Fixed-Income Securities: Characteristics and Valuation

1. 6 Fixed-Income Securities: Characteristics and Valuation

2. Introduction • This chapter focuses on the characteristics and valuation of fixed-income securities. • Long-term debt • Preferred stock

3. 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).

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

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

15. 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.

16. 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).

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

18. 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.

19. 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.

20. 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.

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

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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).

36. 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.

37. 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 the Wall Street Journal.

38. 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.

39. 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.

40. 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 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.

41. 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: 1–10 year maturity • Bonds: 10–30 year maturity

42. 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.

43. 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.

44. Bond Ratings http://www.standardandpoors.com/http://www.moodys.com/

45. 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.

46. 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

47. 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

48. 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.

49. 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.

50. 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.