Chapter 6 introduction
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Chapter 6 Introduction. 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

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Chapter 6 Introduction

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Chapter 6 introduction

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

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

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 terminology1

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

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 features1

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

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

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 bonds1

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 bonds2

Valuing Corporate Bonds

  • The general equation for the value of a bond is:

  • Computing the bond value in this example:


Valuing corporate bonds3

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 bonds4

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 bonds5

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

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 maturity1

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

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 payments1

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 payments2

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

  • 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

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

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 stock1

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

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

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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