Chapter 6 FixedIncome Securities Characteristics and Valuation Copyright

Chapter 6 Fixed-Income Securities: Characteristics and Valuation Copyright © 2003 South-Western /Thomson Learning

Introduction • This chapter focuses on the characteristics and valuation of fixedincome securities. – Long-term debt – Preferred stock

Classification of Long-Term (L-T) Debt • When a company borrows money in the capital markets, it issues long-term debt securities to investors. These bonds are usually sold in denominations of $1, 000 and constitute a promise by the issuing company to repay a certain amount of money (the $1, 000 principal) on a particular date (the maturity date) and to pay a specific amount of interest at fixed intervals (usually twice a year).

Classification of Long-Term (L-T) Debt • Most debt has a par value of $1, 000, and debt prices are often expressed as a percentage of that value. For example, a market price listing of “ 87” indicates that a $1, 000 par value bond may be purchased for $870.

Classification of Long-Term (L-T) Debt • Mortgage bonds are secured by specific physical assets of the issuing company. • Debentures or debenture bonds are unsecured by specific physical assets of the issuing company.

Classification of Long-Term (L-T) Debt • At the present time, utility companies are the largest users of mortgage bonds. In recent years, the use of mortgage bonds relative to other forms of long-term debt has declined, whereas the use of debentures has increased.

Classification of Long-Term (L-T) Debt • Because debentures are unsecured, their quality depends on the general creditworthiness of the issuing company. As a result, they are usually issued by large, financially strong firms.

Classification of Long-Term (L-T) Debt • The yield differential between the mortgage bond and debenture alternatives is another example of the risk-return trade-off that occurs throughout finance.

Classification of Long-Term (L-T) Debt • For example, suppose Midstates Oil company could issue either mortgage bonds or debentures. If the mortgage bonds could be sold with a 10 percent interest rate, the debentures would have to be sold at a higher rate—for example, 10. 25 percent—to attract investors.

Classification of Long-Term (L-T) Debt • This is due to the fact that investors require a higher return on debentures, which are backed only by the unmortgaged assets of the company and the company’s earning power, than they do on mortgage bonds, which are secured by specific physical assets as well as the company’s earning power.

Classification of Long-Term (L-T) Debt • Debt issues are also classified according to whether they are senior or junior. Senior debt has a higher priority claim to a firm’s earnings and/or assets than junior debt.

Classification of Long-Term (L-T) Debt • Unsecured debt may also be classified according to whether it is subordinated to other types of debt. In the event of a liquidation or reorganization, the claims of subordinated debenture holders are considered only after the claims of unsubordinated debenture holders.

Classification of Long-Term (L-T) Debt • In general, subordinated debentures are junior to other types of debt, including bank loans, and may even be junior to all of a firm’s other debt.

Types of L-T Debt • Equipment trust certificates • Collateral trust bonds • Income bonds • Pollution control bonds • Industrial revenue bonds

Equipment Trust Certificate • Equipment trust certificates are used largely by railroad and trucking companies. • The proceeds from these certificates are used to purchase specific assets.

Equipment Trust Certificate • The certificate holders own the equipment and lease it to the company. • The interest and principal are paid by trustee (the financial institution responsible for looking after the investors’ interests).

Collateral Trust Bond • Collateral trust bonds are backed by stocks or bonds of other corporations.

Collateral Trust Bond • A holding company, for example, may raise needed funds by pledging the stocks and/or bonds of its subsidiaries as collateral. In this arrangement, the holding company serves as the parent company. The subsidiary borrows from the parent, and the parent borrows from the capital markets. This makes sense because the parent company can generally get more favorable terms for its debt in the capital markets than the subsidiary.

Income Bond • Income bonds promise to pay interest only if the issuing firm earns sufficient income; if it does not, no interest obligation exists. • Income bonds are often created in reorganization following bankruptcy and are normally issued in exchange for junior or subordinated issues.

Pollution Control Bond and Industrial Revenue Bonds • Pollution control bonds and industrial revenue bonds are issued by local government rather than corporations. • The interest paid to purchasers of municipal bonds is tax-exempt, and the interest rate is typically less than what a corporation would have to pay. The interest payments are guaranteed by the corporation for whose benefit the bonds are issued.

