6 Fixed-Income Securities: Characteristics and Valuation
Introduction • This chapter focuses on the characteristics and valuation of fixed-income securities. • Long-term debt • Preferred stock
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
Types of L-T Debt • Equipment trust certificates • Income bonds • Collateral trust bonds • Pollution control bonds • Industrial revenue bonds
Indenture covenants Trustee TIA 1939 Call feature Call premium Sinking fund Equity-linked debt convertible warrant Coupon rates Size $25–$200 million Characteristics of L-T Debt
Debt Information • Corporate bonds • Majority traded in the over-the-counter market • Some larger issues traded on the NY Exchange • Quotations percent 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 $930.75, down $2.50 from the previous day. • Current information: http://www.etrade.com/
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
Bond Ratings http://www.standardandpoors.com/http://www.moodys.com/
Ratings • Higher rated bonds generally carry lower market yields. • Interest rate spread between ratings is less during prosperity than during recessions. • Junk bonds typically yield 3–6 percent or more.
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.
International Bonds • Eurobonds • Issued outside of the issuer’s country • Denominated in the home currency • May have less regulatory interference • May have less disclosure requirements • Foreign bonds are issued in a single foreign country with interest and principal paid in that foreign currency.
Value of an Asset • Based on the expected future benefits over the life of the asset • Future benefits = cash flows (CFs) • Capitalization of cash flow method • PV of the stream of future benefits discounted at an appropriate required rate of return
Market price Demand & Supply(D&S) Approximated value Equilibrium D&S Intersection Consensus Judgment Market Value of an Asset
Bond Prices and Interest Rates • Relationship between P0 and kd • There is an inverse relationship between a bond’s 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.
Financial calculator example of bond valuation This slide and the next two include steps for the first usage of the calculator. Calcluator: TI BA II Plus Start by resetting the calculator. Press/EnterDisplay 0.00 2nd 0.00 RESET RST? ENTER RST 0.00 CE/C 0.00
Set payments per year and compounding periods per year. Press/EnterDisplay 0.00 2nd 0.00 P/Y P/Y= 12.00 1 P/Y 1 ENTER P/Y= 1.00 C/Y= 1.00 QUIT 0.00
Set the number of places after the decimal. 4 places suggested. Press/EnterDisplay 0.00 2nd 0.00 FORMAT DEC= 2.00 4 DEC 4 ENTER DEC= 4.0000 CE/C 4.0000 CE/C 0.0000
Calculate the intrinsic value of a bond with annual coupon payments • Example on page 216 of MMK 9th Ed. • Calculate interest pmt amount: cM = (.06)(1000) = $60 per year Press/EnterDisplay 0.0000 7 7 N N= 7.0000 8 8 I/Y I/Y= 8.0000
Calculate the intrinsic value of a bond with annual payments (2) Press/EnterDisplay 60 60 PMT PMT= 60.0000 1000 1,000 FV FV= 1,000.0000 CPT FV= 1,000.0000 PV PV= -895.8726
Calculate bond value for a bond with semiannual coupon payments • Example on page 219 of MMK 9th Ed. • Delete previous inputs: CE/C, 2nd, CLR TVM • Calculate semiannual interest amount: cM/2 = (.06)(1,000)/2 = $30 • Find number of payments: n = years 2n = 2(7 years) = 14 payments
Calculate bond value for a bond with semiannual payments (2) (Display) 0.0000 14 14 N N= 14.0000 4 4 I/Y I/Y= 4.0000 30 30 PMT PMT= 30.0000 1000 1,000 FV FV= 1,000.0000 CPT FV= 1,000.0000 PV PV= -894.3688
Calculate yield to maturity for a bond with annual coupon payments • Example on page 220 of MMK 9th Ed. • Delete previous inputs:CE/C, 2nd, CLR TVM • Calculate annual interest amount: cM = (.06)(1,000) = $60
Calculate yield to maturity for a bond with annual payments (2) (Display) 0.0000 7 7 N N= 7.0000 987.5 987.5 +/- -987.5 PV PV= -987.5000 60 60 PMT PMT= 60.0000 1000 1,000 FV FV= 1,000.0000 CPT FV= 1,000.0000 I/Y I/Y= 6.2257
Calculate YTM for a bond with semiannual coupon payments • Problem 13b, page 231, with Semiannual PMTs • Delete previous inputs:CE/C, 2nd, CLR TVM • Calculate semiannual interest amount: cM/2 = (.0775)(1,000)/2 = $38.75 • Find number of payments: n = years 2n = 2(5 years) = 10 payments
Calculate YTM for a bond with semiannual coupon payments (2) (Display) 0.0000 10 10 N N= 10.0000 900 900 +/- -900 PV PV= -900.0000 38.75 38.75 PMT PMT= 38.7500 1000 1,000 FV FV= 1,000.0000 CPT FV= 1,000.0000 I/Y I/Y= 5.1815
Calculate YTM for a bond with semiannual coupon payments (3) I/Y = 5.1815 YTM = 2(I/Y) = 2(5.1815) = 10.3630%
Find YTM, semiannual payments Use Tables and interpolation (1) Ch. 6, problem 13b with semiannual interest payments Bond valuation formula with semiannual pmts:
Find YTM, semiannual payments Use Tables and interpolation (2) • Convert inputs to semiannual basis: • Annual Coupon rate “c” = 7 3/4% = 7.75% per year • Semiannual interest pmt: cM/2 = (0.0775)(1000)/2 = $38.75 • Five years remain until maturity. • So, 2n = (2 pmts per year)(5 years) = 10 payments
Find YTM, semiannual payments Use Tables and interpolation (3) Bond valuation formula with inputs: Start iterative process of finding the YTM: Since the price of the bond is less than $1,000, try a required rate of return that is greater than the semiannual coupon rate. Semiannual cpn rate: c/2 = (7.75%)/2 = 3.8750%
Find YTM, semiannual payments Use Tables and interpolation (4) Try kd/2 = 5%: Is this true? Try kd/2 = 6%: Is this true?
Find YTM, semiannual payments Use Tables and interpolation (5) The $900 market price is bracketed. So, we can interpolate to find the YTM. 5% ? % 6% 913.23 900 843.20 13.23 70.03
Zero Coupon Bonds formula table
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.
Preferred Stock (P/S) • Is in an intermediate position between C/S and L-T debt • Part of equity while increasing financial leverage • Dividends on P/S are not tax deductible. • Has preference over C/S with regard to earnings and assets • Dividends can not be paid on C/S unless the preferred dividend for the period has been paid.
Selling price Par value Adjusted rate P/S Cumulative Participation Maturity Call feature Voting rights Characteristics of P/S
Advantages Flexible Can increase financial leverage Corporate tax advantage Disadvantages High after-tax cost Dividends are not tax deductible P/S Advantages and Disadvantages
Set 1 of Bonus Questions for Ch. 6 • What is a debenture? • What is an indenture with respect to bonds? • How are bond prices quoted in the financial press? • What do bond ratings primarily signify? • Can you give two advantages of long-term debt financing?
Set 2 of Bonus Questions for Ch. 6 • How is an intrinsic value (P) calculated for a bond? • What is the yield to maturity of a bond? • How are zero coupon bonds initially priced? • What equation is typically used to find the intrinsic value (P) for a preferred stock? • What is a junk bond?