7 fixed-income securities: characteristics and valuation ©2006 thomson/south-western
TRANSCRIPT
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
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
6
Corporate bonds
Market for 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/
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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
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Bond RatingsQuality 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/
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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
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.
11
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
12
Market Value of an Asset
Market price
Demand & Supply(D&S)
Approximated value
Equilibrium
D&S Intersection
Consensus Judgment
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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
16
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.
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Yield to maturity of a bond
nd
n
tt
d k
M
k
IP
1110
If the price is known, you can solve for the value of kd
which is the yield to maturity on the bond (the yield that makes the present value of the promised cash flows equal to the market price of the bond.
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Perpetual Bond
dk
I0P
A perpetual bond pays $I forever—the value of a perpetual bond is computed as:
22
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.
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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.
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Characteristics of P/S
Selling price
Par value
Adjusted rate P/S
Cumulative
Participation
Maturity
Call feature
Voting rights
25
P/S Advantages and Disadvantages Advantages
Flexible Can increase
financial leverage
Corporate tax advantage
Disadvantages High after-tax
cost Dividends are
not tax deductible