# Bonds and preferred stock. Basic definitions. Preferred(?) stock. Investing in fixed income securities

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1 Bonds and preferred stock Investing in fixed income securities Basic definitions Stock: share of ownership Stockholders are the owners of the firm Two types of stock: preferred and common Preferred stock: relatively unimportant, safer than common stock but very limited gains Common stock: ultimate owners of the firm, risky, unlimited earnings potential Bond: Corporate IOU, a debt of the firm Bondholders are creditors, not owners of the firm Safer position but lower expected returns than stock Preferred(?) stock Preferred shareholders legally rank behind all creditors (banks, bond holders) but ahead of common stockholders in claim on income and assets No voting rights who cares Not very common nowadays Like common stock, preferred stock has no maturity date Pays a fixed dividend does not rise as company profits rise \$8.00 now and \$8.00 thirty years from now 1

2 Return on preferred stock Buy a share at its current market price and receive an infinite annuity of dividends Use our PV of annuity formula PV 0 = PMT(PVIF a - i% - n) = PMT(PVIF a - i% - ) Turns out that with n=>, PV 0 =PMT/i or i=pmt/pv 0 If P IBM = \$100 and D IBM = \$8.00, yield or rate of return i = D/P = 8/100 = 8.0% (<=remember!) You ll receive an \$8.00 a year dividend (actually \$2.00 each quarter) for ever the \$8.00 is fixed Inverse relationship Even though preferred stock is not important, let s use it to illustrate a very important relationship between interest rate* and price P = D/i or i = D/P (D is fixed or constant) As interest rate rises, price falls As price rises, interest rate falls * interest rate return yield Why P changes as i changes Say HP and GE issue new preferred stock with yields of 10% (perfect substitutes for IBM) Assume P HP =100 and D HP =10 so that i HP =10/100=10% and P GE =50 and D GE =5 so that i GE =5/50=10% Investors will now demand same 10% yield on IBM preferred since it s essentially the same as HP and GE preferred i IBM =10%=D IBM /P IBM Investors can get \$10 dividends by paying \$100 for HP and GE. Why pay \$100 for IBM and get only \$8? With D IBM fixed at \$8.00, P IBM =8/.10=\$80 and IBM shares drop from \$100 to \$80 P IBM must drop to raise its yield up to the market rate 2

3 Why P changes as i changes Say HP and GE issue new preferred stock with yields of 10% (perfect substitutes for IBM) Assume P HP =100 and D HP =10 so that i HP =10/100=10% and P GE =50 and D GE =5 so that i GE =5/50=10% Investors will now demand same 10% yield on IBM preferred since it s essentially the same as HP and GE preferred i IBM =10%=D IBM /P IBM Investors can get \$10 dividends by paying \$100 for HP and GE. Why pay \$100 for IBM and get only \$8? With D IBM fixed at \$8.00, P IBM =8/.10=\$80 and IBM shares drop from \$100 to \$80 P IBM must drop to raise its yield up to the market rate Example of interest rate risk Even though the likelihood of IBM defaulting on its preferred stock is very, very low, there s still risk present If interest rates rise (in our example i goes from 8% to 10%), price of the stock drops from \$100 to \$80 and that s a capital loss of \$20 a share Interest rate risk is especially important when investing in bonds Bonds Bonds: interest bearing IOU s issued by corporations, municipalities and US Gov t Initial buyer lends money to the seller Bondholders are creditors, not owners Buyers investors lenders creditors you and me, IBM, Prudential Insurance Sellers issuers borrowers HP, IBM, City of Bethlehem, U. S. Treasury 3

4 First in line Bondholders have a prior claim on income and assets at the head of the line Bond s coupon interest payment must be paid before any dividends At bankruptcy, all creditors must be 100% satisfied before any stock or equity holders Bond is a contract between the issuer and the investors Everything is spelled out in advance Everything is fixed Principal face value par value \$1000 Annual coupon = 8% payable semi-annual Coupon = (.08x1000)/2 = \$ every 6 months Olden days, granny clipped her coupons (below) Maturity date = August 1, 20XX (25 years) Maturity = 2 x 25 = 50 periods => 50 coupons below Coupons + principal Bondholder receives an annuity of coupons plus the face value at maturity P 0 = C(PVIF a -i%-n) + 1,000/(1+i) n Four variables: P 0, C, i and n Given 3, the calculator can find the 4 th Realistically you ll always know C and n Given i, find P what s the bond s price? Given P, find i what s the bond s yield or return? 4