Characteristics of L-T Debt • Indenture – covenants • Trustee – TIA 1939 • Sinking fund • Equity-linked debt – convertible – warrant • Call feature • Sizes • Call premium • Coupon rates

Characteristics of L-T Debt: Indenture • An indenture is a contract between a firm that issues long-term debt securities and the lenders. In general, an indenture does the following: – It thoroughly details the nature of the debt issue. – It carefully specifies the manner in which the principal must be repaid. – It lists any restriction placed on the firm by the lenders. These restrictions are called covenants, and the firms must satisfy them to keep from defaulting on its obligations.

Characteristics of L-T Debt: Trustee • Because the holders of a large firm’s long-term debt issue are likely to be widely scattered geographically, the Trust Indenture Act of 1939 requires that a trustee represent the debt holders in dealing with the issuing company.

Characteristics of L-T Debt: Trustee • A trustee is a commercial bank or trust company that is responsible for ensuring that all the terms and covenants set forth in the indenture agreement are adhered to by the issuing company. The issuing company must pay the trustee’s expenses.

Characteristics of L-T Debt: Call Feature • A call feature is an optional retirement provision that permits the issuing company to redeem, or call, a debt issue prior to its maturity date at a specified price termed the redemption, or call, price. • Many firms use call feature because it provides them with the potential flexibility to retire debt prior to maturity if, for example, interest rates decline.

Characteristics of L-T Debt: Call Premium • The call price is greater than the par value of the debt, and the difference between the two is the call premium.

Characteristics of L-T Debt: Call Premium • Because a call feature gives the company significant flexibility in its financing plans, while at the same time potentially depriving the lenders of the advantages they would gain from holding the debt until maturity, the issuing company has to offer the investors compensation in the form of the call premium in exchange for the call privilege.

Characteristics of L-T Debt: Call Premium • In addition, the interest rate on a callable debt issue is usually slightly higher than the interest rate on a similar noncallable issue.

Characteristics of L-T Debt: Sinking Fund • Lenders often require that a borrowing company gradually reduce the outstanding balance of a debt issue over its life instead of having the entire principal amount come due on a particular date 20 or 30 years into the future.

Characteristics of L-T Debt: Sinking Fund • The usual method of providing for a gradual retirement is a sinking fund, so called because a certain amount of money is put aside annually, or “sunk, ” into a sinking fund account.

Characteristics of L-T Debt: Equity -Linked Debt • Some debt issues are linked to the equity of the firm through a conversion feature that allows the holder to exchange the security for the company’s common stock at the option of the holder.

Characteristics of L-T Debt: Equity -Linked Debt • Interest costs of a convertible debt issue are usually less than a similar debt issue without the conversion option, because investors are willing to accept the value of the conversion privilege as part of their overall return.

Characteristics of L-T Debt: Equity -Linked Debt • Another form of equity-linked debt is the issuance of warrants with debt securities. A warrant is an option to purchase shares of a company’s common stock at a specified price during a given time period.

Characteristics of L-T Debt: Sizes • Debt issues sold to the public through underwriters are usually in the 25 million to several hundred million-dollar range. • Because the use of an underwriting group in a public offering involves considerable expense, it is usually uneconomically for a company to make a public offering of this nature for debt issues less than about $25 million.

Characteristics of L-T Debt: Coupon Rates • The coupon rates on new bonds are normally fixed and set equal to market interest rates on bonds of comparable quality and maturity so that the bonds sell at or near par value. • On the other hand, the coupon rates can be floating based on some base rates such as London Interbank Offer Rate (LIBOR).

Characteristics of L-T Debt: Coupon Rates • Original issue deep discount (OID) bonds have coupon rates below prevailing market interest rates at the time of issue and hence sell at a discount from par value. Some OID bond issues pay no interest and are known as zero coupon bonds.

