practice affect the following? 3a1) Reported earnings. (1½ marks) 3a2) Reported cash flows. (1½ marks) 3b) Explain how each of the items below would affect the statutory published earnings per share figure for a manufacturing company: Item The impairment of an intangible asset. A new issue of bonus shares to shareholders. Profit on the sale of a property. Solution to Question 3b Impact (1½ marks) Item The impairment of an intangible asset. A new issue of bonus shares to shareholders. Profit on the sale of a property. Impact When an intangible asset is impaired, its carrying amount is reduced, and the impaired amount is written off to the operating statement. This reduces the amount of earnings, and hence the EPS, all else being equal. A new issue of bonus shares results in an increase in total number of shares outstanding. All else being equal, this results in a reduction in published EPS. Profit on the disposal of property results in increase in total earnings, which in turn results in an increase in EPS, all other things being equal. 3c) The Conceptual Framework for Financial Reporting identifies faithful representation as a fundamental qualitative characteristic of useful financial information. Distinguish between fundamental and enhancing qualitative characteristics and explain why faithful representation is important. (1½ marks) (Total 6 marks) Solution to Question 3c The Conceptual Framework for Financial Reporting implies that the two fundamental qualitative characteristics (relevance and faithful representation) are vital as, without them, financial statements would not be useful, in fact they may be misleading. As the name suggests, the four enhancing qualitative characteristics (comparability, verifiability, timeliness and understandability) improve the usefulness of the financial information. Thus financial information which is not relevant or does not give a faithful representation is not useful (and worse, it may possibly be misleading); however, financial information which does not possess the enhancing characteristics can still be useful, but not as useful as if it did possess them. 4

In order for financial statements to be useful to users (such as investors or loan providers), they must present financial information faithfully, i.e. financial information must faithfully represent the economic phenomena which it purports to represent (e.g. in some cases it may be necessary to treat a sale and repurchase agreement as an insubstance (secured) loan rather than as a sale and subsequent repurchase). Faithfully represented information should be complete, neutral and free from error. Substance is not identified as a separate characteristic because the IASB says it is implied in faithful representation such that faithful representation is only possible if transactions and economic phenomena are accounted for according to their substance and economic reality. (1½ marks) (Total: 3 marks) Question 4 - Portfolio Management In a market whose volatility is 15%, you have the following stocks: Stock Beta Standard Deviation A 0.9 14% B 1.2 20% C 1.6 40% a) What is the beta of an equally-weighted portfolio of the 3 stocks A, B and C? b) Compute covariance (A,B). Solution to Question 4 4a) Beta 4b) ij = β i β j 2 M cov(a,b) = 0.9 1.2 15 2 = 234(% 2 ) Question 5 Fixed Income Valuation and Analysis 5a) Prices of zero-coupon bonds reveal the following pattern of forward rates: Year Forward Rate 1 5% 2 7 3 8 In addition to the zero-coupon bond, investors also may purchase a three-year bond making annual payments of 60 with par value 1,000. 5a1) What is the price of the coupon bond? 5a2) What is the yield to maturity of the coupon bond? (Note: If you did not answer (i) above, assume the price of the bond P 0 is 984.10) 5a3) Under the expectations hypothesis, what is the expected realized compound yield of the coupon bond? (3 marks) 5a4) If you forecast that the yield curve in one year will be flat at 7%, what is your forecast for the return on the coupon bond for the one-year holding period? (3 marks) 5a5) Identify the key assumptions of yield to maturity 5

