Running head: INTEREST RATES AND CORPORATE BONDS 1

Interest Rates and Corporate Bonds

Kathryn L. Pineda

California Baptist University

INTEREST & BONDS 2

Abstract

Companies raise new capital through two methods, either equity of debt. Debt is incurred

through the issuance of bonds. A bond is a long-term contract where the borrower (a corporation,

for example) agrees to make regular payments of interest and principal on specific dates

(Brigham & Houston, 2018, p 230). There are several types of bonds: treasury, corporate,

municipal, and foreign. For this analysis the focus will be on corporate bonds. Corporate bonds

are those issued by business corporations. These bonds come with the risk of default. If the

company underperforms financially the value of bonds is in jeopardy. This discussion will focus

on a hypothetical valuation model for a company’s debt with a face value of $100 million.

Along with the valuation there will be an in-depth discussion of the key characteristics of bonds.

This will follow with a review of the determinants of the market interest rate, as the market

interest rate fluctuates. Bonds come with a maturity date and it is important to discuss the

correlation between market rate and bond maturity. Additionally, to expand our understanding

of bonds and interest rate there will be a discussion of factors that influence valuation. This

analysis will culminate with a brief discussion of oversight and compliance of the bond market.
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Bond Market: Determining value with fluctuating determinants

Within the first quarter of 2019, corporate America held over $9 trillion in debt (David,

2019). Corporations raise capital in two ways, either through equity or debt. Bonds are one of

the primary ways for corporations to raise capital. A bond is a fixed financial investment that

pays periodic interest until being repaid at the bond’s maturity rate. A bond, unlike stock, does

not provide the bondholder any ownership in the corporation. Bond valuation, which is

dependent on a number of factors, determines its suitability for potential investors. Valuing

bonds accurately is a key step in the investment process.

Valuation Model

“The growth of the corporate debt sector to a dominant source of finance for U.S.

corporations underlines, by itself, the importance of accurate bond pricing models (Ericsson &

Reneby, 2005, p. 707). With over $9 trillion in corporate date, accurate valuations are what

provide potential investors with data necessary to determine whether or not to invest money in a

particular firm. Corporate bond’s values are determined by considering the face value, coupon

rate, interest rate, market rate, and frequency of coupon payments. The value of the bond is the

sum of its future value, which would include all interest payments and the bond’s principal

payment returned at date of maturity and discounted at the market rate.

Consider the following scenario: A company’s corporate debt has a face value of $100 million

dollars. The assumptions are (a) the bonds have a coupon rate of 5% (b) the coupon frequency is

semiannual (c) the maturity is 15 years (d) rating is AAA and the yield on AAA corporate bonds

is 3.31% (Moody’s, 2019). This company chose a coupon rate of 5% which requires the

company to pay interest at this rate to the bondholder. Coupon rates can vary based on the

credibility of the company and their ability to make coupon payments. Companies that are more
INTEREST & BONDS 4

stable, such as Apple, generally do not offer high coupon rates because their risk of default is

lower. This company chose semiannual coupon payments, which is the preferred schedule of

investors. Fifteen years is the maturity point for this specific bond; however, the maturity date is

determined by how long a company needs access to these funds. This company is rated AAA,

which is best rating and implies the company is very stable with little risk of default. The yield of

this corporate bond is 3.31% (Moody’s 2019), as indicated by Moody’s AAA Corporate Bonds.

