PREMIER UNIVERSITY

Assignment 1

Course Name
Security Analysis and Portfolio Management

Submitted to

Mr. Mohammad Ahsan Uddin

Assistant Professor
Department of Accounting
Premier University, Chittagong

Submitted By
Name : Ringkel Barua
ID : 1902920803306
Program : MBA (1 Year)
Major : Accounting
Semester : 2nd
Batch : 29th

Date of Submission: 23.9.2020

 1. Tenets of Warren Buffett
The “Tenets of the Warren Buffett Way” was examined in the book The Warren Buffett
Way, written by Robert G. Hagstrom.

Business Tenets

• Is the business simple and understandable? (This makes it easier to estimate future cash
flows with a high degree of confidence.)
• Does the business have a consistent operating history? (Again, cash flow estimates can be
made with more confidence.)
• Does the business have favorable long-term prospects? (Does the business have a
franchise product or service that is needed or desired, has no close substitute, and is not
regulated? This implies that the firm has pricing flexibility.)

Management Tenets

• Is management rational? (Is the allocation of capital to projects that provide returns above
the cost of capital? If not, does management pay capital to stockholders through
dividends or the repurchase of stock?)
• Is management candid with its shareholders? (Does management tell owners everything
you would want to know?)
• Does management resist the institutional imperative? (Does management not attempt to
imitate the behavior of other managers?)

Financial Tenets

• Focus on return on equity, not earnings per share. (Look for strong ROE with little or no
debt.)
• Calculate owner earnings. (Owner earnings are basically equal to free cash flow after
capital expenditures.)
• Look for a company with relatively high sustainable profit margins for its industry.
• Make sure the company has created at least one dollar of market value for every dollar
retained.

Market Tenets

• What is the intrinsic value of the business? (Value is equal to future free cash flows
discounted at a government bond rate. Using this low discount rate is considered
appropriate because Warren Buffett is very confident of his cash flow estimates due to his
deep understanding of the business based on extensive analysis. This confidence implies
low risk.)
• Can the business be purchased at a significant discount to its fundamental intrinsic value?
 2. Basic features of bond
Bonds can be defined as the negotiable instrument, issued in relation to borrowing arrangement
that indicates indebtedness. It is an unsecured debt instrument, in which the bond investor
extends credit to the issuer, which in turn commits to repay the loan amount on the specified
maturity date, along with interest throughout the life of the bond. Bonds are securities with
following basic features

 They are typically securities issued by a corporation or governmental body for specified
term: bonds become due for payment at maturity, when the par value/ face value of bond
are returned to the investors.
 Bonds usually pay fixed periodic interest installments, called coupon payments. Some
bonds pay variable income.
 When investor buys bond, he or she becomes a creditor of the issuer. Buyer does not gain
any kind of owner ship rights to the issuer, unlike in the case with equity securities.

3. Bond Characteristics
A bond can be characterized based on (1) its intrinsic features, (2) its type, (3) its indenture
provisions, or (4) the features that affect its cash flows and/or its maturity.

3.1. Intrinsic features

3.1.1. Coupon
The coupon rate is the amount of interest that the bondholder will receive per payment,
expressed as a percentage of the par value.

 Coupon interest rate is usually fixed throughout the life of the bond. It can also vary with
a money market index.
 Not all bonds have coupons. Zero-coupon bonds are those that pay no coupons and thus
have a coupon rate of 0%.
 Based on different coupon rates, there are fixed rate bonds, floating rate bonds, and
inflation linked bonds.

3.1.2. Maturity
Maturity date refers to the final payment date of a loan or other financial instrument.

 As long as all due payments have been made, the issuer has no further obligations to the
bond holders after the maturity date.
 The length of time until the maturity date is often referred to as the term or tenor or
maturity of a bond.
 In the market for United States Treasury securities, there are three categories of bond
maturities: short term, medium term, and long term.
 3.1.3. Principal value
All bonds repay the principal amount after the maturity date; however some bonds do pay the
interest along with the principal to the bond holders.

3.1.4. Type of ownership

 Bearer Bonds do not carry the name of the bond holder and anyone who possesses the
bond certificate can claim the amount. If the bond certificate gets stolen or misplaced by
the bond holder, anyone else with the paper can claim the bond amount.
 A registered bond has its owner's name and contact information recorded with the
issuing entity, ensuring coupon payments are correctly distributed.

3.2. Types of Issues

3.2.1. Secured (senior) bonds (backed by asset)

Secured bonds – bonds secured by the pledge of assets (plant or equipment), the title to which is
transferred to bondholders in case of foreclosure

3.2.2. Unsecured bonds (debentures)

Unsecured bonds – bonds backed up by the faith and credit of the issuer instead of the pledge of
assets.

3.2.3. Subordinated (junior) debentures

Debenture bonds – bonds for which there is no any specific security set aside or allocated for
repayment of principal

3.3. Indenture provisions

An indenture is a legal contract between the issuer and the bondholder. It sets forth the details of
all the terms and conditions of the bonds, such as the exact day of their maturity, the timing of
the interest payments and how they are calculated, and the details of any special features.

