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Chapter 6Introduction

- This chapter introduces bonds and preferred stock.
- Bonds and preferred stock are known as fixed income securities because the cash return expected in the future is fixed and is not expected to vary.

Organization of Chapter 6

- Bond topics
- Terminology and bond features
- Bond ratings
- Valuation and yield to maturity computations

- Preferred stock topics
- Terminology and preferred stock features
- Valuation and yield to maturity computations

Bond Terminology

- A bond is essentially a long-term loan from the investor to the issuing corporation.
- A bond’s par value is the amount paid back at maturity. Bond par values are usually $1,000.
- Bonds usually pay interest every 6 months. The interest paid is called a coupon payment and the annual interest rate is called a coupon rate.

Bond Terminology

- A mortgage bond is backed by collateral.
- A debenture is not secured by collateral but is still backed by the corporation’s cash flow.
- A bond’s seniority refers to the order in which debts are paid off in case of financial difficulty. Terms denoting seniority include:
- Senior and junior
- Unsubordinated and subordinated

Bond Features

- An indenture is the contract governing a bond. The indenture describes the features of a bond, including:
- Interest rate and maturity
- Call and put features
- Sinking funds
- Any equity links

Bond Features

- An indenture will also include a number of restrictive covenants restricting the actions of the issuing corporation to include:
- Limitations on dividend payments
- Limitations on additional debt
- Limitations on other specified activities that could increase risk to the bond investor

Bond Ratings

- Moody’s and S & P both rate bonds for the level of default risk.
- Moody’s: Aaa, Aa, A, Baa, Ba … CC, C
- S & P: AAA, AA, A, BBB, BB, … CC, C, D
- Higher bond ratings (Aaa or AAA) indicate lower default risk. Bonds with lower risk will have lower interest cost.

Valuing Corporate Bonds

- The value of a bond is simply the present value of the cash flows an investor expects to receive. The cash flows are:
- The coupon payment every 6 months. This is equal to the coupon rate times the par value divided by 2.
- The par value at maturity.

Valuing Corporate Bonds

- Suppose a 15-year corporate bond has a 10% coupon rate and a $1,000 par value. For simplicity assume the coupon is paid once a year. What is the value of this bond today if an investor requires a 10% rate of return?
- The value will be the present value of the coupon payment (an annuity) plus the present value of the par value (a lump sum).

Valuing Corporate Bonds

- The general equation for the value of a bond is:
- Computing the bond value in this example:

Valuing Corporate Bonds

- In the last example the rate of return and the coupon rate were the same. What happens to a bond’s value when the market rate of interest is less than the coupon rate?

Valuing Corporate Bonds

- In the last example the rate of return was less than the coupon rate. What happens to a bond’s value when the market rate of interest is greater than the coupon rate?

Valuing Corporate Bonds

- Relationship between market rate of return, coupon rate, and bond value.
- Market rate > Coupon rate Bond value < Par value
- Market rate = Coupon rate Bond value = Par value
- Market rate < Coupon rate Bond value > Par value

Corporate Bonds’ Yield to Maturity

- A bond’s yield to maturity is the investor’s rate of return if the investor buys the bond and holds it to maturity without any default.
- We use the same bond valuation equation, except now we specify the bond’s value and solve for the market rate of interest.

Corporate Bonds’ Yield to Maturity

- Suppose an investor buys our 15-year 10% coupon bond for $900. Use $900 for the value of the bond:
- The investor’s yield to maturity is:

Bonds with Semi-Annual Coupon Payments

- Most bonds pay interest every 6 months. Adjust the bond valuation equation as follows:
- The annuity payment is the annual coupon payment divided by 2.
- The number of annuity payments is the number of 6 month coupon payments until maturity.
- The appropriate interest rate is a 6-month rate.

Bonds with Semi-Annual Coupon Payments

- Let’s use the earlier example of a 15-year bond with a 10% coupon rate, 15 years to maturity and a 12% required rate of return. If the coupon is paid semi-annually, the value is:

Bonds with Semi-Annual Coupon Payments

- Assume this bond is selling for $900. What is the investor’s yield to maturity?
- The investor’s yield to maturity from the equation is 5.70% semi-annually. Multiply this by 2 to obtain an 11.40% nominal annual rate of return compounded semi-annually.

Preferred Stock

- Preferred stock has a “preference” over common stock on a firm’s cash flows and assets. This seniority of preferred stock over common stock is the source of the name “preferred.”
- Preferred stock has a par value of $25, $50, or $100. The dividend is paid quarterly but is usually expressed as an annual amount.
- “Six Flags $1.81 preferred” pays $1.81 in dividends annually.

Preferred Stock Features

- Dividends
- Typically fixed
- Some adjustable-rate
- Some participating in firm’s earnings to a limited extent

- No stated maturity but may be redeemed through:
- A call feature
- A sinking fund

- Most preferred stock is cumulative.

Valuing Preferred Stock

- For introductory purposes we will assume preferred stock pays a dividend once a year and will not be redeemed in the future. If preferred stock has a fixed dividend and no redemption, then it can be viewed as a perpetuity and valued as follows:

Valuing Preferred Stock

- If an investor requires an 11% rate of return on Sullivan Resorts $2.50 preferred, then the value of the preferred stock is:

Computing Rate of Return on Preferred Stock

- If an investor buys Sullivan Resorts $2.50 preferred for $20, what is the investor’s expected rate of return?

Summary of Chapter 6 Topics

- Corporate bonds
- Terminology and features
- Ratings
- Valuation and yield to maturity

- Preferred stocks
- Terminology and features
- Valuation and rate of return

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