Study Unit 6: B.2. Debt Financing (Bonds)
Bonds are a means of financing in which a company borrows money by selling debt securities
(bonds) to
investors. A bond issue represents a loan by the bondholders (investors) to the issuing company. By
selling
the bond, the company is making a promise to pay the investors a certain amount of interest every
period
until the bond matures. On the maturity date, the company promises to pay the face amount of the
bond
to the investors. The interest that will be paid each period, the face (or maturity) value and the
maturity
date are all printed on the face of the debt certificate, the financial instrument that evidences the
debt.
Bonds are used for long-term financing, and they generally are issued with maturities of ten years or
longer.
Investors purchase bonds because the bonds pay a specified amount of interest to the purchaser,
and
additionally, the face amount of the bond will be repaid at the bond’s maturity in the future.
Interest: The Cost of Borrowing, the Return for Investing
Interest is the cost of borrowing paid by a borrower to a lender for the use of the lender’s funds.
Interest
rates are always quoted as annual rates. The rate of interest charged by a lender (or required by a
buyer
of a bond) takes into account the investor’s required rate of return and the investor’s assessment of
the
risk of default by the borrower (the company issuing the bonds). If the investor assesses the issuing
company as being higher risk than average, then they will require a higher return to compensate them
for that
risk.
This risk premium for the investor will be added to the risk-free rate, which is the theoretical rate
that
represents the time value of money when it is invested in a perfectly safe investment.
There is no actual “risk-free rate” that is quoted on money markets, like the prime rate or the fed
funds
rate. The best proxy for a risk-free rate is the short- to intermediate-term U.S. Treasury securities
rate,
because the likelihood of the U.S. government’s defaulting is extremely low.
The rate of interest that the investor will require is also impacted by the assessed liquidity of the
bonds.
The more liquid they are, the less risk there is to the investor that they will not be able to sell the
bonds if
they want to. Less liquid debt will need to pay a higher rate of interest to compensate the investor
for the
higher risk associated with the lower level of liquidity.
Additionally, if the bonds are tax-free bonds, that will also impact the required return for the
investor. If
the investor will not need to pay federal income tax on the interest received for the bond, the
investor may
accept a lower rate of interest paid by the issuer of the bond. The choice of whether the interest on a
particular bond issue is taxable or tax-exempt is usually not for the issuer to make. The interest on
bonds
issued by private-sector corporations is always taxable. Only state and local governments may issue
federally tax-exempt bonds.
The Bond Instrument
Bonds are issued in $1,000 increments. If a company issues $10,000,000 in bonds, that means the
company
has issued 10,000 bonds, each with a face (or par) value of $1,000. Investors can purchase the bonds
individually, so investors can purchase bonds in $1,000 (face value) increments. If an investor wants
to
purchase $10,000 face value of bonds, for example, the investor will purchase ten bonds.
Bonds are issued by a company that needs financing, and the net cash received from their sale goes
to the
issuing company. The investor who purchases an original issue bond or bonds is making a loan to the
company that issued the bonds.
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
137
Study Unit 6: B.2. Debt Financing (Bonds)
How Bonds Work
CMA Part 2
A bond represents a contract between the issuer (the borrower) and the bondholders (the lenders).
The
legal contract is called the indenture and it contains all the terms and conditions of that bond
issuance,
including features such as the maturity date, the interest rate, and the timing of interest payments.
These
terms and conditions are discussed later in this topic.
On the face of the bond itself is a set of information. This information includes the:
• Bond’s par value, which is its stated amount (the face value) of the bond. The par value is used
to calculate how much interest is paid each time interest is paid, because the cash interest is paid
on the bond’s par value. It is also the principal amount that is repaid to bondholders on the bond’s
maturity date.
• Stated interest rate, or coupon rate, which is the interest rate printed on the bond. It is used
along with the par value to calculate the amount of interest that will be paid each time interest is
due. Interest on bonds is usually paid semi-annually, so if the coupon rate on $10,000 in par value
bonds is 5%, every six months the bonds will pay $250 in interest.
• Issue date, which is the date on which the bonds were first issued by the company.
• Maturity date, which is the date on which the issuer will “retire” the bond by paying the face
amount of the bond and the final amount of interest due to the bondholders.
• Information about how often and on what dates the bond pays interest.
Here is a simplified sample of bond showing the information that is on the bond.
BOND
Par (Face) Value – $1,000 Interest Rate – 8% per annum
Issue Date – January 1, 20X0
Maturity Date – December 31, 20X9
Interest – paid semi-annually, June 30 and December 31
All the amounts the issuer will pay to the buyers of the bond over the life of the bond can be
determined
from the information given on the bond. The issuer of the bond will pay two cash flows to the
buyers:
1) Repayment of the par value of the bond, and
2) Regular payments of interest.
1) Par (Face) Value
On the maturity date of the bond, the issuer will pay the face amount of the bond to the
bondholders. Bonds
are issued in face amounts of $1,000. Thus, on December 31, 20X9 (the maturity date), the holders
of each
$1,000 par value bond will receive the regular semi-annual $40 interest payment for the period from
July
1 through December 31 of that year and the $1,000 repayment of the face value of the bond.
2) Interest
Bonds pay interest at their stated interest rate (the stated rate may also be called the nominal rate or
the
coupon rate) based on their par value. For most bonds, the stated interest rate is fixed for the life of
the
bond. The amount of interest to be paid annually by a bond is calculated by multiplying the par (face)
value
of the bond by its stated annual rate of interest. If the bond pays interest semi-annually, as most
bonds
do, the amount of each interest payment is the annual interest amount divided by 2, since interest is
paid
twice a year.
In the bond example provided above, the issuer of the bond will pay $40 in interest for each $1,000
in par
value to the holders of the bonds ($1,000 × 0.08 ÷ 2) every June 30 and December 31 for ten years,
138
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
Section B
Study Unit 6: B.2. Debt Financing (Bonds)
beginning June 30, 20X0, and continuing through December 31, 20X9. The cash interest that
investors
receive over the life of the bond is the same each period because it is calculated from the
information on
the bond itself, which does not change.
From the information on the bond itself, a potential investor can determine all the cash flows that
they will
receive as the owner of the bond. In the example above, the buyer of the bond will receive $40 twice
a
year for 10 years and then will receive $1,000 when the bond matures. Over the life of the bond, the
investor will receive a total of $1,800 from the issuer of the bond, $800 in interest and $1,000 as
return of
principal.
The Sale Price of the Bond
Bonds are valued at and sold at the present value of the future cash payments the company will
make,
including the interest payments and the final principal repayment. The present value is calculated by
using
as the discount rate the market rate of interest on the sale date for bonds of similar terms and risk.
Note: Present value is a time value of money topic. An explanation of time value of money concepts
is
available at https://www.hockinternational.com/download/Time_Value_of_Money.pdf.
Because market rates of interest are always changing, it is possible, but unlikely, that a bond will be
issued
at a market rate of interest that is equal to the stated rate on the bond. If it does happen that the
market
rate and the stated rate are the same, the present value of all the future payments and the selling
price of
the bond will be equal to the face value of the bond. In the example above, if the market rate of
interest
for bonds of similar risk and terms were 8%, the same as the stated rate, the selling price of the
example
bond would be $1,000.
However, usually bonds are issued when the market rate is not equal to the stated rate. When that
happens,
the bond’s selling price will be above or below the face value of the bond. By using the market rate
of
interest to calculate the present value of the future cash flows as the bond’s selling price, the
company is
assuring that an investor who purchases the bond and holds it until its maturity will receive a return
over
the life of the bond equal to the market rate that was current for investments with similar
characteristics
when the investor purchased the bond.
The connection between a bond’s selling price and its face value will be discussed in more detail, but
for
now, remember that the cash flows that the investor will receive are fixed from the moment the
bond is
issued. In the example of a bond with an 8% interest rate, the issuer of the bond will pay 8% of its par
value every year in interest. If investors require a 10% return on a bond paying 8%, it is not possible
for
the issuer to pay $100 of interest each year on each $1,000 bond because the bond’s contractual
interest
rate is 8% of its par value. But, if the investors were to pay less than $1,000 for each bond, the
effective
interest rate would be higher than 8%. A selling price of the bond that is less than face value will
result in
an effective interest rate that is higher than the stated rate. Conversely, a selling price that is higher
than
the face value of the bond will result in an effective interest rate that is lower than the stated rate of
the
bond.
When the market rate is …
than the stated rate
Higher
Lower
The bond will sell at a
Discount
Premium
And the price will be ….
than the face value
Lower
Higher
In addition to the discount or premium on the sale of the bonds, there will also be some issuance
costs that
must be paid by the seller of the bonds. Debt issuance costs include underwriting fees to the
investment
bank (or group of investment banks), accounting fees, legal fees, and costs to promote the offering to
investors.
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
139
Study Unit 6: B.2. Debt Financing (Bonds)
CMA Part 2
Thus, the proceeds an issuing company receives from a bond issue will be the selling price reduced
by the
debt issuance costs.
The Discount or Premium on the Bond
Whenever the current market rate of interest is different from the rate that is stated on the bond
itself, the
selling price of the bond will be different from the face amount of the bond. This difference between
the
selling price of the bond and the face amount of the bond is called a discount or a premium.
If the selling price is less than the face value, the bond is selling at a discount. The difference
between the
face value of the bond and its selling price is the discount. A bond sells at a discount when the
market rate
of interest is higher than the interest rate that is stated on the bond. If the bond were sold at its face
value,
nobody would buy the bond because they can receive a higher return from another bond in the
marketplace.
By reducing the selling price of the bond (but not the amount of interest the bond pays each period)
the
effective interest rate of the bond becomes equal to the market rate of interest for similar investments for investors who buy the bond and hold it until its maturity.
If the market rate of interest is lower than the stated rate of interest on the bond, the bond will be
sold at
a premium, a price above its face value. The difference between the selling price of the bond and the
face
value of the bond is the amount of the premium. This higher sales price of the bond (but with the
same
interest payment made each period) makes the effective interest rate paid by the bond equal to the
market
rate of interest for similar investments for investors who buy the bond and hold it until its maturity.
Example: Boulder Corporation issues bonds with a total face value of $1,000,000 on January 2, 20X0.
The stated interest rate of the bonds is 4% per annum. Interest is payable on January 1 and July 1 of
each year. The bonds’ maturity date is January 1, 20X5. The market rate of interest on January 1,
20X0
is 6% per annum, higher than the stated rate of the bonds.
Boulder will be able to sell the bonds and investors will be willing to buy the bonds at a price that will
give the investors a rate of return of 6% per annum over the life of the bonds if the investors hold the
bonds to maturity. The market value and the selling price of the bonds is the present value of all the
future cash flows to be received from the bonds, discounted at the market rate of interest, which on
the bonds’ selling date is 6%.
To determine the issuance price, first calculate the present value of the principal repayment to be received by the investors on the maturity date by using the Present Value of $1 table, available for
download at https://www.hockinternational.com/download/PVFV_Tables.xlsx. The factor to use is
0.744,
the factor for 3% (1/2 of 6%) for 10 periods, because interest will be paid 10 times during the 5 years
the bond is outstanding. It is not correct to simply discount the principal at 6% for 5 years, because
the
amount of the discount will be amortized with each interest payment, so the net book value of the
bond
on the issuer’s books will change each time interest is paid. For that reason, the principal repayment
must be discounted for 10 periods at one-half of the annual market rate of return.
The issuance price is calculated as below.
Present value of the principal:
$1,000,000 × 0.744 =
$744,000
Next, calculate the present value of the interest payments to be received during the period from
issuance
to maturity by using the present value of an ordinary annuity table. Note again that it is necessary to
use 10 periods and a discount rate of 3%. The factor is 8.530.
Cash interest to be paid to the investors each semi-annual interest period: $1,000,000 × 0.04 ÷ 2 =
$20,000. Therefore, the amount of the annuity is $20,000.
Present value of the interest payments: $20,000 × 8.53 =
170,600
Total present value of principal & interest
(continued)
$914,600
140
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
Section B
Study Unit 6: B.2. Debt Financing (Bonds)
Example (continued):
The market value of the bonds and the amount they can be sold for on January 2, 20X0 is $914,600.
The bond is selling at a discount of $85,400 ($1,000,000 − $914,600). For each $1,000 bond an
investor
buys, the investor will pay $914.60. The bond is selling at a discount because the interest rate it pays
(4%) is lower than the market rate of interest (6%).
Even though Boulder receives only $914.60 for selling each bond, Boulder will need to repay the full
$1,000 face value at the bond’s maturity date. Therefore, Boulder will amortize the discount as an
adjustment to its interest expense over the life of the bond. The amortization schedule for the bond is
presented in Appendix A to this volume.
Someone who purchases a $1,000 bond at $914.60 and holds it until its maturity date will receive a
6%
annual return over the life of the bond. The purchaser will receive interest payments of $20 semiannually
($1,000 × 0.04 ÷ 2) and $1,000 on the bond’s maturity date.
Note: The price of a bond is quoted on markets as its price per $100 of par value. Bonds are priced
and
quoted in two decimal places. Thus, the preceding example of the $1,000 bond priced at $914.60
would
be quoted at 91.46, meaning its price is $91.46 per $100 of par value. If a $1,000 par value bond is
quoted at 103.25, it means the bond’s price is $103.25 per $100 of par value, and the price is
$1,032.50
for a $1,000 par value bond.
Special Features that a Bond MAY Have
Bonds may also be sold with special features. Whether a special feature will increase or decrease the
required return for the investors will depend on whether the feature is beneficial or harmful to the
investors.
If the provision is harmful to the investors, they will require a higher rate of return. If the provision is
beneficial to the investors, they may accept a lower rate of return. The most common provisions for
bonds
are:
• Restrictive covenants limit the actions the company may take that could be detrimental to the
bondholders. The covenants may be related to various ratios that must be maintained, minimum
working capital amounts, or maximum dividend payments that may be made. Covenants are a
means for the bondholders to protect their investment by increasing the likelihood that they will
receive their scheduled interest payments and the repayment of their principal on the maturity
date. Because covenants make the bond issue more attractive to investors, they may enable the
bond issuer to borrow the funds at a slightly lower interest rate.
Examples of common restrictive covenants include:
• A sinking fund may be required. A sinking fund is a separate fund into which the company
must transfer a certain amount of money each year. The money that is accumulated in the
fund will be used to retire the bonds as they come due.
• A mortgage bond’s covenants may include a negative pledge clause stating that the issuer
will not pledge any of its assets as security for any other debt if doing so would give the
holders of the mortgage bond less security.
• Redemption provisions:
o A call provision gives the issuer the option to retire the bond (that is, to pay off the loan)
prior to its maturity at a given price. A call provision in a bond would be exercised by the issuer
if market interest rates were to fall, because the issuer would be able to issue a new bond at
a lower interest rate and use the proceeds to pay off the current bond, thereby benefiting from
the lower market interest rate. A call provision would be advantageous for the issuer but not
advantageous for the investors in the bond, because while the issuer could refinance its debt
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
141
Study Unit 6: B.2. Debt Financing (Bonds)
CMA Part 2
at a lower interest rate, the investors would not be able to reinvest their proceeds at the same
high rate as the called bond had been paying. Therefore, investors would require extra com-
pensation for accepting the risk of investing in a bond that could be called if interest rates were
to decrease.
o A put provision makes the bonds “putable.” When a bond is putable, the investor, or purchaser of the bond, has the option to redeem the bond. If certain events occur, or if the issuing
company violates any bond covenants, an investor can require the issuer to pay off the debt
by repurchasing the bonds from him. The price the issuer must pay to repurchase the bonds
will either be specifically established in the indenture or can be calculated in accordance with
the terms in the indenture. A put provision is beneficial to the investor, so it may enable the
issuer to issue the bonds at a lower coupon rate.
• Conversion provisions: A convertibility clause allows an investor to convert the bond into the
issuing company’s common stock at a specified conversion rate. With a convertibility clause, if the
market price of the bond were to decline due to rising interest rates or some other reason, investors
would have another option in addition to holding the bond or selling it at the market price. A
convertibility clause is beneficial to the investor and would therefore decrease the required yield.
A convertible bond can be advantageous to the issuer, too, because if it is converted by the bondholder into common stock, the financing becomes equity financing instead of debt financing. The
issuer of the bond is no longer contractually required to pay interest during the original term of the
bond or to repay the bond’s principal at what would have been the maturity date.
• Options:
o An embedded sinking fund option allows the issuer to retire a part of an issue annually up to a
specified limit.
o Options that may be granted to the investor include warrants that may be attached to the
bond, giving the bondholder the right to buy a certain number of shares of the issuer’s common
stock at a set price.
Types of Bonds
In addition to the different characteristics that bonds may have, bonds come in many different forms.
Candidates do not need to memorize this list word for word but should be familiar with the different
forms
that bonds may take. These types of bonds may be combined with the different characteristics of
bonds.
For example, a debenture bond may be callable, or a convertible bond may be putable.
Convertible bonds (beneficial to the holder of the bond) can be converted by the bondholder into a
stated
number of shares of the issuer’s common stock at any time during the bond’s life. A convertible
clause is a
very advantageous provision for the bondholder because if the price of the company’s common
stock increases significantly during the bond’s life, the bondholder can convert at the conversion price and
receive
stock that may have a greater potential for appreciation.
A convertible bond can be advantageous to the issuer too, because if it is converted by the
bondholder into
common stock, the financing becomes equity financing instead of debt financing. The issuer of the
bond is
no longer contractually required to pay interest during the original term of the bond or to repay the
bond’s
principal at what would have been the maturity date.
Debenture bonds (greater risk for the holder of the bond) are unsecured, meaning they are not
backed
by any specific asset as collateral. The only backing to the bond is the creditworthiness of the
company
itself. Because of the lack of specific assets pledged as collateral, only a company that has a very high
credit
rating and enjoys a large amount of public confidence can issue debenture bonds.
Mortgage bonds (less risky for the holder of the bond) have a specific asset or assets pledged as
collateral
for the debt.
142
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
Section B
Study Unit 6: B.2. Debt Financing (Bonds)
Subordinated debentures (greater risk for the holder of the bond) are bonds that are unsecured and
that
rank below other, more senior debt, in their claim on assets or earnings. In case of a bankruptcy, all
superior
debts will be settled before subordinated debenture holders receive any interest or repayment of
principal.
Income bonds (greater risk for the holder of the bond) pay interest only if the company achieves a
certain
level of income.
Serial bonds are bonds issued with varying maturity dates so that some of the bonds mature each
year.
The issuer of the bonds is thereby able to retire the bonds a little at a time over a period of years
without
the need for a single, large cash payment. Serial bonds offer investors the ability to choose the term
that
fits their needs.
Zero-coupon bonds do not pay any interest, but they sell at a price significantly less than the face
value.
Participating bonds (beneficial to the holder of the bond) can participate in dividends (the
distributions
of profits) of the company during a period of high profits.
Indexed bonds have an interest rate that is indexed to some other measure, such as a price index or a
general economic indicator. Instead of paying a fixed interest rate, they pay a variable interest rate.
International bonds include two types of bonds: foreign bonds and Eurobonds. Both are sold outside
of the issuing companies’ home countries (for a U.S.-based company, the bonds are sold outside the
U.S.),
but they differ in the currency in which they are denominated.
• Foreign bonds are issued in a country that is different from the issuing corporation’s home country
and are usually denominated in the currency of the country in which they are sold. For example, a U.S. company may issue bonds in Japan that are denominated in yen. Frequently, the
proceeds of these bond issues are used to finance company assets in the foreign country.
• Eurobonds are international bonds that are denominated in a currency that is different from the
currency of the country in which they are sold. A Eurobond can be issued in any country’s
currency. It is usually issued in the currency of the issuer’s home country, but that is not a requirement. In fact, there can be as many as three different countries involved in a Eurobond: the
country where the issuing company is located, the country where the bond is issued, and the
country whose currency the bond is issued in. For example, a Eurobond denominated in Japanese
yen could be issued in Canada by an Australian company.
The main advantage of issuing Eurobonds is that the issuer can choose the market that has the
most favorable interest rates available to them. Often, this allows the company to find a lower
interest rate than may be available to them in their home country. Eurobonds may be a
less expensive form of financing because they may have fewer regulatory compliance costs than
domestic bonds.
The Eurobond market is generally available only to large issues ($50 million or more) by large
companies, banks, or governments. An additional drawback of Eurobonds is that if the bond is
issued in a currency that is different from the issuer’s home currency, the issuer will be subject to
foreign exchange rate risk because the payments of interest and the principal will be due in the
currency in which the bonds are issued.
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
143
Study Unit 6: B.2. Debt Financing (Bonds)
Bonds and Rating Agencies
CMA Part 2
A company that issues bonds must have its debt issues rated by outside agencies, for which it pays
them
a fee. The primary rating agencies are Moody’s Investors Service, Standard & Poor’s, and Fitch
Ratings.
Whenever a new bond is to be issued, the corporation contracts with Moody’s, Standard & Poor’s,
and Fitch
to rate the quality of the new issue as well as to update its overall rating with respect to all its
outstanding
debt.
The agencies rate an issue in terms of the probability that the corporation will default on the debt.
The
highest rating, reserved for securities that are judged to have negligible default risk, is a triple-A
rating.
The top four categories of each agency’s rating system are considered investment grade quality,
while
bonds rated below that are considered speculative grade or junk bonds.
Investment grade bonds are high quality bonds issued by companies that have a high capacity to
repay and
for which there is little risk of default.
Among corporate bonds, speculative grade or junk bonds are usually bonds issued in leveraged
buyouts
and mergers that are very risky. However, they also carry the potential of very high rewards because
they pay a high interest rate. For a company in a difficult financial position, a junk bond may be the
only
source of financing available, and the company will have no choice but to pay the high interest rates
on the
bonds.
When something in the company’s business or financial situation changes for the worse, the rating
agencies
will downgrade the company’s debt. A downgrade will lead to a higher cost of capital for the
company,
because the lower the company’s debt rating is, the higher the interest rate that the company will
need to
pay to lenders because of the higher credit risk. A downgrade by the ratings agencies also usually
leads to
a decline in the company’s stock price.
In theory, bond investors can mitigate the credit risk they undertake by selecting only investment
grade
bonds for investment. However, in the past the rating agencies have sometimes been slow to react to
a
change in a business’s financial outlook; so, the rating on a given bond issue may be out of date.
Relationship Among Inflation, Interest Rates, and Prices of Financial Instruments
Interest Rates and Inflation
The inflation rate is the annual rate at which prices for goods and services are rising in an economy. It
is,
therefore, the amount by which purchasing power is falling.
There is an inverse relationship between market interest rates and inflation.
• When market interest rates are low, businesses increase their capital spending because financing
becomes less expensive. Households also borrow more money and spend more. As a result, economic activity increases and the economy expands. Businesses hire more workers and
unemployment decreases, leading to more money available for workers to spend. The increased
spending by households and businesses caused by lower interest rates and lower unemployment
leads to an excess of demand over supply for goods and services. The excess demand causes prices
in the economy to increase because buyers bid up the prices they are willing to pay, leading to
inflation.
• When market interest rates increase, businesses decrease their capital spending because financing
is more expensive. Households also borrow less and spend less. Demand decreases and economic
activity decreases. The economy contracts, leading to decreased expansion or even recession.
Unemployment increases because business activity has decreased, and businesses have cut back
on their staffing. The lack of spending money by unemployed workers leads to further recessionary
pressures.
144
© HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
Section B
Study Unit 6: B.2. Debt Financing (Bonds)
Since interest rates affect economic expansion and contraction and thus inflation, the primary tool of
monetary policy used by a nation’s central bank to control inflation is controlling the level of interest
rates. In
the U.S., the central bank is the Federal Reserve Bank.
Market interest rates are a function of the supply of money and the demand for money, and a
nation’s
central bank uses open market operations—buying and selling government securities on the open
market—
to control the supply of money and, in turn, affect interest rates which affects inflation.
• If the central bank wants to expand the money supply and increase economic activity, it buys
government securities on the open market. That puts money into the economy, which makes more
money available for loans and causes the market interest rates to decrease. However, expansion
of the money supply can bring about too much economic expansion, leading to inflation.
• If the central bank wants to bring down inflation, it causes the money supply to contract by selling
government securities on the open market, which takes money out of the economy. The decrease
in the supply of money causes market interest rates to increase, which causes less borrowing and
less economic activity and causes inflation to decrease.
Interest Rates and Market Prices of Financial Instruments
There is also an inverse relationship between interest rates and market prices of financial
instruments.
Market prices of financial instruments, primarily stocks and fixed income securities such as bonds,
are
affected by market interest rates because of the responses of investors to changes in market interest
rates.
• When market interest rates increase, market prices of both stocks and fixed income bonds decrease. The amount investors are willing to pay for fixed income bonds decreases because they
want to receive the higher market rate of interest on their fixed income investments. Investors are
also less willing to hold stocks because the interest rate they can earn on bonds has increased, so
more investors sell stocks to move investment money into bonds. The market prices of stocks
decrease because the demand for stocks decreases.
• The opposite happens when market rates of interest decrease. Market prices of both stocks and
fixed income bonds increase. Market prices of bonds increase so that the interest rate bond investors will receive will be in line with the decreased market rate of interest. Furthermore, investors
want to invest more in stocks because the interest they can earn on bonds is decreased, and
investors expect to be able to earn a higher return in stocks from both capital gains and dividends.
Thus, the demand for stocks increases, which pushes stock prices higher.
The Impact of Income Taxes on Financing Decisions
Interest paid on debt is tax deductible, and its tax deductibility effectively reduces the actual cost of
the
interest, and the actual cost of the interest to the company is less than the amount of the interest
expense
recognized. Because of the tax deductibility of interest and the lower inherent risk in bonds than in
equity
sources, bonds are usually the least expensive source of new financing for a company.
However, there is a limit to how much a company’s debt can be increased before it causes the
company’s
cost of capital to increase. If debt becomes too high in proportion to equity in the company’s capital
structure, both debt holders and equity investors will perceive that the increased debt has caused their
investment holdings to become riskier. They will require higher returns to compensate for the
increased
risk they are bearing, leading to increased costs for both debt and equity for the company.
The cost of debt is covered in the next Study Unit, Study Unit 7, and the cost of equity is covered in
Study
Units 14 and 15 in this section.