Debt Information • The over-the-counter (OTC) market is a network of security dealers who buy and sell bonds and stock from each other, either for their own account or for their retail clients. • Price information on bonds that are traded over-the-counter is not reported in the Wall Street Journal. Price quotations for corporate bonds listed and traded on the NY exchange are published daily in

Debt Information • See Table 6. 1. • Bond prices are quoted as a percentage of their par value (usually $1, 000). For example, the closing price for the Duke Energy issue was $1, 015 ($1, 000*101. 5%). The “ 7 s 33” after the Duke. En name means the bond offers a contract, or coupon, interest rate of 7 percent. Thus, a holder of the issue receive $35 in interest per bond every six months, for a total of $70 (7%*$1, 000) each year. This debt issue, or series (the s stands for “series”), matures in the year 2033, hence the 33 after the coupon interest rate.

Debt Information The current yield is calculated by dividing the annual interest by the day’s closing price; for example, $70/$1, 015 = 6. 9 percent. However, this current yield is only an approximation of the true promised yield on the bond, called the yield to maturity, which is discussed later in the chapter. A cv in the current yield column, which appears for the Hilton bonds, indicates that the bond issue is convertible into common stock under certain conditions.

Debt Information Also, note that the Four Seasons Hotel bond issue (Four. Seas) has a zr before the expiration date of the bond (2029), which indicates that this is a zero coupon bond—a bond that pays no interest. Rather, it is initially sold at a discount for par value ($1, 000), and the purchaser receives a return by holding the bond to maturity, at which point it is redeemed for $1, 000. You will note that this bond is currently selling for only 27 percent of its par value, or $270.

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 (no explicit interest payment) • Treasury notes and bonds – Notes: 1– 10 year maturity – Bonds: 10– 30 year maturity L-T

U. S. Government Debt Securities • The quote for a typical Treasury bill on October 18, 2001 as follows: – The bill shown above matures in 181 days. The “bid” and “asked” prices indicate the annualized percentage discount from maturity value. – A “bid” price is the price at which buyers (dealers) are willing to purchase, and the “asked” price is the price at which sellers (dealers) wish to sell.

U. S. Government Debt Securities – For Treasury bills, the “bid” and “ask” quotes represent discounts from value. – An asked discount of 2. 12 percent translates into a cash discount from $10, 000 of approximately $105. 13 [=(2. 12%)/(365/181)*$10, 000], or an asked price of $10, 000 $105. 13 = $9, 894. 87. – The ask yld. is the annualized yield an investor will receive by purchasing this bill and holding it to maturity.

Bond Ratings Quality S & P’s Moody’s Highest AAA Aaa High AA Aa Upper Medium A A Medium BBB Baa Junk BB, B, CCC, Ba, B, Caa, C C D Default 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 – Its relatively low after-tax cost due to the tax deductibility of interest – The increased EPS possible through financial leverage – The ability of the firm’s owners to maintain greater control over the firm

L-T Debt: Advantages and Disadvantages • Disadvantages – The increased financial risk of the firm resulting from the use of debt – The restrictions placed on the firm by the lenders

L-T Debt: Advantages and Disadvantages • From the investors’ viewpoint, in general, debt securities offer stable returns and therefore are considered relatively lowrisk investments compared with common stock investments. Because debt holders are creditors, however, they do not participate in any increased earnings the firm may experience.

L-T Debt: Advantages and Disadvantages • During periods of relatively high inflation, holders of existing debt find that their real interest payments decrease because the nominal interest payments remain constant.

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 – Present value (PV) of the stream of future benefits discounted at an appropriate required rate of return

Value of an Asset • The required rate of return on an asset is a function of the uncertainty, or risk, associated with the returns from the asset as well as the risk-free interest rate. (Recall that risk was defined in Chapter 5 as the possibility that actual future returns will deviate from expected returns. ) This function is upward sloping, indicating that the higher the risk, the greater the investor’s required rate of return.

Market Value of an Asset • Market Price • Demand & Supply (D&S) • Approximated Value • Market Equilibrium: the expected rate of return on the asset = the marginal investor’s required rate of return • D&S Intersection (Figure 6. 2) • Consensus Judgment

The Value of a Bond is the Present Value of its Cash Flows See Figure 6. 3.

The Value of a Bond is the Present Value of its Cash Flows - Example • AT&T issued $3 billion of 6 percent bonds maturing on March 15, 2009. The bonds were issued in $1, 000 denominations (par value). For purposes of simplifying this example, assume that the bonds pay interest on March 15 each year.

