Chapter 6 Introduction

1. 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.

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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.

8. 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.

9. 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).

10. Valuing Corporate Bonds • The general equation for the value of a bond is: • Computing the bond value in this example:

11. 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?

12. 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?

13. 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

14. 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.

15. 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:

16. 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.

17. 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:

18. 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.

19. 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.

20. 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.

21. 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:

22. 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:

23. 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?

24. 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