FN3003__

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School

Walden University *

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3001

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Finance

Date

Jan 9, 2024

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FN3003 Assessment Template Part 3: Third Friday Questions Price and Yield-to-Maturity The relationship between bond prices and interest rates or yield-to-maturity (YTM) is inverse, meaning that when interest rates rise, bond prices tend to fall, and when interest rates fall, bond prices tend to rise. This is because when interest rates rise, investors are generally able to get a higher return on their money by purchasing a new bond that pays higher rates. As a result, the demand for older bonds that pay lower rates of interest decreases, causing their prices to fall. Conversely, when interest rates fall, the demand for older bonds that pay higher rates of interest increases, causing their prices to rise. (Course hero, Bond Risk, n.d) Additionally, the relationship between bond prices and interest rates is not always perfectly inverse, and other factors such as credit risk, inflation expectations, and liquidity can also affect bond prices. Long- and Short-Term Bonds The main reason why long-term bonds are subject to greater risk is because of these are more sensitive to interest rates change in the market. When interest rates rise, bond prices fall and vice-versa. When interest rates rise it negatively affects the bond market price. (Chris Gallant, 2005). As a result, older bonds usually have less value and traders will try to sell these. Additionally, long-term bonds have a greater probability that interest rates will change. Long- term bonds also have greater duration than short-term bonds. Coupon payments left until maturity will have investors receiving underpaid coupons. Depending on how many coupon payments left, this may cause a greater drop in the bond price. Considerations for Issuing Bonds When a company is considering issuing a bond, they can decide to include a call provision. A call provision allows the issuer to redeem the bond before the bond’s maturity date, furthermore, it gives the issuer the right to buy back the bond at a predetermined price at a certain time. (Key Characteristics of Bonds, n.d.). Call provisions are usually done when interest rates drop. There are three types of callable bonds. 1. Bermudan callable, which has many call dates. 2. European callable, which only has one call date. 3. American callable, can be called anytime before the maturity date. The cost to of a call provision is the cost of the straight bond minus the Price of call option. Meaning that a bond with call option is always lower than the price of a straight bond, this is since a call option adds value to an issuer. Bonds that are puttable means that the holder has the right, but not the obligation, to demand early repayment of the principal. Therefore, it is important to note that not all bonds have a fixed maturity date. Callable bonds can be called back at anytime before the maturity date. The bond buyer or investor needs to inquire before buying any fixed-income security. Page 1 of 4

Part 4: Fourth Friday Questions Coupon Rate The company that issues the bond decides on the coupon rate based on current market history, which is the interest rate that the bond will pay to its holders. There are several factors that a company may consider when determining the appropriate coupon rate to set for a bond. One factor that a company may consider is the current market interest rates. If market interest rates are high, the company may need to offer a higher coupon rate to attract investors. On the other hand, if market interest rates are low, the company may be able to offer a lower coupon rate and still attract investors. Another factor is the company’s credit rating. Weaker credit rating means the company must offer higher coupon rates than a strong credit worthiness company. The bond credit rating assesses the credit worthiness of corporations, Moody’s, Standard & Poor’s, and Fitch Ratings are the credit agencies that assign letter designation such as AAA, B, CC. these letters represent the quality of the bond. (Course hero, Bond Risk, n.d.). Financial needs are another factor that may be used to determine a coupon rate. If it needs to raise cash, it will offer higher rates to attract investors. The coupon rate expressed as a percentage of the face value is the interest rate that is paid to the bond holder. The required rate of return, also known as the yield to maturity, is the rate of return that investors expect to receive on a bond. Par Value There are a few reasons why some bonds sell at a premium over their par value or at a discount. If Interest rates rise, the bond would be sold at a discount. If the interest rise fall, the bond will sell at a premium over par value. Par value refers to the amount the bond holder will get back once the bond matures. Bonds can be sold at par, premium or discount. (Key Characteristics of Bonds, n.d.). The coupon rate is the annual interest rate that a bond pays to its holder, while the yield to maturity (YTM) is the total return anticipated on a bond purchased today at market price and held until maturity, and that all coupon and principal payments are made on schedule. (Course hero, Bond Risk, n.d.). For a premium bond, the coupon rate is typically lower than the YTM. This is because the bond is being sold for a price above its face value, so the additional return that the investor receives comes from the capital appreciation of the bond. Bonds selling for a discount are said to be selling below par. Bonds selling at par value means it is selling at its face value or the price it was first issued at. Current Yield and YTM When a bond's yield to maturity (YTM) is greater than its current yield, the bond is selling at a discount, which is less than par value. The bond is selling below the face value. On the other hand, a premium bond is when YTM is less than current yield or above the par value. The bond is trading at a price above the face value. (Key Characteristics of Bonds, n.d.). If YTM equals current yield, the bond is selling at par value. This is because the bond is being sold for its face value, so the investor's total return will be equal to the coupon payments received. The bond is worth the amount equivalent to the original issue value. Page 2 of 4

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References Course hero . (n.d.). Course Hero | Make every study hour count. https://www.coursehero.com/study- guides/boundless-finance/rules-and-rights-of-common-and-preferred-stock/ Caroline Banton. (2019, August 29). Financial terms dictionary . Investopedia. https://www.investopedia.com/terms/ Course hero: Stock Valuation . (n.d.). Course Hero | Make every study hour count. https://www.coursehero.com/study-guides/boundless-finance/stock-valuation/ Claire Boyte-White. (2022, January 29). 4 Reasons a Company Might Suspend Its Dividend . https://www.investopedia.com/articles/investing/101215/4-reasons-company-might- suspend-its-dividend Course hero, Bond Risk. (n.d.). Course Hero. https://www.coursehero.com/study-guides/boundless- finance/bond-risk/ Chris Gallant. (2005, September 22). Interest rate risk between long-term and short-term bonds . Investopedia. https://www.investopedia.com/ask/answers/05/ltbondrisk Key Characteristics of Bonds . (n.d.). Course Hero. https://www.coursehero.com/study-guides/boundless- finance/key-characteristics-of-bonds/ Page 4 of 4