Moody’s is an investment indicator of bond performance . To determine the market value of this

bond you calculate the present value of all cash flows, discounted at the semiannual yield on

AAA Corporate Bonds, which is the market rate, (3.31%//2=1.66%). The semiannual coupon

payment = face value * coupon rate/2 ($100 * 5% /2 = $2.5). Because the firm needs to raise

$100 million, it must issue $1 million such bonds each with a face value of $100. The market

value of firm’s debt is $119.8544 x 1 million = $119,854,400. This valuation model provides us

with the opportunity to compare market value with par value. That comparison helps us to

determine if a bond is trading at a premium or discount. A bond whose price is above par is

selling at a premium (Hickman, 2013). Furthermore, the model determines the fair value of the

company’s debt which is $119,854,400. An investor would not want to pay over $119.85 for this

bond issued by company, especially if they are confident in Moody’s annual yield for such bonds

at 3.31%.
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Valuation Model

Face Value $100

Coupon Rate 5.0%
Semiannual coupon rate 2.5%
Annual yield 3.31%
Semi-annual yield 1.66%

Payments Coupon Principal Total Cash Flow PV of Cash flow

1 $2.50 $2.50 $2.46
2 $2.50 $2.50 $2.42
3 $2.50 $2.50 $2.38
4 $2.50 $2.50 $2.34
5 $2.50 $2.50 $2.30
6 $2.50 $2.50 $2.27
7 $2.50 $2.50 $2.23
8 $2.50 $2.50 $2.19
9 $2.50 $2.50 $2.16
10 $2.50 $2.50 $2.12
11 $2.50 $2.50 $2.09
12 $2.50 $2.50 $2.05
13 $2.50 $2.50 $2.02
14 $2.50 $2.50 $1.99
15 $2.50 $2.50 $1.95
16 $2.50 $2.50 $1.92
17 $2.50 $2.50 $1.89
18 $2.50 $2.50 $1.86
19 $2.50 $2.50 $1.83
20 $2.50 $2.50 $1.80
21 $2.50 $2.50 $1.77
22 $2.50 $2.50 $1.74
23 $2.50 $2.50 $1.71
24 $2.50 $2.50 $1.69
25 $2.50 $2.50 $1.66
26 $2.50 $2.50 $1.63
27 $2.50 $2.50 $1.60
28 $2.50 $2.50 $1.58
29 $2.50 $2.50 $1.55
30 $2.50 $100 $102.50 $62.64

PV of Bond $119.8544
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Determinants

The market interest rate, or the prevailing interest rate, is influenced by several

determinants. There are risks associated with the purchase of bonds. Nominal (or risk-free

interest) is one in which the investor has no risk. Default risk premium is additional

compensation to bond holder for undertaking the default risk. It is the difference between interest

rate of a US treasury and a corporate bond of equal maturity. Maturity risk considers the

uncertainty of the interest rate at maturity. Liquidity risk is the difference between two securities

and how easily they be converted to cash (Brigham & Houston, 2018, p. 108). Another

determinant is the inflation premium which is additional compensation to investor due to an

increase in inflation over time. These determinants, either individual or in combination with one

another, affect the market interest rate

Market rate and maturity

The maturity of a bond carries a risk. The length of the bond until it reaches maturity

correlates to this risk. The yield curve is the “relationship between short and long-term interest

rates” (Campbell, 1995, p. 129). The yield curve is important to policymakers and individuals as

even a small increase in interest rates has a dramatic effect on long bond yields. (Campbell,

1995) The yield curve is upward sloping, as the time to maturity lengthens so does the

corresponding interest rate. This signifies that debts issued for a longer period of time carry a

greater risk due to inflation or default. Additionally, maturity risk premium varies over time as

interest rates rise during periods of volatility and decrease during stability.

Bond characteristics and valuation

As noted by Brigham and Houston (2018) there are several key characteristics of bonds.

The par value is the “face value of the bond” (p. 231). The par value is a representation of the
INTEREST & BONDS 7

money the firm issuing the bonds has borrowed with a promise to repay. The coupon interest is

the amount of interest paid each year. This is generally a fixed price, however, floating-rate

bonds also exist, and the payment is referred to as the coupon payment (p. 231). The interest rate

is calculated by dividing the annual coupon payment by the par value (p. 231). The coupon

interest rate is one method of encouraging investors to buy the bonds. The higher the coupon

rate the higher the price, this works conversely as well with a lower coupon rate involving lower

price. Maturity date is another key attribute and is a specified date the par value must be repaid

(p. 232). The maturity period of bonds usually spans from 10-40 years. It is important, however,

to note that the bond with the shorter maturity period will trade at a higher value as depreciation

impacts the value of the bond from one year to the next. The interest rate is an obvious

characteristic. Interest rates influence the discount rates of a bond. With inflation comes higher

interest rates which require higher discount rates which effectively decreases the price of a bond.

