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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 - PowerPoint PPT Presentation
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Copyright ©2003 South-Western /Thomson Learning
Chapter 6Fixed-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
Characteristics of L-T Debt
• Indenture
– covenants
• Trustee
– TIA 1939
• Call feature
• Call premium
• Sinking fund
• Equity-linked debt
– convertible
– warrant
• Coupon rates
• 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 L-T– Notes 1–10 year maturity – Bonds 10–30 year maturity
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,C
Ba,B,Caa,Ca,C
Default D
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
tt
t
i
CF
1 ) (1 V
0
Market Value of an Asset
• Market price
• Demand & Supply(D&S)
• Approximated value
• Equilibrium
• D&S Intersection
• Consensus Judgment
The Value of a Bond is the Present Value of its Cash Flows
nd
n
tt
d k
M
k
IP
1110
)(PVIF)(PVIFA0 k, nk, n MIP
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/Enter Display
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/Enter Display
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/Enter Display
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/Enter Display
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/Enter Display
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) 0.000014 14N N= 14.00004 4I/Y I/Y= 4.000030 30PMT PMT= 30.00001000 1,000FV FV= 1,000.0000CPT FV= 1,000.0000PV 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) 0.00007 7N N= 7.0000987.5 987.5+/- -987.5PV PV= -987.500060 60PMT PMT= 60.00001000 1,000FV FV= 1,000.0000CPT FV= 1,000.0000I/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) 0.000010 10N N= 10.0000900 900+/- -900PV PV= -900.000038.75 38.75PMT PMT= 38.75001000 1,000FV FV= 1,000.0000CPT FV= 1,000.0000I/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%
Ch. 6, problem 13b with semiannual interest payments
Bond valuation formula with semiannual pmts:
nd
kPVIFM
ndk
PVIFAIP
2,2
2,2
20
Find YTM, semiannual payments Use Tables and interpolation (1)
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 = $38.75
• Five years remain until maturity.
• So, 2n = (2 pmts per year)(5 years) = 10 payments
Find YTM, semiannual payments Use Tables and interpolation (3)
Bond valuation formula with inputs:
Start iterative process of finding the YTM:
10,
2
000,1$
10,2
75.38$900$
dk
PVIFdk
PVIFA
Since the price of the bond is less than $1,000, try a required rate of return that is greater than the semiannual coupon rate.
Semiannual cpn rate: c/2 = (7.75%)/2 = 3.8750%
Find YTM, semiannual payments Use Tables and interpolation (4)
Try kd/2 = 5%: Is this true?
614.010%,5
000,1$
722.710%,5
75.38$900$
PVIFPVIFA
$913.23$900 No,
558.010%,6
000,1$
360.710%,6
75.38$900$
PVIFPVIFA
$843.20$900 No,
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.
913.23 900 843.20
13.235% 6% 5% 5.1889%2 70.03kd
2 2 5.1889% 10.3778%2kdk
d
5% ? % 6%
13.23 70.03
Perpetual Bond
d0 k
IP
Zero Coupon Bonds
formula nk
MP
)(1 d0
)(PVIF ,0 d nkMP 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
• Par value
• Adjusted rate P/S
• Cumulative
• Participation
• Maturity
• Call feature
• 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
p
p
k
DP 0
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?