For example, the indenture gives bondholders exact instruction about whom to contact if

the bonds are called and describes the procedures for tendering their certificates and receiving
their compensation. Other details in a bond indenture include a description of how the bond
certificates will look and what language will appear on them, as well as a list of
financial covenants the issuer must abide by and the formulas for calculating whether the issuer
is abiding by the covenants.

3.4. Features affecting a bond’s maturity

3.4.1. Callable :
A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it
reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt
early. A business may choose to call their bond if market interest rates move lower, which will
allow them to re-borrow at a more beneficial rate. Callable bonds thus compensate investors for
that potentiality as they typically offer a more attractive interest rate or coupon rate due to their
callable nature

3.4.2. Convertible:
Convertible bonds are bonds that give to its owner the privilege of exchanging them for other
securities of the issuing corporation on a preferred basis at some future date or under certain
conditions.

3.4.3. Put provision:

A put provision is a provision in some bonds which allows the bondholder to resell a bond back
to the bond’s issuer at par or the face value of the bond before the bond matures. While
exercising the put provision will mean that the bondholder does not receive the full anticipated
return, or yield-to-maturity,(YTM) of the investment, it does protect the bondholder from an
ultimate loss on their investment. 

A put provision will generally specify multiple dates when the bond may be redeemed before the
maturity date. Multiple dates provide the bondholder with the ability to reassess their investment
every few years, in the event, they wish to redeem for reinvestment. 

4. Rates of Return on Bonds

A rate of return (RoR) is the net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment’s initial cost. The rate of return on a bond is
computed in the same way as the rate of return on stock or any asset. It’s determined by the
beginning and ending price and the cash flows during the holding Period. The major difference
between stocks and bonds is that the interim cash flow on bonds (i.e., the interest) is contractual
and accrues over time, as discussed subsequently, whereas the dividends on stock may vary.
Therefore, the holding period return (HPR) for a bond will be:

∫ ¿i ,t −Pi ,t ¿
HPR i,t = P i ,t +1 +
Pi , t

Where:

HPRi,t = the holding period return for bond i during Period t

Pi,t+1 = the market price of bond i at the end of Period t

Pi,t= the market price of bond i at the beginning of Period t

Inti,t= the interest paid or accrued on bond i during Period t

Assume an investor buys a stock for $60 a share, owns the stock for five years, and earns a total
amount of $10 in dividends. If the investor sells the stock for $80, his per share gain is $80 - $60
= $20. In addition, he has earned $10 in dividend income for a total gain of $20 + $10 = $30. The
rate of return for the stock is thus a $30 gain per share, divided by the $60 cost per share, or 50%.

5. Participating Issuers
There are at least five types of bonds. They each have different sellers, purposes, buyers, and
levels of risk versus return.

5.1. Sovereign bonds (e.g., the U.S. Treasury):

These are bonds issued by sovereign governments. In the United States they are called U.S.
Treasury bonds. In Canada they’re called Canadian Treasury Bonds, and in the U.K. they’re
called Gilts.

Sovereign bonds are tradable, fixed-income bonds backed by the full faith and credit of the
country’s treasury. These are considered one of the safest investments on the market because the
state has the power to tax its people to meet its obligations. (Note: “Safe” doesn’t mean free of
risk.)

But with low risk comes low returns. Sovereign government bonds are one of the weakest
performing securities in terms of profit.

5.2. Agency Bonds:

Agency bonds are bonds issued by government agencies, rather than the treasury. But like
treasury bonds, they are backed by the full faith and credit of the government. You can expect
regular interest payments from the issuing agency and the full face of the bond remitted to you at
the maturity date. They are a bit less liquid than treasury bonds, however, so they offer a slightly
higher interest rate.

Agency bonds can also be issued by government sponsored entities. These are quasi-government
organizations that are privately owned but heavily regulated and given a mission to provide
public services. Bonds from GSEs are not fully guaranteed in the same way as sovereign
government bonds and municipal bonds, so they come with a higher risk.

5.3. Securitized/Collateralized Issues:

These can be either government agencies or corporate issues that are backed by cash flow
securities such as mortgages or car loans. Collateralized securities can include several different
issues and structured cash flows.

5.4. Corporations:
Corporate bonds are bonds issued by corporations, LLCs, partnerships, and other commercial
entities. These are bonds that have BBB or better ratings from Standard & Poor’s or Moody’s
Investors Service. These bonds don’t come with much risk of default because the investing
services have evaluated them and declared them to be low-risk. (We’ll talk about bonds with
lower ratings in a minute.)

Nevertheless, companies who issue corporate bonds aren’t as resilient as governments or

municipalities, so there’s more risk. This also means higher returns. That said, there are no tax
advantages to these bonds.

These kinds of bonds are classified by their maturity:

 Short-term bonds: Five year term or less.

 Intermediate bonds: Maturity between five and 12 years.
 Long-term bonds: 12 year term or more.

