1. Fixed-Income Securities: Characteristics and Valuation6
Fixed-Income Securities: Characteristics and Valuation

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. 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/ ¾ –1/4
Meaning a Duke Energy bond with an interest rate (coupon rate) of 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:

7. 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

8. 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

9. 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. 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.

11. 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.

12. 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

13. Market Value of an Asset
Market price
Demand & Supply (D&S)
Approximated value
Equilibrium
D&S Intersection
Consensus Judgment

14. The Value of a Bond is the Present Value of its Cash Flows

15. 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.

16. Perpetual Bond

17. Zero Coupon Bonds
formula
table

18. 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.

19. 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.

20. Characteristics of P/S
Selling price
Par value
Adjusted rate P/S
Cumulative
Participation
Maturity
Call feature
Voting rights

21. P/S Advantages and Disadvantages
Flexible
Can increase financial leverage
Corporate tax advantage
Disadvantages
High after-tax cost
Dividends are not tax deductible

22. Value of P/S