5 Given the yield, find the price P 0 = C(PVIF a -i%-n) + 1,000/(1+i) n Recap: n=50 periods, C=\$/period If similar bonds are yielding 11%, compounded semiannually, i=.11/2=.055 P 0 = (PVIF a -5.5%-50) /(1+.055) 50 =>PMT 5.5=>i 50=>n 1000=>FV solve PV= P 0 = \$ < 1000 sells at a discount If you pay \$ for the bond and hold it for 25 years (50 periods) you ll earn 11%/yr, csa Given the price, find the yield P 0 = C(PVIF a -i%-n) + 1,000/(1+i) n Recap: n=50 periods, C=\$/period Let s say you could buy one of these bonds for \$1, , = (PVIF a -i%-50) /(1+i) =>PV =>PMT 50=>n 1000=>FV solve i = 3.5%/period or 7%/yr csa If you pay \$1, for the bond and hold it for 25 years (50 periods) you ll earn 7%/yr, csa Enough yields and prices for now If you pay \$ for the bond and hold it for 25 years (50 periods) you ll earn 11%/yr, csa If you pay \$1, for the bond and hold it for 25 years (50 periods) you ll earn 7%/yr, csa We ll see later what happens if you sell early Since the coupons and \$1000 par are fixed, the more you pay for the bond, the lower will be the yield int rate return 5

6 Corporates Treasuries Types of bonds Bills, notes and bonds Munies General obligations Revenue bonds Corporate bonds Long-term debt or IOU s of a corporation Interest paid is tax-deductible for the firm Gives firm incentive to use debt financing Interest received by investors is taxed as regular income Moody s and Standard & Poor s rate nearly all bonds Paid a fee by the issuing company Increases a bond s marketability Ratings are based on perceived risk Bond ratings Moody s High grade Aaa Aa A Medium grade Baa Ba B Speculative grade B Caa Ca Default C Standard & Poor s High grade AAA AA A Medium grade BBB BB B Speculative grade CCC CC C Default DDD DD D 6

7 Risk vs. yield Higher ratings mean lower probability of default So, lower interest rates or yields Lower ratings mean higher probability of failure So, higher interest rates or yields are necessary to induce investors to buy them Junk Bonds Ba and BB and below aka high-yield bonds nicer name only Still junk Yields on corporate > yields on US Gov ts What you need to know Details are spelled out in indenture Big legal document, no need to read Check out the prospectus if interested Most important things to know: Is it secured or unsecured? What s its coupon rate? How long to maturity? Is it a convertible or a coupe? Is it callable? Collateral or security Mortgage bonds Secured by specific pledged assets of firm If failure, pledged assets sold => proceeds go to bond holders Safest bonds lowest yielding bonds Debentures Unsecured, backed by firm s earning power If failure, general creditors (ahead of stock) Riskiest bonds highest yielding 7

8 Coupon and maturity Coupon = (coupon rate x par value) / 2 Fixed semi-annual interest payment Maturity in periods = maturity in years x 2 Short-term (< 5 years) safer, lower yielding Intermediate-term (5 to 10 years) Long-term (10 to 30 years) riskier, higher yielding Can always sell a bond in bond market prior to maturity Convertible bonds Some bonds contain a convertible feature Gives investor the option of exchanging bond for a specified number of shares of firm s common stock Conversion ratio of, say, 20 shares per bond Conversion price = 1,000/20 = \$50/share If firm does well and its stock price rises above \$50 to, say \$60, investor can swap bond for 20x60=\$1,200 of stock Investors find attractive so lower yields Callable bonds Some bonds contain a call feature Gives firm option of redeeming bonds at specified price prior to maturity if interest rates have dropped Rather than continuing to pay old rate of 12%, firm issues new bonds at 8% and uses proceeds to call old bonds saves 4% Investors lose the 12% and replace with 8% Investors find unattractive so higher yields 8

