Bond Pricing

• A bond is a fixed-rate security that represents a corporation's debt obligation. An investor of a bond becomes a creditor of the company. Bondholders take first priority over preferred and common stockholders in the event that the company becomes insolvent and files for bankruptcy. The par value of a corporate bond is $1,000, quoted as 100. A bond is selling at a discount if it is quoted at 98, $980, and a premium if it is priced at 103, $1,030. Bond interest payments are made semi-annually. Thus, a 10-year bond priced at 100 with a 5 percent coupon pays $25 every six months. At maturity, the bond investor receives his principal of $1,000. A bond that pays no interest is called a zero coupon bond. These bonds sell at a discount and mature at par value. The most common type of zero coupon bonds are Treasury Bills.
  
  

Valuing Debt

• Yield-to-maturity, YTM, is the internal rate of return, IRR, for a bond or fixed-rate security. The YTM measures the annual return of a bond if an investor held the bond to maturity. You will need a financial calculator to figure a bond's YTM. A bond is selling at a discount if the coupon rate is less than the YTM. The bond is selling at a premium if the coupon rate is greater than the YTM. For example, if a10-year, 7 percent coupon bond is selling at $98.56, its YTM is 7.20 percent. Conversely, the YTM for a 10-year, 8 percent coupon bond selling for 102.40 is 7.65 percent.
  
  

Preferred Stock

• Preferred stock is a hybrid security that combines dividend payments of common stock with attributes of a fixed-rate security. Preferred shareholders receive dividends; however, dividends payments remain fixed. A preferred stock is a constant growth stock with a dividend growth rate of zero. Thus, the valuation formula for preferred stocks is Pp = Dp/r. Where:
  
  Pp = preferred stock price,
  
  Dp = preferred dividend, and
  
  r = required rate of return.
  
  For example, a preferred stock dividend is $8 and the required rate of return is 7 percent, the preferred stock price is $114.
  
  

Considerations

• Adding bonds and preferred stocks can enhance your investment portfolio's performance. Government bonds such as Treasuries, municipal and state-issued bonds are a low-risk investment. Furthermore, municipal and state-issued bonds are nontaxable at the federal level. The predictability of preferred dividends and interest payments offsets common share price fluctuations.