5b) Now assume you are evaluating the following two bonds, A and B that are equally rated: Bond Coupon (%) Maturity Years YTM (%) A 12 4 10.50 B 11.75 5 10.40 5bi) Which of these two bonds has a longer duration and why? No calculations required. 5bii) You are expecting a rise in interest rates for all maturities. Which bond will be the better investment and why? No calculations required. 5biii) Assume bond B is puttable. How will this embedded put option affect the bond price in the case of rising interest rates? Explain. (6 marks) (Total: 16 marks) Solution 5a) 5a) Year Forward Rate PVF 1 5% 1/1.05 = 0.9524 (1/3 mark) 2 7% 1/(1.05)(1.07) = 0.8901 (1/3 mark) 3 8% 1/(1.05)(1.07)(1.08) = 0.8241 (1/3 mark) 5a1) P o = (60 0.9524) + (60 0.8901) + (1,060 0.8241) = 984.10 5a2) The YTM is given by the IRR of the following cfs: Year 0-984.10 1 60 2 60 3 1,060 The IRR = YTM = 6.60% 5a3) Step 1: Determine the future value of the payments associated with the bond. Year Payment FV FV received Factor 1 60 (1.07)(1.08) 69.34 2 60 1.08 64.80 3 1060 1 1060.00 Total future value 1194.14 Step 2: Compute the realised compound yield (RCY) The RCY is the single rate of interest that makes the current market value ( 984.10) to amount to 1194.14 after three years: 984.10 (1 + RCY) 3 = 1194.14 RCY = 6.66% 5a4) Step 1: Determine P 1, that is, the value of the bond in one year's time. 6

In one year's time the bond will have 2 years remaining to maturity. The value, at 7%will be: Step 2: Determine the holding period return. 5a5) = 5.88% 1) It is assumes that the bond is held to maturity 2) It is assumes that the interim coupons are reinvested at the yield to maturity. 3) It is assumes that the coupons and the face value are paid as and when due. (1 mark for any two points mentioned) 5bi) Bond B has a lower coupon rate, a lower YTM and a longer time to maturity than Bond A, which results in a longer duration. 5bii) Rising interest rates have a negative impact on bond prices. The shorter the duration, the smaller the negative impact. As bond A has a shorter duration than bond B, bond A will be less affected by the rising interest rates. 5biii) Price of the putable bond = Price of the non putable bond + Value of the put option In case of rising interest rates, the price of a non putable bond goes down but the value of the put option goes up. So the put option will compensate a part of the price reduction. 5c Mr. Lucky John has the following liabilities to settle as indicated: Year Amount '000 3 10,000 4 10,000 5 10,000 6 10,000 John plans to make use of the following bonds to construct an immunised position: Bond Coupon YTM Maturity Duration A 10% 11% 4 years 3.478 B 0% 11% 8 years? Assume a flat yield curve in all cases. 5c1) Calculate the present value of the liabilities and duration of the liability side. 5c2) Calculate the duration of Bond B. 5c3) If John wants to fully fund and immunise his portion, how much should be invested in each of the two bonds? (4 marks) 5c4) What will be the par value of each of the bonds in (5c3) above. (4 marks) 5c5) Suppose that 1 year has passed, and the interest rate remains 11%. You are aware that the duration of Bond A would have dropped to 2.73 years after the passage of one year. 5c5i) Is John still fully funded? 5c5ii) Is his position fully immunised? (Total: 16 marks) 7

Solution 5c 5c1) The PV of liabilities (PV L) is: PV L = 10,000 + 10,000 + 10,000 + 10,000 = 25,180 ( 000) or 25,180,000 The duration of the liability side (D L ) is computed as follows: Year (n) Cash flows PVF at 11% PV '000 PV n 000 3 10,000 0.73119 7,312 21,936 4 10,000 0.65873 6,587 26,348 5 10,000 0.59345 5,935 29,675 6 10,000 0.53464 5,346 32,076 D L = 110,035/25,180 = 4.37 years Alternative method 25,180 110,035 (½ mark each) For a level annuity starting from year 1, the duration is given by: D L = = 2.37 (½ mark each) But this assumes that the annuity starts from year 1. Since the annuity starts from year 3 in this case, we simply add 2 to the above result to get D L = 4.37 years 5c2) Bond B is a zero-coupon bond. The duration is the same as the maturity, i.e. 8 years. 5c3) To be completely immunised, D A = D L Let = weight of Bond A = weight of Bond B. D A = 3.47 + 8 Since this must equal D L, we have: 3.47 + 8 = 4.37 3.47 + 8 8 = 4.37 4.522 = 3.63 = 3.63/4.52 = 0.803 = 1 0.803 = 0.197 Amount invested on Bond A = 25, 180,000 0.803 = 20,219,540 Bond B = 25, 180,000 0.197 = 4,960,460 25,180,000 5c4) Calculation of Par (face) value Bond A. Let k = total face value (repayable in year 4) Annual coupon = 0.10 k = 0.10k (year 1 4) PV of cash flow: Yr CF PVF at 11% PV 1 4 0.10k 3.10245 0.31025k 4 K 0.68201 0.68301k 0.99326k 8

