Fixed-Income Securities: Characteristics and Valuation

1. 6 Fixed-Income Securities: Characteristics and Valuation

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

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. Types of L-T Debt • Equipment trust certificates • Income bonds • Collateral trust bonds • Pollution control bonds • Industrial revenue bonds

5. 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

6. 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/

7. 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

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

9. 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.

10. 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.

11. 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.

12. 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

13. Market price Demand & Supply(D&S) Approximated value Equilibrium D&S Intersection Consensus Judgment Market Value of an Asset

14. The Value of a Bond is the Present Value of its Cash Flows

15. 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.

16. Perpetual Bond

17. Zero Coupon Bonds formula table

18. 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.

19. 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.

20. Selling price Par value Adjusted rate P/S Cumulative Participation Maturity Call feature Voting rights Characteristics of P/S

21. Advantages Flexible Can increase financial leverage Corporate tax advantage Disadvantages High after-tax cost Dividends are not tax deductible P/S Advantages and Disadvantages

22. Value of P/S