5.5. High-Yield/Emerging Market:

High-yield bonds are also called  Junk bonds or speculative bonds. These are corporate bonds
with the lowest possible ratings from the investment services, which means the companies are
not financially sound. This means they are at high risk.

While junk bonds are the riskiest type of bonds you can buy, they’re still generally safer than
stocks. They also offer higher yields with interest rates that are several times higher than
government bonds.

6. THE FUNDAMENTALS OF BOND VALUATION

Bond valuation is a technique for determining the theoretical fair value of a particular bond.
Bond valuation includes calculating the present value of a bond's future interest payments, also
known as its cash flow, and the bond's value upon maturity, also known as its face value or par
value. Because a bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for a bond investment to be worthwhile.

6.1. The Present Value Model

The present value (PV) of a bond represents the sum of all the future cash flow from that contract
until it matures with full repayment of the par value.
2n
C i /2 Pp
∑
Pm = t =1
( i
(1+ )
2
t
+
i 2n
(1+ )
2 )
Where,

Pm = the current market price of the bond

n = the number of years to maturity

Ci = the annual coupon payment for Bond

 i = the prevailing yield to maturity for this bond issue

Pp = the par value of the bond

The results show the following important relationship:

 if y > coupon rate, P < face value

 if y = coupon rate, P = face value
 if y < coupon rate, P > face value

The results also demonstrate that there is an inverse relationship between yields and bond prices:

 when yields rise, bond prices fall

 when yields fall, bond prices rise

6.2. The Yield Model

The YTM is the most important and widely used measure of the bonds returns and key measure
in bond valuation process. YTM is the fully compounded rate of return earned by an investor in
bond over the life of the security, including interest income and price appreciation. YTM is also
known as the promised yield-to- maturity. Yield-to-maturity can be calculated as an internal rate
of return of the bond or the discount rate, which equalizes present value of the future cash flows
of the bond to its current market price (value). Then YTM of the bond is calculated from this
equation:
2n
C i /2 Pp
∑
Pm = t =1
( i t
+
i 2n
(1+ ) (1+ )
2 2 )
Where, the variables are the same as previously, except:

i = the discount rate that will discount the expected cash flows to equal the current market price
of the bond
 7. COMPUTING BOND YIELDS
When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers
agree to pay investors interest on bonds through the life of the bond and to repay the face value
of bonds upon maturity.

Bond investors traditionally have used five yield measures:

7.1. Nominal yield

Nominal yield, or the coupon rate, is the stated interest rate of the bond. The simplest way
to calculate a bond yield is to divide its coupon payment by the face value of the bond. This is
called the coupon rate.

Annual Interest Payment

Nominal yield=
Par value

7.2. Current yield

Bonds trade in the secondary market, they may sell for less or more than par value, which will
yield an interest rate that is different from the nominal yield, called the current yield, or current
return. Since the price of bonds moves in the opposite direction of interest rates, bond prices
decrease when interest rates increase, and vice versa.

Annual Interest Payment

Current yield=
Current Market Price of Bond

7.3. Promised yield to maturity

Promised yield to maturity is the most widely used bond yield figure because it indicates the
fully compounded rate of return promised to an investor who buys the bond at prevailing prices,
if two assumptions hold true. Specifically, the promised yield to maturity will be equal to the
investor’s realized yield if these assumptions are met. The first assumption is that the investor
holds the bond to maturity. This assumption gives this value its shortened name, yield to
maturity (YTM). The second assumption is implicit in the present value method of computation.
2n
Ci /2 Pp
Pm
¿∑
t=1
( i t
(1+ ) ( 1+ )
2 2
+
i 2n
)
7.4. Promised Yield to Call
Yield to call (YTC) is a financial term that refers to the return a bondholder receives if the bond
is held until the call date, which occurs sometime before it reaches maturity. This number can be
mathematically calculated as the compound interest rate at which the present value of a bond's
future coupon payments and call price is equal to the current market price of the bond. Generally
speaking, bonds are callable over several years. They are normally called at a slight premium
above their face value, though the exact call price is based on prevailing market rates.
2nc
C i /2 Pc
∑
Pm = t =1
( i
(1+ )
2
t
+
i 2nc
(1+ )
2 )
Where,

Pm = the current market price of the bond

Ci = the annual coupon payment for Bond i

nc = the number of years to first call date

Pc = the call price of the bond

7.5. Realized (Horizon) Yield

 Realized yield is the actual return earned during the holding period for an investment, and
it may include dividends, interest payments, and other cash distributions.
 The realized yield on investments with maturity dates is likely to differ from the stated
yield to maturity under most circumstances.
 In the bond market, it is common to use the terms "realized yield" and "realized return"
interchangeably.
 The term "realized yield" is applied to bonds, CDs, and fixed-income funds, but "realized
return" is generally the preferred term for stocks.

The realized yields over a horizon holding period are variations on the promised yield
equations. The substitution of P f(future selling price) and hp into the present value model
provides the following realized yield model:

2 hp
Ci/ 2 Pf
∑
Pm = t =1
( i
(1+ )
2
t
+
i 2hp
(1+ )
2 )