Interest rates and bond Valuation

Topics: Bond, Bonds, Interest Pages: 132 (18482 words) Published: September 15, 2014
CHAPTER

6

INTEREST RATES AND
BOND VALUATION
L E A R N I N G

LG1

Describe interest rate fundamentals, the term
structure of interest rates, and risk premiums.

LG2

Review the legal aspects of bond financing and
bond cost.

LG3

LG4

Discuss the general features, quotations, ratings,
popular types, and international issues of corporate bonds.

LG5

LG6

G O A L S
Apply the basic valuation model to bonds and
describe the impact of required return and time to
maturity on bond values.
Explain yield to maturity (YTM), its calculation,
and the procedure used to value bonds that pay
interest semiannually.

Understand the key inputs and basic model used
in the valuation process.

Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand interest rates and the
various types of bonds in order to be able to account properly for amortization of bond premiums and discounts and for bond purchases and retirements.

Marketing: You need to understand how the interest rate level and the firm’s ability to issue bonds may affect the availability of financing for marketing research projects and new-product development.

Information systems: You need to understand the data that you will need to track in bond amortization schedules and bond
valuation.

Operations: You need to understand how the interest rate level may affect the firm’s ability to raise funds to maintain and increase the firm’s production capacity.

Management: You need to understand the behavior of interest
rates and how they will affect the types of funds the firm can raise and the timing and cost of bond issues and retirements.

262

FORD
FORD CRUISES
THE DEBT MARKETS
ord and Ford Motor Credit Co. (FMCC), its finance unit, were frequent visitors to the corporate debt markets in 2001, selling over $22 billion in long-term notes and bonds. Despite the problems in the auto industry, investors nervous about stock market volatility were willing to accept the credit risk to get higher yields. The company’s 2001 offerings had something for all types of investors, ranging from 2- to 10-year notes to 30-year bonds. Demand for Ford’s debt was so high that in January the company increased the size of its issue from $5 billion to $7.8 billion, and October’s plan to issue $3 billion turned into a $9.4 billion offering. The world’s second largest auto manufacturer joined other corporate bond issuers to take advantage of strengthening bond markets. Even though the Federal Reserve began cutting shortterm rates, interest rates for the longer maturities remained attractively low for corporations. Unlike some other auto companies who limited the size of their debt offerings, FMCC decided to borrow as much as possible to lock in the very wide spread between its lower borrowing costs and what its auto loans yielded.

All this debt came at a price, however. Both major bond-rating agencies—Moody’s Investors Service and Standard & Poor’s (S&P)—downgraded Ford’s debt quality ratings in October 2001. Moody’s lowered Ford’s long-term debt rating by one rating class but did not change FMCC’s quality rating. Ford spokesman Todd Nissen was pleased that Moody’s confirmed the FMCC ratings. “It will help us keep our costs of borrowing down, which benefits Ford Credit and ultimately Ford Motor,” he said. S&P’s outlook for Ford was more negative; the agency cut ratings on all Ford and FMCC debt one rating class. The lower ratings contributed to the higher yields on Ford’s October debt. For example, in April FMCC’s 10-year notes yielded 7.1 percent, about 2 points above U.S. Treasury bonds. In October, 10-year FMCC notes yielded 7.3 percent, or 2.7 points above U.S. Treasury bonds.

For corporations like Ford, deciding when to issue debt and selecting the best maturities requires knowledge of interest rate fundamentals, risk premiums, issuance costs, ratings, and similar features of corporate bonds. In this chapter...
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