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Chapter 6 Fixed-Income Securities: Characteristics and Valuation

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Chapter 6 Fixed-Income Securities: Characteristics and Valuation

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    1. Finance 311 1 Chapter 6 Fixed-Income Securities: Characteristics and Valuation

    2. Finance 311 2 Introduction This chapter focuses on the characteristics and valuation of fixed-income securities. Long-term debt Preferred stock

    3. Finance 311 3 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.

    4. Finance 311 4 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

    5. Finance 311 5 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

    6. Finance 311 6 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

    7. Finance 311 7 Features of L-T Debt - Concluded Call feature Call premium Immediate call Deferred call Sinking fund Equity-linked debt Convertibles Warrants

    8. Finance 311 8 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.

    9. Finance 311 9 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 000’s). Source: Wall Street Journal, June 3, 2005, page C13.

    10. Finance 311 10 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

    11. Finance 311 11 Bond Ratings

    12. Finance 311 12 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).

    13. Finance 311 13 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.

    14. Finance 311 14 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 firm’s flexibility

    15. Finance 311 15 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.

    16. Finance 311 16 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

    17. Finance 311 17 Value of an Asset Based on the expected future benefits over the life of the asset Future benefits = cash flows ( CF’s )

    18. Finance 311 18 Market Value of an Asset Market price or Market Value Demand & Supply (D&S) Market Equilibrium Consensus Judgment

    19. Finance 311 19 The Value of a Bond is the Present value of its Cash Flows

    20. Finance 311 20 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).

    21. Finance 311 21 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

    22. Finance 311 22 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)

    23. Finance 311 23 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

    24. Finance 311 24 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)

    25. Finance 311 25 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.

    26. Finance 311 26 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.

    27. Finance 311 27 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

    28. Finance 311 28 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%

    29. Finance 311 29 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? Don’t forget to set P/YR = 1. 6.92%

    30. Finance 311 30 Bond Prices and Interest Rates Relationship between P0 & 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

    31. Finance 311 31 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.

    32. Finance 311 32 Valuing a Perpetual Bond P0 =

    33. Finance 311 33 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

    34. Finance 311 34 Ethical Issue In many leveraged buyouts ( LBO’s ), 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”).

    35. Finance 311 35 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.

    36. Finance 311 36 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

    37. Finance 311 37 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

    38. Finance 311 38 P/S Advantages and Disadvantages Advantages Flexible Can increase financial leverage (Secondary Leverage) Corporate tax advantage (70% Dividends Received Deduction) Disadvantages High after tax cost Dividends are not tax deductible to issuer

    39. Finance 311 39 Value of P/S P0 =

    40. Finance 311 40 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

    41. Finance 311 41 Preferred Stock -- Example Problem If SCE&G 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%

    42. Finance 311 42 Conclusion Long Term Debt Types Features Ratings International Bonds Bond Valuation Yield to Maturity Preferred Stock Characteristics

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