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’sHighest AAA AaaHigh AA AaUpper Medium A AMedium BBB BaaJunk BB,B,CCC,CC,

CBa,B,Caa,Ca,C

Default Dhttp://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

iCF

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 kM

kIP

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.

Perpetual Bond

d0 k

IP

Zero Coupon Bonds

formula nkMP

)(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

kD

P 0