Chapter 6 FixedIncome Securities: Characteristics and Valuation

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Chapter 6Fixed-Income SecuritiesCharacteristics
and Valuation
2
Introduction

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

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Classification of Long-term ( L-T ) Debt

• Mortgage bonds secured.
• Debentures unsecured.
• Subordinated and Unsubordinated.
• Claims of subordinated debenture holders are
  considered only after the claims of
  unsubordinated debt holders.

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Special Types of L-T Debt

• Equipment Trust Certificates
• Collateral Trust bonds
• Pollution Control bonds
• Industrial Revenue bonds

• Income bonds
• Asset-backed securities
• Securitized debt, for example, automobile loan
  payments

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Features of L-T Debt

• Indenture covenants
• Typical restrictions - minimum net working
  capital, limitations on dividends
  
• Other restrictions, for example, protects against
  event risk by providing for a poison put
  
• Trustee represents bondholders
• Bond refunding
• Similar to refunding a mortgage
• Discount at after-tax interest rate on new debt
• Covered in the Appendix to this chapter
  

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Features of L-T Debt - Continued

• Coupon rates
• Fixed rate bonds
• Floating rate bonds, might be tied to LIBOR
• Size (usually) 25-700 million
• Original issue discount (OID) bonds
• Zero coupon or money multiplier bonds
• Typically maturities of 15 to 30 years
• Extendable notes or put bonds

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Features of L-T Debt - Concluded

• Call feature
• Call premium
• Immediate call
• Deferred call
• Sinking fund

• Equity-linked debt
• Convertibles
• Warrants

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Debt Information

• Corporate bonds.
• Majority traded in the over-the-counter (OTC)
  market.
  
• Some larger issues traded on the NY exchange.
• Quotations as per text - of par value 1000.
• DukeEn 63/8 08 6.8 40 93¾ 1/4
• Meaning a Duke Energy bond with an interest
  rate (coupon rate) of 6.375 percent, maturing in
  2008, yielding 6.8 percent, 40,000 dollars
  traded, closing price of 937.50, down 2.50 from
  the previous day.

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Corporate Bonds

• The Wall Street Journal provides a table of the
  40 most active fixed-coupon bonds.
  
• The coupon rate for these bonds are given in
  decimal form (e.g. Ford Motor, 7.000 coupon,
  October 1, 2013 maturity, 97.260 Last Price,
  7.445 Last Yield, 355 EST Spread in basis
  points over comparable Treasury note/bond,
  10-year UST-comparable Treasury, and 201,673 EST
  Volume in 000s).
• Source Wall Street Journal, June 3, 2005, page
  C13.
  

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U.S. Government Debt Securities

• U.S. Treasury bills S-T
• Maturities of 3, 6 and 12 months
• Minimum denominations of 10,000
• Sold at a discount from maturity value
• Treasury notes and bonds L-T
• Notes 1-10 year maturity
• Bonds 10-30 year maturity

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Bond Ratings
http//www.standardandpoors.com/
http//www.moodys.com/
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Ratings

• Higher rated bonds generally carry lower market
  yields
  
• May have a modifier
• Moodys - 1, 2, or 3
• S P () or (-)
• Interest rate spread between ratings is less
  during prosperity than during recessions
  
• Junk bonds typically yield 3 to 6 more than
  high quality corporate bonds
  
• Rates on 5-year AAA Banking Finance on June 5,
  2005 were 4.28, while rates on 10-year AAA
  Finance Banking were 4.63 (Source
  Bloomberg).

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Junk Bonds

• Junk bonds are rated Ba or below.
• The high yield sector averaged approximately 30
  percent of the total value of all new corporate
  bond issues from 1997 to 2001.
  
• Wall Street firms charge 1.8 of the value of
  high-yield deals vs. 0.50 for investment-grade
  bond sales.

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L-T Debt Advantages and Disadvantages

• Advantages
• Tax deductibility of interest
• Financial leverage can increase EPS
• Ownership is not diluted

• Disadvantages
• Increased financial risk
• Indenture provisions restrict firms flexibility

Long Term Debt is sometimes referred to as Funded
Debt.
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International Bonds

• Eurobonds are issued by a corporation domiciled
  in one country like Japan and sold in another
  country like the U.S.
  
• In a currency not that of the country where
  issued
  
• May have less regulatory interference
• May have less disclosure requirements
• Are bearer bonds --- anonymity
• Interest is paid once a year
• Eurobonds do not have to be in Euros.

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International Bonds - Continued

• Foreign bonds are issued in a single foreign
  country with interest and principal paid in that
  foreign currency (e.g. Yankee bonds)
  
• For example, Bell of Canada issuing bonds in the
  U.S., Denominated in U.S. Dollars

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Value of an Asset

• Based on the expected future benefits over the
  life of the asset
  
• Future benefits cash flows ( CFs )

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Market Value of an Asset

• Market price or Market Value
• Demand Supply(DS)
• Market Equilibrium
• Consensus Judgment

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The Value of a Bond is the Present value of its
Cash Flows
Please use your HP 10b II Financial Calculator to
calculate the value of a bond.
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In Valuing Bonds, Unless Told Otherwise, Assume
That

• Face value or maturity value or par value
  1,000
  
• Coupon rate is fixed over life of bond
• The required rate of return Kd
• Typically U.S. corporate bonds pay interest twice
  a year (semi-annual payments).

