Brigham and Houston Essay
Brigham and Houston
1. Whenever we are interested in buying a bond from the bond market, the bond’s issuer promises to pay back the principal (or par value) when the bond matures (Brigham and Houston, 2001). During this time, the issuer is obliged to pay interest in order to compensate the use of money. The interest payment is made on coupon rate which is fixed. There is an inverse relationship between the coupon rate and the bond prices, when: • Interest rate increase, leads to rise in income, whereas the price of the bond declines.
• Interest rate decrease, leads to decline in income, whereas the price of the bond rises. Also we need to consider that the coupon rate is inversely related to duration because higher coupon rates lead to quicker recovery of the bond’s value, resulting in a shorter duration, relative to lower coupon rates. If coupon rate is greater than the market rate then it is favourable for issuer and if coupon rate is less than the market rate then it is favourable for purchaser (Brigham and Houston, 2001).
The reason behind the variations in the coupon rates of various bonds is the market interest rate; company’s performance, time length, and credit worthiness of the issuer. So, all these factors have an implication on the bond yields. 2. Ratings of these bonds are determined on the basis of both qualitative and quantitative factors some of which are listed below: • If a company uses conservative accounting policies, its reported earnings will be higher than if it uses less conservative procedures. • Various ratios including the debt ratio and the Times Interest Earned (TIE) ratio also have some implications on these bond ratings.
• If company explores any new sites containing oil, gas, coal fields etc. • Increase in the company’s sales & net profit increase both domestically and internationally also uplift the bond ratings and it showed that debt holder show the confidence on the company’s policy. Bond ratings might take a downward leap when: • There is a signal of bankruptcy, internal mismanagement and financial distress in the firm (Helfert, 2001). • When the company does not abide by the law, i. e. it breaches the laws, this may be related to environment, etc.
• When the product life cycle is going downwards and company can’t add more products in their product line. • Negative bond covenants also hits the bond ratings of the company. • Labour unrest or strikes may cause instability in the bonds ratings. • Economic recession in the country. 3. We know that whenever the interest rate rises, bond prices tend to fall, and when rates fall, bond prices tend to rise (Helfert, 2001). This primarily occurs due to the economic condition of the country and also because of the market sentiments.
If the price of the bond goes down it is less attractive (pays less interest) in comparison with current offerings and when the price of the bond goes up it is more attractive (pays more interest) in comparison with current offerings. This may also be described as when the coupon rate is greater than market rate then it is favourable for issuer and if coupon rate is lesser than market rate then it is favourable for the purchaser. Some bonds are sold below par value, which means (at discount) or greater than par value, which means (at premium).
This mainly occurs due to the risk perceived for the debt of that particular organization. Market interest rate fluctuations usually effect the performance of the bonds in the secondary markets. Federal bank monetary and fiscal policy, inflation rate, recession in the economy, etc are the factors that may force organizations to sell the bonds at discount or at premium. One must also consider that sale of bonds on discount or at premium also has some impact on the yield and also the maturity of the bond, the shorter a bond’s maturity, the less its duration.
Bonds with higher yields also have lower durations. Also the company’s performance reflects in bond valuations, i. e. its bond ratings, bond covenants and credit worthiness etc (Helfert, 2001). 4. The yield to maturity (YTM) is a reflection of the return on investment, that is earned at the current price, incase the bond is held by the issuer to its date of maturity and redeemed at par value. In other words, YTM is the discount rate that equates the present value of future inflows from the bond equal to its present price.