FixedIncome Securities: Characteristics and Valuation

1
Chapter 6

• Fixed-Income SecuritiesCharacteristics and
  Valuation

2
Introductions

• This chapter focuses on the characteristics and
  valuation of fixed-income securities.
• Long-term debt
• Preferred stock

3
Fixed Income Securities

• Promise to pay a regular income
• Two basic types
• debt securities interest income
• short-term debt
• maturity ? 1 year
• long-term debt (bonds)
• maturity gt 1 year
• preferred stock dividend income

4
Classification of Bonds by Security

• Mortgage bonds (secured)
• promised obligations are secured by specific
  physical assets.
• Debentures (or Debenture bonds) (Unsecured)
• Claims of subordinated debenture holders are
  considered only after the claims of
  unsubordinated debenture holders.

5
Features of a Typical Bond

• Has a defined maturity period
• Pay
• regular fixed interest (semi-annual)
• principal at maturity (redemption)
• 1000, 10, 3-year bond
• Period 1 2 3 4 5 6
• Interest 50 50 50 50 50 50
• Principal 1000

6
Other Features of Bonds

• Perpetual Bonds
• no finite maturity
• Zero Coupon Bonds
• pay no interest, only principal at maturity
• sold below par value

7
Other Features of Bonds

• Callable Feature (Callable Bonds)
• gives the option to the company to redeem prior
  to maturity.
• call price par value call premium
• Deferred call callable several years after issue
  date
• Why callable bonds? To take advantage of lower
  interest rates in the future

8
Other Features of Bonds

• Convertible Bonds
• gives bondholder the right to convert into common
  shares
• gives the opportunity to gain from future
  increase in share price
• interest rates less than non-convertible bonds

9
Other Features of Bonds

• Floating Rate Bonds (Variable Rate Bonds)
• coupon rate is linked to some other interest rate
  (base rate)
• coupon rate varies with the changes in the base
  rate
• protects the investor against interest rate risk

10
Corporate Bond Quotations

• Bonds Cur Vol. Close Net Chg.
• Yld.
  
• DukeEn 6 3/8 08 6.8 40 93¾ -1/4
• Coupon rate 6.375 (63.75)
• Maturity 2008
• Current Yield 6.8
• Volume traded 40,000 bonds
• Closing price 93.75 x 1,000 937.50
• Change from previous day -0.25 x1000
• 
  -2.50
• Current Yield 63.75/937.50 6.8

11
Bond Ratings

• Independent Assessment of the credit quality
  (credit risk / Default risk) of bonds
• Credit quality means the ability and willingness
  to service promised obligations on a timely
  basis.
• Ratings assigned on the basis of the credit
  quality
• Major Rating Agencies Standard and Poors
  Corporation, Moodys Investor Services

12
Bond Rating Symbols
13
Ratings

• Higher rated bonds generally carry lower market
  yields.
• Junk bonds typically yield 36 percent or more.

14
Advantages and Disadvantages of Debt

• Advantages
• Tax deductibility of interest
• Financial leverage can increase EPS
• Ownership is not diluted
• Disadvantages
• Increased financial risk
• Indenture provisions restrict firms flexibility
  

15
International Bonds

• Eurobonds
• bonds issued outside of the issuers country and
  denominated in the home currency.
• Ex A Japanese company selling
• yen-denominated bonds in the
• US.

16
International Bonds

• Foreign bonds
• bonds issued outside of the issuers country and
  denominated in foreign currency.
• Ex A Japanese company selling
• US-denominated bonds in the
• US.

17
Intrinsic Value vs Market Value

• Intrinsic Value is the present value of the
  future stream of cash flows discounted at an
  appropriate required rate of return.
• Market value (price) is the price determined by
  the demand and supply conditions in the market
  for the asset.

18
Valuing Finite-Maturity Bonds
Po Bond Value at time zero I Interest per
period M Principal value (1000) n number
of periods kd required rate of return on bond
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Example Annual Interest

• What is the value of a 1000, 7 bond maturing in
  7 years if the required rate of return is 8?
  Interest paid annually.
• I 1000 x 7 70 year
• M 1000, n 7 , kd 8
• 7 n, 8 I/Y, 70 PMT, 1000 FV
• CPT PV
• PV -947.94 i.e. Value 947.94

20
Example Semi-annual Interest
What is the value of a 1000, 7 bond maturing in
7 years if interest is paid semi-annually? The
required rate of return is 8. I 1000
x 7 70/2 35 M 1000, n 7 x 214 , kd
8/24 14 n, 4 I/Y, 35 PMT, 1000 FV CPT
PV PV -947.18 i.e Value 947.18
21
Valuing Perpetual Bonds
What is the value of a 1000, 7 perpetual bond,
if the required rate of return is 8? Po
70/0.08 875.00
22
Valuing Zero Coupon Bonds
What is the value of a 1000, 7-year, zero coupon
bond, if the required rate of return is 8?
(Assume annual compounding) 1000 FV, 7 n, 8 I/Y,
0 PMT, CPT PV PVo -583.49 i.e. Value583.49
23
Yield to Maturity (YTM)

• Promised rate of return of a bond, assuming
• investor holds it to maturity and
• interest cash flows are reinvested at the same
  rate as the YTM.

24
YTM of a Finite-Maturity Bond
If you buy at the current market price and
holds the bond until maturity, what is the rate
of return you can expect to earn?
Answer Solve for kd
25
YTM of a Finite-Maturity Bond
What is the YTM of a 1000, 7 bond maturing in 7
years if interest is paid semi-annually? The
current market price is 900. I 1000 x
7 70/2 35 M 1000, n 7 x 214 P
900 14 n, 35 PMT, 1000 FV, -900 PV, CPT
I/Y I/Y 4.48 YTM 4.48 x 2 8.96
26
YTM of a Zero Coupon Bond
Solve for kd
27
YTM of a Zero Coupon Bond
What is the YTM of a 1000, zero coupon bond
maturing in 7 years. The current market price is
500. (assume annual compounding) M 1000,
n 7 , P 500 7 n, 1000 FV, -500 PV, 0
PMT, CPT I/Y I/Y 10.41 YTM 10.41
28
YTM of a Perpetual Bond
Pm I/ Kd Kd I/Pm PmMarket Price What is the
YTM of a 1000, 7 perpetual bond if the current
market price is 500. I 70,
P500 YTM 70/500 14
29
Risks of Investing in Bonds

• Interest Rate Risk
• possibility of variation in the market price of
  the bond due to future changes in interest rates.
• Particularly concerned with increases in interest
  rates.

30
Risks of Investing in Bonds

• Reinvestment Risk
• possibility that the interest rate at which
  future cash flows (interest and principal) can be
  reinvested will fall.

31
Risks of Investing in Bonds

• Default Risk
• possibility that the issuer will default promised
  obligations (interest and/or principal).

32
Valuation of Preferred Stock
Dp DPS on preferred kp required return
on preferred
33
Valuation of Preferred Stock
What is the value of a 8 preferred stock. The
par value is 20. The required return is
12 Dp 8 x 20 1.60 kp 12
Po 1.60/0.12 13.33