Chapter 6

Fixed-Income Securities:
Characteristics and
Valuation
Copyright 2003 South-Western /Thomson Learning
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
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 ratefor example,
10.25 percentto 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 companys earning power, than they
do on mortgage bonds, which are
secured by specific physical assets as
well as the companys 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 firms 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 firms 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 Sinking fund

covenants Equity-linked debt
Trustee convertible
TIA 1939 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 firms
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 trustees
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 companys
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 companys
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 7s33 after
the DukeEn 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 days 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 (FourSeas) has a zr before the
expiration date of the bond (2029), which
indicates that this is a zero coupon bonda
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 L-T

Notes: 110 year maturity
Bonds: 1030 year maturity
U.S. Government Debt Securities

The quote for a typical Treasury bill on

October 18, 2001 as follows:
Maturity Days to Mat. Bid Ask Chg. Ask Yld.
April 18 02 181 2.13 2.12 -0.02 2.17

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 & Ps Moodys
Highest AAA Aaa
High AA Aa
Upper Medium A A
Medium BBB Baa
Junk BB,B,CCC,CC, Ba,B,Caa,Ca,
C C
Default D
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 36 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 firms 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 low-
risk 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 issuers 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
n CFt n CFt
V0 (1 i)
t 1
t
Vt
t t 1 (1 i ) t
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 investors required rate of
return.
Market Value of an Asset

Market Price Market

Equilibrium: the
expected rate of return
Demand & Supply on the asset = the
marginal investors
(D&S) required rate of return

Approximated D&S Intersection

Value (Figure 6.2)

Consensus
Judgment
The Value of a Bond is the Present
Value of its Cash Flows
n
I M
P0
t 1 (1 k d ) (1 kd )
t n

P0 I (PVIFA kd , n ) M (PVIFkd , n )

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:
P0 = $60(PVIFA0.08, 7) + $1,000(PVIF0.08, 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
7n
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:
2n
I /2 M
P0
1 kd / 2 1 kd / 2
t 2n
t 1

P0 I / 2(PVIFA kd / 2, 2 n ) M (PVIFkd / 2, 2 n )
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:
P0 = $30(PVIFA0.04, 14) + $1,000(PVIF0.04, 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 P0 and kd

There is an inverse relationship between a
bonds value, P0, 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.

I
P0
kd
Perpetual Bond - Example

Consider the Canadian Pacific Limited

Railroads 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
P0 = $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, P0, 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:
n
I M
P0
1 kd 1 kd
t n
t 1
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 bonds exact yield to
maturity.
Yield to Maturity - Example

7n
-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.
M
P0 M (PVIF )
(1 kd ) n k d , n

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

8n
-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:

I I
P0 kd
kd P0
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 1980s.

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
companys 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
firms 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 firms 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 companys
board of directors.
Characteristics of P/S: Voting
Rights
However, special voting procedures
frequently take effect if the company
omits its 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 companys board
of directors. This ensures that the
preferred holders will have direct
representation on the board.
P/S Advantages and Disadvantages

Advantages Disadvantages
Flexible High after-tax
Can increase cost
financial Dividends are
leverage not tax
Corporate tax deductible
advantage:
See next slide.
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:
Dp Dp
P0
t 1 (1 k p ) t
kp
Value of P/S: Example

Assume that DuPont 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.
P0 = $4.50/0.08 = $56.25