The Value of a Bond is the Present Value of its Cash Flows - Example • An investor who wishes to purchase one of these AT&T bonds on March 15, 2002 and requires an 8 percent rate of return on this particular bond issue would compute the value of bond as follow: – P 0 = $60(PVIFA 0. 08, 7) + $1, 000(PVIF 0. 08, 7) = $60(5. 206) + $1, 000(0. 583) = $895. 36

The Value of a Bond is the Present Value of its Cash Flows - Example • These calculations assume that the investor will hold the bond until maturity and receive seven annual (n = 7) interest payments of $60 each (I = $1, 000*0. 06) plus a principal payment, M, of $1, 000 at the end of the seventh year, March 15, 2009.

The Value of a Bond is the Present Value of its Cash Flows - Example • 7→n 8. 0 → i% 60 → PMT 1, 000 → FV Compute PV = -895. 87

The Value of a Bond is the Present Value of its Cash Flows • Most bonds pay interest semiannually. With semiannual interest payments and compounding, the bond valuation formula becomes:

The Value of a Bond is the Present Value of its Cash Flows - Example • With semiannual interest and compounding, the value for the AT&T bond is calculated as follows: – P 0 = $30(PVIFA 0. 04, 14) + $1, 000(PVIF 0. 04, 14) = $30(10. 563) + $1, 000(0. 577) = $893. 89

The Value of a Bond is the Present Value of its Cash Flows - Example • 14 → n 4. 0 → i% 30 → PMT 1, 000 → FV Compute PV = -894. 37

Bond Prices and Interest Rates • Relationship between P 0 and kd – There is an inverse relationship between a bond’s value, P 0, and its required rate of return, kd. See Figure 6. 4. • 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. See also Figure 6. 4.

Risk • If the market price of the bond declines due to a rise in prevailing interest rates and if the bond is sold prior to maturity, the investors will earn less than their required rate of return and may even incur a loss on the bond. This variation in the market price (and hence in the realized rate of return of a bond) is known as interest rate risk.

Risk • When a bond issue matures (or is called) and, because of a decline in interest rates, the investor has to reinvest the principal at a lower coupon rate. This is known as reinvestment rate risk.

Perpetual Bond • A perpetual bond, or perpetuity, is a bond issued without a finite maturity date. Perpetual bonds promise to pay interest indefinitely, and there is no contractual obligation to repay the principal, that is, M = 0.

Perpetual Bond - Example • Consider the Canadian Pacific Limited Railroad’s perpetual 4 percent debentures. What is the value of a $1, 000 bond to an investor who requires an 8 percent rate of return of these Canadian Pacific bonds? • I = 4%*$1, 000 = $40 P 0 = $40/8% = $500

Yield to Maturity • The yield to maturity of a bond is the discount rate that equates the present value of all expected interest payments and the repayment of principal from a bond with the present bond price. • In contrast, the current yield, which is equal to the annual interest payment divided by the current price, ignores the repayment of the principal.

Yield to Maturity • If the current price of a bond, P 0, the uniform annual interest payments, I, and the maturity value, or principal, M, are known, the yield to maturity of a bond having a finite maturity date can be calculated by solving the following formula for kd:

Yield to Maturity - Example • Consider again the AT&T 6 percent bonds discussed earlier. Again, assume that interest is paid annually on March 15 each year. Suppose that the bonds are selling for $987. 50 on March 15, 2002 (seven years prior to maturity). Determine the bond’s exact yield to maturity.

Yield to Maturity - Example • 7→n -987. 50 → PV 60 → PMT 1, 000 → FV Compute i% = 6. 23%

Zero Coupon Bonds • For zero coupon bonds that pay no interest over their life, the only payment to holders is the principal payment at maturity. • See Figure 6. 5.

Zero Coupon Bonds - Example • To illustrate the calculation of the yield to maturity for a zero coupon bond, consider the Honeywell International zero coupon money multiplier notes that mature on April 21, 2009. Suppose these bonds having a par value of $1, 000 were purchased for $600 on April 21, 2001 (eight years prior to maturity). Determine the yield to maturity on these bonds.