9 Government bonds Issued by the U. S. Treasury Default-free since government can always print money to pay interest Interest received is exempt from state and local taxes Never callable Purchase directly from gov t, thru banks or in securities mkt using broker, in \$1,000 units Bills, notes and bonds T-Bills Short-term (28, 91 or 182 day maturities) Sold each week on a discount basis Mature at face value no coupon Buy a 6-month T-Bill for \$975, matures for \$1000 ( ) yield = x2 = 5.13% 975 Interest is taxable by IRS Notes and bonds Treasury notes Mature in 2, 5 or 10 years Semi-annual coupons electronically i notes > i bills Treasury bonds Mature in 10 to 30 years Semi-annual coupons electronically Highest yielding 30-year Treasury is the bench-mark 9

10 Secondary market Market for trading Treasury securities is enormous You can buy any maturity Want a 2-week T-Bill? We got that Want 7.5 year note? We got that, too Prices (and therefore, yields) are determined by supply and demand Municipal bonds - munies Issued by state and local governments Two types of munies General obligation bonds Backed by full faith and credit (taxing power) of the issuer Revenue bonds Proceeds fund a specific project Hospital, toll road, power plant, etc. Backed only by revenue generated from project Riskier so higher yields than general obligation bonds What s so special about munies Interest received is exempt from federal income taxes Interest received is exempt from state and local income taxes if investor lives in same state as issuer yield muni < yield corp bonds (deceiving) Say 30% tax-bracket Stated rates i corp =10% and i muni =8% After-tax rates i corp =.10(1-.30)=7% vs i muni =8% 10

11 Bond yields and prices Even if bond is 100% default-free, it s still susceptible to interest rate risk If interest rates rise, bond prices fall Our original AAA-rated debenture at issuance Coupon=8%/yr, maturity=25 yrs, par=\$1,000 Coupon=.08x1000/2=\$/per and n=25x2=50 per Other 25-yr AAA debentures yield 8%/yr=4%/per P 0 = (PVIF a -4%-50) /(1.04) 50 = \$1,000 Normally bonds are issued close to par = \$1,000 What a difference 10 yrs makes Let s pick up the action 10 years later 15 years (30 periods) left to maturity Now 15-yr AAA debentures yield 12%/yr = 6%/per P 10 = (PVIF a -6%-30) /(1.06) 30 =>PMT 6=>i 30=>n 1000=>FV solve PV= P 10 = \$ If you sell now (year 10), take a \$275 capital loss If you don t sell, you ll get \$1,000 in 15 yrs But your money is tied up earning 8% when it could be earning 12% - you need to learn to think this way! Same 10 years, happier scenario Instead of AAA-debenture rate rising from 8% to 12%/yr, assume it drops to 4%/yr or 2%/period P 10 = (PVIF a -2%-30) /(1.02) 30 =>PMT 2=>i 30=>n 1000=>FV solve PV=-1, P 10 = \$1, and you d get a \$448 capital gain Remember our important inverse relationship between yield and price? What rate of return did you make in this happy scenario? 11

12 Your 10-year return You paid \$1,000, received coupons for 10 years (20 periods), sold it for \$1, PV 0 = C(PVIF a -r%-n) + FV/(1+r) n 1,000 = (PVIF a -r%-20) /(1+r) 20-1,000=>PV =>PMT 1,447.93=>FV 20=>n solve for r = 5.31%/period x 2 = 10.62%/year csa Maturity and yield Maturity is key factor affecting bond s yield Long-term bonds are inherently riskier than short-term bonds Lots more can go wrong over the life of 20-year bond than over the life of a 2-year bond or a 2-week bond (T-Bill) For a given i P 20 yr > P 2 yr > P 2 wk Normally i LT > i ST to compensate for higher risk Inducing investors to buy If bond has an unattractive feature, issuer will need to offer an incentive to investor in the form of a higher yield i debenture > i mortgage i long-term > i short-term i callable > i noncallable i nonconvertible > i convertible i CCC > i AAA But is the extra yield worth it? 12

13 Lots of time and effort Investing in stocks and bonds can be financially rewarding But takes a lot of time to research the buy and sell decisions Is there an easier way to get the benefits of investing in stocks and bond? Yes see next module 13

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