fixed-income securities: characteristics and valuation

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


• 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


• 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)


• 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


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%


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?


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?

fixed-income securities: characteristics and valuation

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