Bonds may contain provisions. One such provision is a call which provides the bond issues the

right to redeem the bonds prior to the maturity date. The call premium is an additional cost paid

by the bond issuer to buy back the bonds at a predefined price in the future. This benefits the

issue because they are able to take advantage of a lower interest rate in the market through

refinancing. The call premium will decline as it approaches maturity (p. 232). Another type of

provision is the sinking fund, this is an orderly and defined retirement of the bonds. With this

provision the bond issuer buys back a portion of the bonds each year, otherwise the company is

in default. The sinking funds are mandatory payments and non-negotiable after purchase.

Sinking fund bonds are bought through either a lottery administered by a trustee or on the open

market (p. 232). The method chosen is based on cost with the least-cost method being the
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preferred choice. The effect of various bond characteristics on bond price are summarized

below.

Bond Characteristic Effect Bond Price

Interest Rate Increases Decreases
Time to Maturity Increases Decreases
Coupon Rate Increases Increases
Sinking Fund Provision Included Increases
Call Provision Included Decreases

With so many factors involved with pricing bonds, it is surprising there was no

compliance system in place until 2002. Prior to July 2002, the corporate bond market was less

transparent. The passage of the Transaction reporting and Compliance Engine (TRACE) marked

a period of transparency (Bessembinder & Maxwell, 2008, p. 217). Implementation of TRACE

was to ensure all trades for publicly issues bonds were reported with the data available to the

public. This initiation of this compliance of the bond market was a shock and has had both

critics and proponents of the reporting requirement. Investors have benefited because of reduced

bid-ask spread (difference between buyer’s highest price and seller’s lowest acceptable offer)

they pay to bond dealers (Bessembinder & Maxwell, 2008, p. 232). Unfortunately, bond dealers

have seen dramatic decreases in employment opportunities and compensation. It is argued that

trading is more difficult researchers “anticipate…efficiency improvements from increased

competition in the provision for corporate bonds post-TRACE” (p. 232). In conclusion,

transparency is necessary in the financial sector to ensure compliance and to provide investors

with accurate data.

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References

Besembinder, H., and Maxwell, W. 2008. “Markets: Transparency and the Corporate Bond
Market.” Journal of Economic Perspectives, 22 (2): 217-235. DOI: 10.1257/jep22.2.217.

Brigham, E. F., Houston, J. F. (20180124). Fundamentals of Financial Management, 15th

Edition [VitalSource Bookshelf version]. Retrieved from vbk://9781337671002

Campbell, J. Y. 1995. “Some Lessons from the Yield Curve.” Journal of Economic Perspectives,
9 (3): 129-152. DOI: 10.1257jep.9.3.129.

David, J. E. (2019, July 13). Investors aren’t sweating US’s massive corporate debt pile, but
maybe they should. Retrieved July 18, 2019, from
https://finance.yahoo.com/news/corporate-debt-surges-but-investors-arent-worried-yet-
140000257.html.

Erricsson, J., & Rreneby, J. (2005). Estimating Structural Bond Pricing Models. The Journal of
Business, 78(2), 707-735. Doi: 10.1086/427644.

Hickman, K.A., Byrd, J. W. & McPheson, M. (2013). Essentials of Finance [Electronic version]

“Moody’s Seasoned AAA Corporate Bond Yield.” Moody’s Seasoned AAA Corporate Bond
Yield, St. Louis Fed, 1 July 2019, fred.stlouisfed.og/series/AAA>