Foundations of Financial Management: An Analysis (part 60)

"Wealth consists not in having great possessions, but in having few wants." 

--Epictetus

Investment Banking (Part D)

 by

 Charles Lamson 

Bond Prices, Yields, and Ratings

The financial manager must be sensitive to interest rate changes and price movements in the bond market. The treasurer's interpretation of market conditions will influence the timing of new issues, the coupon rate offered, and the maturity date.

The price of a bond is directly tied to current interest rates. One exception to this rule is when survival becomes a key factor in pricing and valuation. We will look at the more normal case where interest rates are the key factor in determining price.

A bond paying 5.10 percent ($51 a year) will fare quite poorly when the going market rate is 8.10 percent ($81 a year). To maintain a market in the older issue, the price is adjusted downward to reflect current market demands. The longer the life of the issue, the greater the influence of interest rate changes on the price of the bond. The same process will work in reverse if interest rates go down. A 30 year, $1,000 bond issued to yield 8.10 percent would go up to $1,500 if interest rates declined to 5.10 percent (assuming the bond is not callable). A further illustration of interest rate effects on bond prices is presented in Table 3 for a bond paying 12 percent interest. Observe that not only interest rates in the market but also years to maturity have a strong influence on bond prices.

Table 3 Bond price table

Bond Yields

Bond yields are quoted three different ways: coupon rate, current yield, and yield to maturity. We will apply each to a $1,000 par value bond paying $100 per year interest for 10 years. The bond is currently priced at $900.

Coupon Rate (Nominal Yield) Stated interest payment divided by the par value.

Current Yield Stated interest payment divided by the current price of the bond.

Yield to Maturity The yield to maturity is the interest rate that will equate future interest payments and the payment at maturity (principal payment) to the current market price. This represents the concept of the internal rate of return. In the present case, an interest rate of approximately 11.70 percent will equate interest payments of $100 for 10 years and a final payment of $1,000 to the current price of $900. A simple formula may be used to approximate yield to maturity.

Extensive bond tables indicating yield-to-maturity are also available. Calculators and computers may also be used to determine yield to maturity. When financial analysts speak of bond yields, the general assumption is that they're speaking of yield to maturity. This is deemed to be the most significant measure of return.

Bond Ratings

Both the issuing corporation and the investor are concerned about the rating their bond is assigned by the two major bond rating agencies---Moody's Investors Service and Standard & Poor's Corporation. The higher the rating assigned a given issue, the lower the required interest payments are to satisfy potential investors. This is because highly rated bonds carry lower risk. A major Industrial Corporation may be able to issue a 30-year bond at 6.5 to 7 percent yield to maturity because it is rated Aaa, whereas a smaller, regional firm may only qualify for a B rating and be forced to pay 9 or 10 percent.

As an example of bond rating systems, Moody's Investors Service provides the following 9 categories of ranking:

Aaa Aa A Baa Ba B Caa Ca C

The first two categories of bond ratings represent the highest quality; the next 2, medium to high quality; and so on. Beginning a 1982, Moody's begin applying numerical modifiers to categories. Aa through B: 1 is the highest in a category, 2 is the mid-range, and 3 is the lowest. Thus, a rating of Aa2 means the bond is in the mid-range of Aa. Standard & Poor's has a similar letter system with + and - modifiers.

Bonds receive ratings based on the corporation's ability to make interest payments, its consistency of performance, its size, its debt-equity ratio, its working capital position, and a number of other factors. The yield spread between higher and lower rated bonds changes with the economy. If investors are pessimistic about economic events, they will accept as much as 3 percent less return to go into securities of very high-quality, whereas in more normal times the spread may be only 1.5 percent.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 471-476*

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