This must equal the current market value: 0.99326k = 20,219,540 k = 20,356,744 Bond B For a zero-coupon bond, the face value is payable at maturity. FV = PV(1 + YTM) n = 4,960,460(1.11) 8 = 11,431,156 5c5i) Funding Status Assets side If rates have not changed, the value of each of the bonds would have gone up by 10%: Bond A 20,219,540 l.10 = 22,241,494 Bond B 4, 960,460 1.10 = 5,456,506 Total 25,180,000 (1.10) = 27,698,000 Liabilities Similarly, the total value of liabilities would have gone up by the same percentage, i.e. move from 25,180,000 to 27,698,000 Therefore John is still fully funded: V A = V L 5c5ii) Immunisation Status With passage of 1 year, the duration of the liabilities will simply drop by 1 year to 3.37 years. The duration of Bond A is now 2.73 years and duration of Bond B is now 7 years. The duration of asset is no longer the same as the duration of liabilities. John's position is no longer immunised. A re-balancing will be required. 5d) An investor considers investing in one of two risk free investment options. Option A gives the Investor 2% return every six months for the next 5 years, when he would get back his principal. Every semester the investor can reinvest the return in the same scheme. Option B guarantee a return of 21% to the investor after 5 years. 5d1) The investor wants to opt for option B. Is it the right option? Calculate the holding period returns for each option and justify your answers. Solution 5d 5d1) Holding period return: Option A: (1 0.02) 10 1 = 21.9% Option B: 21% (given) Since the holding period return of option A is higher than that of option B, the investor should choose option A. (Total 5d: 2 marks) 9

Question 6 - Financial Accounting and Financial Statement Analysis 6a) In order to gain market share, Wazobia Limited has offered longer credit terms to customers in 2017. Comparative figures for 2016 and 2017 are shown below: Ratio 2017 2016 Sales for the year. 60,000,000 50,000,000 Operating profit for the year. 5,600,000 4,000,000 Closing balance of trade receivables. 9,000,000 5,000,000 6a1) Calculate the receivables collection period for 2016 and 2017. Solution Computation of receivables collection period Receivables collection period = Trade receivables x 365 days Sales 2016 N5,000,000 X 365 days = 36.5 days N50,000,000 2017 N9,000,000 X 365 days = 54.75 days N60,000,000 6a2) Has this policy had any impact on the company s performance? Solution to 6a2) Apparently, the policy appears to have benefited the company. Sales grew by 20% from N50m in 2010 to N60m in 2011, while profit equally grew by 40% from N4m to N5.6m. A possible explanation for this is that by relaxing credit policy, customers had an incentive to buy from Wazobia Limited rather than from its competitors. The company may have gained a higher market share in the process, especially if the company s competitors did not follow suit by relaxing their own credit policy. 6b) You have been hired as an analyst for Manifold Investment and your team is working on an independent assessment of Reward Plc, a firm that specializes in the production of freshly imported farm products from France. Your assistant has provided you with the following data for Reward Plc and their industry. Ratio 2017 2016 2015 2017 Industry Average Long-term debt 0.45 0.40 0.35 0.35 Inventory Turnover 62.65 42.42 32.25 53.25 Depreciation/Total Assets 0.25 0.014 0.018 0.015 Days sales in receivables 113 98 94 130.25 Debt to Equity 0.75 0.85 0.90 0.88 Profit Margin 0.082 0.07 0.06 0.075 Total Asset Turnover 0.54 0.65 0.70 0.40 Quick Ratio 1.028 1.03 1.029 1.031 Current Ratio 1.33 1.21 1.15 1.25 Times Interest Earned 0.9 4.375 4.45 4.65 Equity Multiplier 1.75 1.85 1.90 1.88 6b1) In the annual report to the shareholders, the CEO of Reward Plc wrote, 2017 was a good year for the firm with respect to our ability to meet our short-term obligations. We had higher liquidity largely due to an increase in highly liquid current assets (cash, account receivables and short-term 10

