Question

Q3       Exerpt taken from Engro Corporations press release:

“Engro Corp is one of Pakistan’s largest conglomerates, in operation for over 45 years, and with businesses ranging from fertilizers to power generation. Currently Engro Corp’s portfolio consists of seven businesses which include chemical fertilizers, PVC resin, a bulk liquid chemical terminal, industrial automation, foods, power generation and commodity trade.

Engro Corporation Limited has announced the launch of the second issue of the Engro Rupiya Certificates savings option, which provides investors with an unprecedented 14.5% (coupon) rate of return. This issuance follows the successful launch of the certificates in October 2010.

The second release of Engro Rupiya Certificates also offers profit payments twice in a year for a minimum amount of PKR 25,000, invested for a period of 3 years. The product offers investors the option to encash the certificates at any time, with the profit accumulated from the date of purchase to the date of encashment. Engro has also provided a unique service for the convenience of its customers, enabling certificate holders to conduct transactions and receive profit payments at home.”

1. Assuming the yield to maturity on the bond is 11.25%, calculate the price of the bond at the time of issue [2 marks]
2. Assuming the yield curve is flat and doesn’t shit, calculate the bond price two years after the issue? [2 marks]
3. Compare your answer to part 1 and justify. [2 marks]
4. Evaluate the relevance of the types of risk for this bond. [5 mark]

Answer 1

1. Price of the bond at the time of issue

Price of the Bond = [25000/ (1+0.1125*6/12) ^6] = 18002.76

2. Price of Bond after 2 years of issue

Price of Bond after 2 years = PV of Interest + Present Value of Lump sum

PV of Interest = [(25000*14.5%/2)/(1+0.1125*6/12)^2 + (25000*14.5%/2)/(1+0.1125*6/12)^4 ] = 3080.76

PV of Lump sum = 25000 /(1+0.1125*6/12)^4 = 20085

Price of Bond after 2 years = 3080+20085 = 23165

3. Justification of the Above answer

Price at the time of issue is 18002. This amount is invested. We will receive interest at Coupon rate of 14.5% i.e. amount of PKR 2610 (which will divided into two payments in a year. Therefore

Total amount = 18002 + 2610+2610 = 23220*

*the difference in amount is due to rounding off

4. Relevance of the types of risk for this bond

1. Interest Rate Risk and Bond Prices

Interest rates and bond prices have an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends to fall. If the prevailing interest rate were on the rise, investors would naturally jettison bonds that pay lower interest rates. This would force bond prices down.

2. Reinvestment Risk and Callable Bonds

Another danger that bond investors face is reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than the funds were previously earning. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers.

The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder receives the principal payment, which is often at a slight premium to the par value.

However, the downside to a bond call is that the investor is then left with a pile of cash that he or she may not be able to reinvest at a comparable rate. This reinvestment risk can have a major adverse impact on an individual's investment returns over time.

3. Inflation Risk and Bond Duration

When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held.

But what happens if the cost of living and inflation increase dramatically, and at a faster rate than income investment? When that happens, investors will see their purchasing power erode and may actually achieve a negative rate of return (again factoring in inflation).

4. Credit/Default Risk of Bonds

When an investor purchases a bond, he or she is actually purchasing a certificate of debt. Simply put, this is borrowed money that must be repaid by the company over time with interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith and credit of the U.S. government, but instead depend on the corporation's ability to repay that debt. Investors must consider the possibility of default and factor this risk into their investment decision.