HFT 4464

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HFT 4464

• Chapter 6
• Fixed Income Securities

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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.

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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

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Bond Terminology

• A bond is essentially a long-term loan from the
  investor to the issuing corporation.
• A bonds 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.

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Bond Terminology

• A mortgage bond is backed by collateral.
• A debenture is not secured by collateral but is
  still backed by the corporations cash flow.
• A bonds 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

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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

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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

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Bond Ratings

• Moodys and S P both rate bonds for the level
  of default risk.
• Moodys 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.

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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.

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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 10 rate of return? (market rate)
• The value will be the present value of the coupon
  payment (an annuity) plus the present value of
  the par value (a lump sum).

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Valuing Corporate Bonds

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

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Calculating Values Using the
Tables

• V (CP x (PVA (p. 102)) (Bond Face Value x
  PVLS ( p.93))
• Bond Face Value 1,000
• Interest Rate 10 for 15 Years
• V (100 x 7.6061) (1,000 x.2394) 1,000.00

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Valuing Corporate Bonds

• In the last example the rate of return and the
  coupon rate were the same. What happens to a
  bonds value when the market rate of interest is
  less than the coupon rate? Market rate 8,
  coupon rate 10

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Calculating Values Using the
Tables

• V (CP x (PVA (p. 102)) (Bond Face Value x
  PVLS ( p.93))
• Bond Face Value 1,000
• Interest Rate 10 for 15 Years
• Market Rate 8
• V (100 x8.5595) (1,000 x.3152) 1,171.19

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Valuing Corporate Bonds

• In the last example the rate of return was less
  than the coupon rate. What happens to a bonds
  value when the market rate of interest is greater
  than the coupon rate? Market rate 12, coupon
  rate 10

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Calculating Values Using the
Tables

• V (CP x (PVA (p. 102)) (Bond Face Value x
  PVLS ( p.93))
• Bond Face Value 1,000
• Interest Rate 10 for 15 Years
• Market Rate 12
• V (100 x6.8109) (1,000 x.1827) 863.78

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Valuing Corporate Bonds

• Relationship between market rate of return,
  coupon rate, and bond value.
• Market rate gt Coupon rate Bond value lt Par
  value
• Market rate Coupon rate Bond value Par
  value
• Market rate lt Coupon rate Bond value gt Par
  value

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Corporate Bonds Yield to Maturity

• A bonds yield to maturity is the investors 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 bonds value and solve for the
  market rate of interest.

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Corporate Bonds Yield to Maturity

• Suppose an investor is willing to buy our 15-year
  10 coupon bond for 754.32. Use 754.32 for the
  value of the bond
• 754.32 (Coupon Pmt x PVA m) (Par Value x
  PVLS m)
• 754.32 (100 x 6.1422) (1,000 x .1401)
• The investors yield to maturity is 14

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Corporate Bonds Yield to Maturity

• Suppose an investor is willing to buy our 15-year
  10 coupon bond for 1,080.57. Use 1,080.57 for
  the value of the bond
• 1,080.57 (Coupon Pmt x PVA m) (Par Value x
  PVLS m)
• 1,080.57 (100 x 8.0607) (1,000 x .2745)
• The investors yield to maturity is 9

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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.

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Bonds with Semi-Annual Coupon Payments

• Lets 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

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Bonds with Semi-Annual Coupon Payments

• Assume this bond is selling for 900. What is
  the investors yield to maturity?
• The investors 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.

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Preferred Stock

• Preferred stock has a preference over common
  stock on a firms 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.

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Preferred Stock Features

• Dividends
• Typically fixed
• Some adjustable-rate
• Some participating in firms earnings to a
  limited extent
• No stated maturity but may be redeemed through
• A call feature
• A sinking fund
• Most preferred stock is cumulative.

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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

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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

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Computing Rate of Return on Preferred Stock

• If an investor buys Sullivan Resorts 2.50
  preferred for 20, what is the investors
  expected rate of return?

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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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Homework

• Problems 3,6,9