CF-CS2

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit II Upon completion of this unit, students should be able to:

6. Apply the time value of money (TVM) to capital budget decision-making. 6.1 Explain how the TVM works. 6.2 Explain different types of risk that bond investors and issuers face. 6.3 Discuss how a bond’s terms and collateral can be changed to affect its interest rate.

Course/Unit Learning Outcomes

Learning Activity

6.1

Unit Lesson Chapter 4, pp. 139-183 Chapter 5, pp. 195-218 Video Segment: “Time Value of Money” Unit II Case Study

6.2

Unit Lesson Chapter 4, pp. 139-183 Chapter 5, pp. 195-218 Unit II Case Study

6.3

Unit Lesson Chapter 4, pp. 139-183 Chapter 5, pp. 195-218 Unit II Case Study

Required Unit Resources Chapter 4: Time Value of Money, pp. 139–183 Chapter 5: Bonds, Bond Valuation, and Interest Rates, pp. 195–218 In order to access the following resource, click the link below. Thomson Learning (Producer). (1995). Time value of money (Video segment 4 of 5). In Fundamental

concepts in financial management. https://libraryresources.columbiasouthern.edu/login?auth=CAS&url=http://fod.infobase.com/PortalPla ylists.aspx?wID=273866&xtid=5845&loid=505923

The transcript for this video can be found by clicking the “Transcript” tab to the right of the video in the Films on Demand database.

Unit Lesson

Fixed-Income Securities Fixed-income securities refer to a type of investment that provides a fixed periodic payment return, in terms of a fixed interest rate with the eventual return of the principal at the time of maturity. These are normally issued by the government or companies to borrow money to finance their operations, while investors use fixed- income securities as a way to invest their money to earn interest with the expectation that they will get the full amount of their investment in a predetermined date in the future (i.e., the maturity). In order to fully

UNIT II STUDY GUIDE

Fixed Income Securities

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understand fixed-income securities, we will discuss the different types of bonds, their benefits and risks, and the risk or return assessment.

Types of Fixed-Income Securities When people talk about fixed-income securities, they are primarily referring to bonds that are fixed-income investments where an investor loans money to an entity (usually the government or corporations) for a predetermined period of time at a variable or fixed interest rate. We are only going to focus on fixed-income securities, which are those that provide periodic income payments at an interest rate known in advance by the holder. There are generally two types of bonds: government and corporate. Government bonds are those fixed- income securities that are issued by the government. Generally speaking, developed countries, such as the United States and European nations, are considered risk-free investments because people are most likely to get their principal investment at the date of maturity. However, in less stable and less developed countries, government bonds are generally considered riskier and less safe, often resulting in a higher yield. For instance, Fan, Titman, and Twite (2012) found that investors’ decisions to invest in government bonds are influenced by perceptions of corruption, legal structures, and explicit policies that protect investors. The next type of bond, corporate bonds, are issued by corporations, which make up a large portion of the overall bond market. By and large, corporate bonds provide a higher yield than government bonds because of a higher risk of defaulting. To understand the differences in risk between the two, think about the following scenario: A company is much more likely to go bankrupt and default as compared to the U.S. government. It is safer to assume that the government will not run out of money and default. Not all corporations are equal; however, some are riskier than others, which then results in a higher yield. For instance, companies with top-flight credit quality are less risky. You are more likely to get your money back at the maturity date of the bond, which means that they tend to offer a lower interest rate. Other types of fixed-income securities include treasury bills, treasury notes, certificates of deposit (CD), and preferred stock. All of these are fixed-income securities because the interest/dividend/earnings are fixed and predetermined. To illustrate how people can choose between government or corporate bonds based on specific requests, needs, or preferences, the following case is presented. Lisa is one of those people who does not want to constantly monitor the financial market and simply wants to invest her money in the safest and most convenient way possible instead of a regular savings account in a bank. She wants to earn a little bit of interest with the utmost certainty that her money will be safe. If you are going to advise Lisa on the choice of a fixed-income security using either corporate or government bonds, what would you tell her? Answer: She should invest her money in a government bond. It is almost certain that she will get her money back because the U.S. government is almost certainly not going to default, and she can also earn a little bit of interest. The interest may not be as high as corporate bonds, but she still earns money by investing in government bonds. This fits her preference for a relatively low risk investment while earning money.

Benefits of Fixed-Income Securities There are many benefits for investors in procuring fixed-income securities such as bonds. First, fixed-income securities are a good diversifier (i.e., the financial portfolio is varied and not just invested in one place). Second, fixed-income securities are less volatile than equities, which means that fixed-income securities tend to be less risky for investors. Third, fixed-income securities provide stable and predictable income because the terms (e.g., the interest rate) are predetermined from the start until the maturity. As an example of somebody benefiting from investing through fixed interest bonds, here is a scenario: Michelle is starting to feel that her money in her savings account is not earning enough and that she is wasting an opportunity to earn more. She wants to explore other options that could increase her earnings. After getting some advice from a financial advisor, she invested half of her savings account money in a corporate bond with a maturity length of 5 years. Through those 5 years, the interest that she had been receiving from the bond was almost 10 times more than what she had been earning from her savings

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account. Because she was so happy with the results at the time of the maturity of her bond investment, she decided to invest in another corporate bond for 5 more years.

