Transcript No Slide Title

Chapter
6
Fixed-Income Securities:
Characteristics and Valuation
Copyright ©2003 South-Western /Thomson Learning
Introduction
• This chapter focuses on the
characteristics and valuation of fixedincome 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
Characteristics of L-T Debt
• Indenture
– covenants
• Trustee
– TIA 1939
• Sinking fund
• Equity-linked debt
– convertible
– warrant
• Call feature
• Coupon rates
• Call premium
• Size $25–$200 million
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
– Notes 1–10 year maturity
– Bonds 10–30 year maturity
L-T
Bond Ratings
Quality
S & P’s
Moody’s
Highest
AAA
Aaa
High
AA
Aa
Upper Medium A
A
Medium
BBB
Baa
Junk
BB,B,CCC,CC, Ba,B,Caa,Ca,
C
C
D
Default
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
n
V0  
t 1
CFt
(1 i )
t
Market Value of an Asset
• Market price
• Equilibrium
• Demand & Supply
(D&S)
• D&S Intersection
• Consensus
• Approximated value
Judgment
The Value of a Bond is the Present
Value of its Cash Flows
n
I
M
P0  

t
n
1 kd 
t 1 1  kd 
P0  I (PVIFA k, n )  M(PVIFk, n )
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.
Perpetual Bond
I
P0 
kd
Zero Coupon Bonds
M
P0 
n
(1 kd )
formula
P0  M(PVIFkd, n )
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.
Characteristics of P/S
• Selling price
• Participation
• Par value
• Maturity
• Adjusted rate P/S
• Call feature
• Cumulative
• Voting rights
P/S Advantages and Disadvantages
• Advantages
– Flexible
– Can increase
financial
leverage
– Corporate tax
advantage
• Disadvantages
– High after-tax
cost
– Dividends are
not tax
deductible
Value of P/S
Dp
P0 
kp