marketable securities). Is the CEO correct? Explain and use only relevant information in your analysis. Solution to Question 6b1) Note: The answer should be focused on using the current and quick ratios. While the current ratio has steadily increased, it is to be noted that the liquidity has not resulted from the most liquid assets as the CEO proposes. Instead, from the quick ratio one could note that the increase in liquidity is caused by an increase in inventories. For a fresh food firm one could argue that inventories are relatively liquid when compared to other industries. Also, given the information, the industry-benchmark can be used to derive that the firm's quick ratio is very similar to the industry level and that the current ratio is indeed slightly higher - again, this seems to come from inventories. 7b2) What can you say about the firm's asset management? Be as complete as possible given the above information, but do not use any irrelevant information. (3 marks) Solution to Question 6b2) Note: Inventory turnover, days sales in receivables, and the total asset turnover ratio are to be mentioned here. (½ march each) Inventory turnover has increased over time and is now above the industry average. This is good - especially given the fresh food nature of the firm's industry. In 1999 it means for example that every 365/62.65 = 5.9 days the firm is able to sell its inventories as opposed to the industry average of 6.9 days. Days' sale in receivables has gone down over time, but is still better than the industry average. So, while they are able to turn inventories around quickly, they seem to have more trouble collecting on these sales, although they are doing better than the industry. Finally, total asset turnover went down over time, but it is still higher than the industry average. It does tell us something about a potential problem in the firm's long term investments, but again, they are still doing better than the industry. (1½ marks) (Total 7b2: 3 marks) 7b3) You are asked to provide the shareholders with an assessment of the firm's gearing/leverage. Be as complete as possible given the above information, but do not use any irrelevant information. (3 marks) Solution to Question 6b3) Solvency and leverage is captured by an analysis of the capital structure of the firm and the firm's ability to pay interest. Capital structure: Both the equity multiplier and the debt-to-equity ratio tell us that the firm has become less leveraged. To get a better idea about the proportion of debt in the firm, we can turn the D/E ratio into the D/V ratio: 1999: 43%, 1998: 46%, 1997:47%, and the industry-average is 47%. So based on this, we would like to know why this is happening and whether this is good or bad. From the numbers it is hard to give a qualitative judgement beyond observing the drop in leverage. In terms of the firm's ability to pay interest, 2014 looks pretty bad. However, remember that times interest earned uses EBIT as a proxy for the ability to pay for interest, while we know that we should probably consider cash flow instead of earnings. Based on a relatively large amount of depreciation in 2017 (see info), it seems that the firm is doing just fine. (3 marks) 6c) On 1 January 2017, company A had an authorized share capital of 4 million shares and an issued share capital of 2 million shares. The nominal value of each share is 25k. During 2017, the company undertook the transactions below: January 8 share. March 30 A successful rights issue of 1 new share for 5 at N2.12 per A bonus issue of 1 share for every 2 held. 11

