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Fixed-Income Securities: Characteristics and ValuationPowerPoint Presentation

Fixed-Income Securities: Characteristics and Valuation

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### 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

- Subordinated and unsubordinated

Types of L-T Debt

- Equipment trust certificates
- Income bonds
- Collateral trust bonds
- Pollution control bonds
- Industrial revenue bonds

covenants

Trustee

TIA 1939

Call feature

Call premium

Sinking fund

Equity-linked debt

convertible

warrant

Coupon rates

Size $25–$200 million

Characteristics of L-T DebtDebt 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

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

Demand & Supply(D&S)

Approximated value

Equilibrium

D&S Intersection

Consensus Judgment

Market Value of an AssetBond 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/EnterDisplay

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/EnterDisplay

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/EnterDisplay

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/EnterDisplay

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/EnterDisplay

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

- Example on page 219 of MMK 9th Ed.
- 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) payments

(Display) 0.0000

14 14

N N= 14.0000

4 4

I/Y I/Y= 4.0000

30 30

PMT PMT= 30.0000

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

PV PV= -894.3688

Calculate yield to maturity for a bond with annual coupon payments

- Example on page 220 of MMK 9th Ed.
- 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) 0.0000

7 7

N N= 7.0000

987.5 987.5

+/- -987.5

PV PV= -987.5000

60 60

PMT PMT= 60.0000

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

I/Y I/Y= 6.2257

Calculate YTM for a bond with semiannual coupon payments (2)

- 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) (2)

(Display) 0.0000

10 10

N N= 10.0000

900 900

+/- -900

PV PV= -900.0000

38.75 38.75

PMT PMT= 38.7500

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

I/Y I/Y= 5.1815

Calculate YTM for a bond with semiannual coupon payments (3) (2)

I/Y = 5.1815

YTM = 2(I/Y) = 2(5.1815) = 10.3630%

Find YTM, semiannual payments Use Tables and interpolation (1)

Ch. 6, problem 13b with semiannual interest payments

Bond valuation formula with semiannual pmts:

Find YTM, semiannual payments Use Tables and interpolation (2)

- 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

Find YTM, semiannual payments Use Tables and interpolation (3)

Bond valuation formula with inputs:

Start iterative process of finding the YTM:

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%

Find YTM, semiannual payments Use Tables and interpolation (4)

Try kd/2 = 5%: Is this true?

Try kd/2 = 6%: Is this true?

Find YTM, semiannual payments Use Tables and interpolation (5)

The $900 market price is bracketed.

So, we can interpolate to find the YTM.

5% ? % 6%

913.23 900 843.20

13.23

70.03

Perpetual Bond (5)

Ethical Issue (5)

- 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) (5)

- 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.

Selling price (5)

Par value

Adjusted rate P/S

Cumulative

Participation

Maturity

Call feature

Voting rights

Characteristics of P/SAdvantages (5)

Flexible

Can increase financial leverage

Corporate tax advantage

Disadvantages

High after-tax cost

Dividends are not tax deductible

P/S Advantages and DisadvantagesValue of P/S (5)

Set 1 of Bonus Questions for Ch. 6 (5)

- 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 (5)

- 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?

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