Zero Coupon Bonds - Example • 8→n -600 → PV 0 → PMT 1, 000 → FV Compute i% = 6. 59%

Yield to Maturity of a Perpetual Bond • The rate of return, or yield to maturity, on a perpetual bond can be found by solving the perpetual bond valuation equation presented earlier for kd:

Yield to Maturity of a Perpetual Bond - Example • For example, recall the 4 percent Canadian Pacific Limited Railroad debentures described earlier. If the current price of a bond is $640, what is the yield on the bond? • Kd =$40/$640 = 0. 0625 or 6. 25%

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.

Preferred Stock (P/S) • P/S is in an intermediate position between C/S and L-T debt • P/S is part of equity while increasing financial leverage • Dividends on P/S are not tax deductible. • P/S 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.

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

Characteristics of P/S: Selling Price and Par Value • The selling price, or issue price, is the per-share price at which preferred stock shares are sold to the public. • The par value is the value assigned to the stock by the issuing company, and is frequently the same as the initial selling price. No relationship necessarily exists between the two, however.

Characteristics of P/S: Adjustable Rate Preferred Stock • This type of preferred stock became popular in the early 1980 s. • With these issues, dividends are reset periodically and offer returns that vary with interest rates.

Characteristics of P/S: Cumulative • Most preferred stock is cumulative. This means that if, for some reason, a firm fails to pay its preferred dividend, it cannot pay dividends on its common stock until it has satisfied all or a prespecified amount of preferred dividends in arrears.

Characteristics of P/S: Cumulative • The principal reason for this feature is that investors are generally unwilling to purchase preferred stock that is not cumulative.

Characteristics of P/S: Participation • Stock is said to be participating if the holders share in any increased earnings the company might experience. • Virtually all preferred stock, however, is nonparticipating; that is, the preferred dividend remains constant, even if the company’s earnings increase. Any dividend increases resulting from higher earnings accrue directly to the common stockholders.

Characteristics of P/S: Maturity • Preferred stock is technically part of a firm’s equity capital. As such, some firms issue preferred stock that is intended to be perpetual, that is, a permanent portion of the stockholders’ equity having no specific maturity date. • Many preferred stock investors, however, desire sinking fund provisions, which guarantee that the issue will be retired over a specified time period.

Characteristics of P/S: Call Feature • Preferred stock can be redeemed, or called, at the issuing firm’s option at some specified price.

Characteristics of P/S: Call Feature • Whereas the call feature allows the issuing company a measure of flexibility in its financing plans, the call feature is generally not attractive to investors. Thus, a firm usually must also provide investors with a call premium, or the difference between the call price and the original selling price, should it decide to attach a call feature to its preferred stock.

Characteristics of P/S: Call Feature • The probability that a firm will exercise the call privilege is likely to increase during times when market interest rates have decreased below those that existed at the time of issue. After calling the original issue, the firm can replace it with a lower-cost issue.

Characteristics of P/S: Voting Rights • As a general rule, preferred stockholders are not entitled to vote for the company’s board of directors.

Characteristics of P/S: Voting Rights • However, special voting procedures frequently take effect if the company omits preferred dividends or incurs losses for a period of time. In such a case, the preferred stockholders often vote as a separate group to elect one or more members of the company’s board of directors. This ensures that the preferred holders will have direct representation on the board.

P/S Advantages and Disadvantages • Advantages – Flexible – Can increase financial leverage – Corporate tax advantage: See next slide. • Disadvantages – High after-tax cost – Dividends are not tax deductible

Corporate tax advantage of PS • From the investors’ perspective, companies who purchase the preferred stock of other companies accrue certain tax advantage resulting from the 70 percent exclusion of intercompany dividends from federal income taxes.

Value of P/S • Because many preferred stock issues do not have maturity dates, the cash flows from holding no-maturity preferred stock can be treated as a perpetual stream of payments, or a perpetuity. Capitalizing the perpetual stream of dividend payments gives the following valuation expression:

Value of P/S: Example • Assume that Du. Pont pays annual end-of -year dividends on its $4. 50 series B cumulative preferred stock issue. What is the value of this stock on an investor who requires an 8 percent annual rate of return on the investment? Assume that the issue will not be called for the foreseeable future. • P 0 = $4. 50/0. 08 = $56. 25