How many authorized and issued shares will the company have at the end of its 2017 financial year? Ignoring transaction costs, how much money has company A raised? Solution to Question 6c) 6c) The issued share capital is the key number here. Jan 2nd 400,000 new shares (2.4 million total) and raising N848,000. March 3rd 1,200, 000 new shares (3.6 million total). No money raised. (i) Dividend share capital = N3.6million and N848,000 raised (ii) Authorised capital stays the same. (Total 6c: 2 marks) 6d) A director of a manufacturing company was heard to say, Non-current asset turnover attracts too much analyst attention margin improvement has to be our key objective. Briefly state why improving non-current asset turnover may be important for such a company. Solution to Question 7d) 6d) Manufacturing assets are expensive and mean a great deal of capital is tied up and a return needs to be made on this investment. The return can only be achieved in two ways - charging a mark-up on cost or by getting more sales out of the assets. Asset turnover measures the latter of the two. 6e) Reservator Limited recently approached the bank in which you work seeking further finance. Your manager has asked you to review the loan application. While researching the company you found a recent newspaper article in which Reservator was described as a company with gearing ratio of 51.8. 7e1) Explain what is meant by high gearing. 7e2) Discuss the implications of a high gearing ratio on the loan application submitted Solution to Question 6e) 6e1) The term gearing is used to describe the capital structure of a company which is usually made up of a combination of debt and equity. Equity refers to the monies owners (shareholders) have invested in the business and debt refers to the funds which have been borrowed. A company that is highly geared has a lot of debt relative to equity and a company that does not have a lot of debt relative to equity is said to have low gearing. The gearing ratio of a company is calculated as follows: Non-current Liabilities x 100 (Share Capital + Reserves +Non-current Liabilities) 1 Reservator gearing ratio is 52%* which means that for every N invested in the business 52 kobo of it came from borrowed funds, that is more than half the funds invested came from debt. While this is not a negligible level of debt it is not at a critically high level unless of course the company was unable to service this debt. 12

Some of the disadvantages of a highly geared company are as follows: 1. Companies with high levels of gearing normally find it more difficult to borrow than companies with low gearing. 2. Interest on debt must be paid every year regardless of profits whereas there is no such obligation to pay dividends on ordinary shares. 3. Higher levels of debt results in higher interest charges and less funds available for the ordinary shareholders. (½ marks for any two mentioned) However there are some advantages to having higher gearing levels: 1. Interest is tax deductible whereas dividends are not. 2. When debt is used to finance the business instead of equity the ownership of the business is less diluted that businesses with low levels of gearing. (½ marks for any two mentioned) 6e2) While Reservator Limited has a relatively high level of gearing it may be generating sufficient profits to service the debt and still has profits available to make a dividend distribution to shareholders. Therefore I may not consider the current gearing levels to be too high and would like to review profit forecasts to determine whether the company can continue to service current and possibly higher debt levels. Question 7 - Portfolio Management 7 Ifeolu recently joined an investment banking firm as research analysts. One of the partners asks her to determine whether a certain stock, Kasco Holdings, is overvalued or undervalued, and by how much (expressed as percentage return). Ifeolu runs a regression and finds the following information on the stock. σ m = 0.70, where m = market Cov s,m = 0.85, where s = stock and m = market. The price today (P 0 ) equals 35.00. The expected price in one year (P 1 ) is 39.00. The firm typically pays an annual 1.50 dividend. The 3-month Treasury bill is yielding 4.50%. The historical average market return is 12.0%. 7a) Is the stock overvalued or undervalued? 7a2) What is the alpha of the stock? Solution to Question 7 7a1) (4 marks) Holding period return (= expected return) 13

Beta of stock: Required return using CAPM R i = 4.5 + 1.73 (12 4.5) = 17.48% The required return is greater than the expected return, so the stock is overvalued negative alpha, as shown below. 7a2) Expected return 15.71% Required return (17.48%) Alpha value (1.77%) (Total: 4 marks) 7b) Theoretically, the standard deviation of a portfolio can be reduced to what level? Explain. Realistically, is it possible to reduce the standard deviation to this level? Explain. Solution to Question 7b) Theoretically, if one could find two securities with perfectly negatively correlated returns (correlation coefficient = -1), one could solve for the weights of these securities that would produce the minimum variance portfolio of these two securities. The standard deviation of the resulting portfolio would be equal to zero. However, in reality, securities with perfect negative correlations do not exist. (Total: 6 marks) 14