Risks of Fixed-Income Securities There are associated risks with choosing fixed-income securities. The riskiest aspects of fixed-income securities are tied to the interest rate, credit risk, and inflation risk. For example, fixed interest bonds can be risky if the prevailing interest rate goes up; the investor cannot amend the fixed interest rate during the entire term. Debtor defaulting is another risk, particularly for corporate bonds that have low credit quality ratings. Finally, inflation is a risk because the actual value of investment can be lower during the maturity when massive inflation occurs during the time period of the bond. Here is a scenario to illustrate how fixed-income securities can be risky for an investor: Henry invested $100,000 in a corporate bond with a maturity of 10 years. When he invested the money, the interest rate was 2%, which will be the same interest rate for the entire 10 years until maturity. Since the economy has been booming for the last several years, the prevailing interest rate has gone up to 3%. Being that Henry was tied to a fixed interest rate of 2% for the entire 10 years, he could not change the terms of the bond. In the end, he lost the opportunity to earn more because he was stuck with the lower interest rate.

Risk/Return Assessment Audrey and Shirley were debating whether to invest their money in a bond or to just save their money as cash. Audrey is more of a risk-taker, whereas Shirley is more of a risk-averse person who prefers to see and hold her money to feel secure and safe. Audrey decides to invest in a corporate bond because she wants to earn a higher interest rate. She has the full expectation that her savings will be returned to her in the full amount in 5 years. However, Shirley decides to just keep her money in a traditional savings account so that she can get her money anytime she wants. Both Audrey and Shirley made decisions about risk versus return and their own personal situations. A yield curve provides information about how bond investors see the future and help to guide borrowers on the direction of interest rates. A yield curve links the total return expected from bonds of a similar type over different maturities. From the perspective of investors, the yield curve can also reveal how future interest rates are being viewed. In certain situations, the yield curve can be an early indicator of impending trouble. The normal yield curve is somewhat sloped upward with higher expected return as the length of the maturity increases (i.e., 10 years > 5 years). This is primarily due to the risk associated with time. The assumption in this yield curve is that there will be economic expansion, which means that longer maturity bonds would be disadvantageous for investors locked in an interest rate that is expected to climb as the years go on. As a result, shorter-term bonds tend to increase during times of anticipated economic expansion.

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The inverted yield curve is somewhat sloped downward with lower expected return as the length of the maturity increases (i.e., 10 years < 5 years). The assumption in this yield curve is that there will be an economic recession, which means that longer maturity bonds would be advantageous for investors because they would receive a fixed interest rate despite the anticipated decrease in the interest rate. As a result, longer-term bonds tend to increase during times of anticipated economic recession.

To illustrate how the yield curve can be helpful for the decision-making of bond investors, take a look at the scenario below. Media reports have widely claimed that an economic recession is about to occur. As a bond investor, Faye wondered what would be the best thing that she could do to invest her money using fixed-income securities. If you are a financial adviser and you are using the yield curve as a guide, what would you say to her? Answer: If fixed-income securities are her choice of investment, she should be advised that the optimal thing for her to do is lock in the current interest rate by investing in long-term maturity bonds. This way, she would be able to benefit from a favorable interest rate that is expected to go down as the economic recession progresses. If Faye was able to secure an interest rate of 5% with a maturity of 10 years, regardless of whether the interest rate decreases to 2% 5 years from now, she would still be receiving the fixed rate of 5%.

Conclusion In this unit, you learned about the various fixed-income securities along with some of their risks and benefits. Fixed-income securities are debt instruments that obligate the issuing party and the lender to raise and repay funds according to the term of their contract. These debt instruments could be bonds, certificates, mortgages, a building lease, or other debentures. Fixed-income securities allow an investor to receive a return on his or her investment for a specific, fixed period of time while waiting to collect on the principal when the security

Adapted from the "Daily Treasury Yield Curve Rates" by the U.S. Department of the Treasury, 2020

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reaches maturity. Fixed securities are a part of an investor’s diversified portfolio and generally provide low risk with steady return.

References Fan, J. P., Titman, S., & Twite, G. (2012). An international comparison of capital structure and debt maturity

choices. Journal of Financial and Quantitative Analysis, 47(1), 23–56. doi:10.1017/S0022109011000597

U.S. Department of the Treasury. (2020). Daily treasury yield curve rates. https://www.treasury.gov/resource-

center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield