Interest Rates, Bonds & Debt Capacity

Posted: August 27th, 2021

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Interest Rates, Bonds & Debt Capacity

1. What Is the Relationship Between Interest Rate Level and Bond Price? Why Must This Relationship Be True? How Has the Current Rate Environment Impacted the Prices of Bonds?

            Interest rates have an inverse relationship with bonds.Interest rates are payments made to acquire bond (FIDELITY INVESTMENT). Thus, as the interest rate increases, prices to acquire bonds fall and the reverse is true when interest rates decrease.

Although the inverse relationship between bonds and interest appears illogical at first glance, it is sensible. The reason is that most bonds offer fixed interest rates whose attractiveness increases with a fall in interest rates, thus increasing the demand hence the bond price (FIDELITY INVESTMENT). On the other hand, a rise in interest rates discourages investors from going for fixed interest rate paying bonds. Thus, this results in a decrease in bond prices.

The current rate environment has impacted the prices of bonds negatively. Essentially, bonds compete with one another based on the interest income that investors are expected to attain (FIDELITY INVESTMENT). Increases in interest rates particularly in the current free-market setting have often resulted in the emergence of new bonds, issued with high-interest rates, thus promising higher income to investors than their predecessors. However, older bonds, are unable to increase their interest rates or value when market interest rates go up (FIDELITY INVESTMENT). They are hence locked out of the market because of the original terms. In this case, bond issuers are forced to reduce the bond price as the only way to increase the value of older bonds. This implies that original bondholders end up holding bonds with lower prices that fail to sustain their value as those newly introduced to the market (FIDELITY INVESTMENT). For example, a current bond with a par value of $1,500 with ten (10) years duration promises an original value of $1,500 at its expiry. The bond has a 4% coupon rate, implying the investor earns $60 per year. Thus, for a semi-annual payment, the investor receives $30 as coupon payments. He can decide to sell sometimes later when market interest rates increase to 5%. Since buyers can purchase a $1,500 bond at an interest rate of $37.5 (semi-annually) coupon payments, a $30 is no longer great. In this case, the new bond earns the buyer $75 annual for 10 years amounting to $750 against $600. Therefore, the investor can create an incentive for the buyers by discounting the bond; instead of $1,500, sell at $1,495.

• What Are Some Factors to Consider in Evaluating a Company’s Ability to Make Payments On Outstanding Debt? Please Explain the Factors Rather Than Just Providing a List

            The debt capacity is the debt amount a business incurs and can cover adequately in accordance to conditions of the agreement. Thus, when evaluating the company’s ability to make payments on outstanding debts, several factors should be considered (Kiril). They include EBITDA, use of credit metrics such as interest coverage and debt/EBITDA as well as debt-to-equity.

EBITDA refers to Earnings Before Interest, Tax, Depreciation, and Amortization. A company that reports high EBITDA can create more retained earnings to meet its outstanding debt requirements (Kiril). Thus, debt capacity increases with an increase in the level of EBITDA. Credit metrics such as interest coverage and debt/EBITDA are key factors that determine the ability of the company to meet its outstanding debt requirements. High-interest coverage and debt/EBITDA ratio imply that the company has high debt capacity. Similarly, the debt to equity ratio communicates the capital structure of a company.

Works Cited

FIDELITY INVESTMENT. “Bond Prices, Rates, and Yields – Fidelity.” Fidelity Investments – Retirement Plans, Investing, Brokerage, Wealth Management, Financial Planning and Advice, Online Trading, 2016, www.fidelity.com/learning-center/investment-products/fixed-income-bonds/bond-prices-rates-yields.

Kiril. “Debt Capacity.” Corporate Finance Institute, Corporate Finance Institute, 15 Sept. 2020, corporatefinanceinstitute.com/resources/knowledge/finance/assessing-debt-capacity/.