Use your financial calculators.
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Bond Valuation

• Calculator
• PV (value of bond)
• PMT coupon payment
• N number of periods coupon payment is received
• For annual payments use P/YR 1. For semi-annual
  payments, use P/YR 2 (also divide the PMT by 2)
  
• FV face value of bond
• I/yr required rate of return Kd

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Example Problem - Bond Valuation

• XYZ corporation has some bonds that mature in 15
  years. The coupon rate is 8 with interest paid
  annually. The required rate of return for bonds
  of the risk of XYZ is 10. What is the value of
  one of these bonds?
• FV 1000 pmt 8 x 1000 80
• 1 P/YR
• N 15 I 10
• PV (847.88)

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Example Problem Continued --

• Assume that the required rate of return changes
  to 12, what happens to the value of the bonds?
  
• 727.57
• Changes to 8?
• 1,000.00
• Changes to 6?
• 1,194.24

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Example Problem Continued --

• Assume interest is paid semi-annually and the
  required rate of return is 10, what is the value
  of one of these bonds?
  
• P/YR 2
• N 15 xP/YR 30
• FV 1000
• I 10
• PMT 80/2 40
• PV (846.28)

Please remember to set your P/YR back to 1.
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Yield-to-maturity (YTM)

• Defined as the interest rate that makes the PV of
  CFs from the bond its price. The same thing as
  the IRR.
  
• The rate of return you would receive if you
  bought the bond and held it to maturity.
  (Although not necessarily true for a coupon bond
  due to reinvestment risk.).
• Zero coupon bond guarantees the interest rate and
  eliminates reinvestment risk. High Price Risk.

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Yield-to-call (YTC)

• The interest rate that makes the PV of CFs
  through expected call date its price
  
• Usually you will get a call premium over the face
  value of the bond.

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Finding the YTM and YTC

• Before financial calculators and spreadsheet
  programs were invented, this was time consuming
  to do. We had to use trial-and-error. There is
  also an approximation formula. With financial
  calculators, you know PV(bond price), n
  term to maturity (twice that figure if
  semi-annual interest payments), P/YR 2 for
  semi-annual interest, FV face value, PMT
  coupon payment (divided by two if semi-annual
  payment), solve for I/YR YTM or YTC

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Example Problem - YTM

• The bonds of Paw Corporation sell for 887.50.
  They mature in 20 years and the coupon rate is 9
  with interest paid annually. What is the YTM?
  
• I/YR 10.35
• What if the coupon payment is semi-annually?
• With an HP, P/YR 2.
• PV (887.50)
• 20 xPYR 40 or n 40
• PMT 45.00
• FV 1,000
• I/YR 10.34

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Example Problem - YTC

• The bonds of Tiger Town Toys sell for 1150. The
  annual coupon rate (assume annual payment of
  interest) is 9. They mature in 10 years, but
  are callable at 1,090 in 5 years. What is the
  YTC? Dont forget to set P/YR 1.
• 6.92

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Bond Prices and Interest Rates

• Relationship between P0 kd
• There is an inverse relationship between a bonds
  value P0 and its required rate of return kd
  
• L-T Vs S-T Bonds
• A change in kd changes the value of a long-term
  bond more than the value of a short-term bond

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Bond Risk

• Interest Rate Risk
• Price Risk
• Price risk refers to losses from changes in the
  market price of bonds due to changes in
  prevailing interest rates and if the bond is sold
  prior to maturity.
• Reinvestment Rate Risk
• Reinvestment Rate risk occurs when a bond matures
  or is called and also interest is received, and
  because of a decline in interest rates
  reinvestment is at a lower rate.

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Valuing a Perpetual Bond

• P0

I
Kd
Consol
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Zero Coupon Bonds

• formula

• PV P0 price of bond
• M Maturity Value
• n term to maturity
• PMT 0
• FV Maturity value
• I/yr kd required rate of return or YTM

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Ethical Issue

• In many leveraged buyouts ( LBOs ), the buyer
  of the firm financed the purchase with a large
  amount of debt.
  
• Often, stockholders made a large gain while
  bond prices plummeted because of the higher
  leverage the firm has assumed. (Event Risk).

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Preferred Stock ( P/S )

• Is in an intermediate position between C/S and
  L-T debt. Often called a hybrid security.
  
• Part of equity while increasing financial
  leverage. Typically does have a maturity.
  
• Dividends on P/S are not tax deductible to the
  issuing corporation. But preferred dividends are
  taxed at a maximum 15 rate for individual
  stockholders.
• First issued by the B O Railroad in 1836.

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Preferred Stock ( P/S ) -Continued

• TOPRS, QUIPS
• Not eligible under June 2003 Tax Act
• Has preference over C/S with regard to earnings
  and assets
  
• Dividends can not be paid on C/S unless the
  preferred dividends for the period have been
  paid
  

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Characteristics of P/S

• Selling price
• Par value
• Adjustable Rate P/S were a failure
• Money Market Pfd.
• Cumulative

• Participation
• Very rare!
• Maturity
• Sinking Fund
• NAIC
• Call feature
• No Voting rights
• Convertibility

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P/S Advantages and Disadvantages

• Disadvantages
• High after tax cost
• Dividends are not tax deductible to issuer

• Advantages
• Flexible
• Can increase financial leverage
• (Secondary Leverage)
• Corporate tax advantage
• (70 Dividends Received Deduction)

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Value of P/S

• P0

Dp
Kp
Theoretically
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Preferred Stock -- Example Problem

• Duke Energy has some 50 par value perpetual
  preferred stock that pays a dividend of 5 per
  year (or 2.50). If you require a rate of return
  of 6 for preferred stock of the risk of Duke
  Energy, what is the value of one of these
  shares?
• 41.67

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Preferred Stock -- Example Problem

• If SCEG has an issue of preferred stock
  outstanding that sells for 87.50 and pays a
  quarterly dividend of 1.50, what is the rate of
  return?
• 6.86

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Conclusion

• Long Term Debt
• Types
• Features
• Ratings
• International Bonds
• Bond Valuation
• Yield to Maturity
• Preferred Stock
• Characteristics