Fixed-Income Securities: Characteristics and Valuation 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 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 Quotations percent of par value $1000 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 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 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

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

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

Zero Coupon Bonds formula 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 Flexible Can increase financial leverage Corporate tax advantage Disadvantages High after-tax cost Dividends are not tax deductible

Value of P/S