MANAGERIAL FINANCE I 4
Duringthe purchase of bond, either directly or using mutual funds, it isclear that one lends money to the bond`s user. The bond user promisesto pay back in the event of bond maturation (Langohr & Langohr,2010). Meanwhile, there is an agreement between the issuer and thebond user concerning the periodic interest payments to act ascompensation for the used money. The rate at which the bond user ispaid, which is the interest rate, is always fixed during theissuance. An inverse relationship exists when new bonds are issued.In this case, the new bond holds coupon rates that are close to theprevailing market interest rate. Thus, when bond prices go high,interest rates decrease and vice versa.
Changein interest rates significantly affects the bond prices (Nielsen &Ronn, 2011). The price of a bond in the market today accounts for thetotal of all future cash flows in discountable values because theyare not at hand. The discount rate in use depends on the rate ofinterest in the prevailing market for bonds sharing the same maturityand risks (Langohr & Langohr, 2010). Therefore, in an event ofchanges in interest rates the price of all bonds is affected but indifferent degrees. Coupon rates paid by the issuer also affects thevolatility of the bond price. Meaning, in the case of a higher bondmore cash inform of interest costs, reaches the investor before thematurity of the bond than in cases of a lower coupon bond. Implying,increased interest rates, leads to a discount in future cash flowingat a higher rate, and shortly the lower coupon bond will result in areasonably more cash flow to the investor. The greater portion of thetotal cash flow corresponds to maturity price of the bond, leading toa remarkable decrease in the value of the bond.
Theeffect of interest rates on the coupon bonds differs from zero-couponbonds since for the coupon bonds one get fixed annual interest andfor some, semi-annual interests (Parameswaran, 2011). Zero couponbonds do not incur periodic interest costs, what happens is that abond is bought at a cut-rate to face value, and it matures atcountenance values. Again, zero coupon bonds tend to lose their valuefaster in the case of a rise in interest rate than the counterpartcoupon bond that is mature.
Forthe past few years, bond-rating agencies have not been impressive.They were blamed for precipitating the financial crisis that led to acollapse in bond markets cutting the industry`s revenue by a third(Langohr & Langohr, 2010). The rating agencies are said to beovergenerous in their issuing of rates and giving unduly high chargesto mortgage-backed securities. There are notable efforts to improvethe industry, so far the fruits of their hard work are evidenced bybooming of the bond market, and the industry would be back to itscommercial nature. Thus, there is room for improvement in case thereis a boom of the bond market emanating from the global improvement ofthe economy.
Primarymarkets are different from the secondary markets in that, for theprimary markets, investors purchase securities directly from theorganization issuing the securities. On the other hand, for thesecondary markets, investors are involved in trading securities amidthemselves while the organization having the securities that arebeing traded is not involved in the transaction (Parameswaran, 2011).
Langohr,H., & Langohr, P. (2010). Therating agencies and their credit ratings: what they are, how theywork, and why they are relevant.Chichester, England: Wiley.
Nielsen,S. S., & Ronn, E. I. (2011). Thevaluation of default risk in corporate bonds and interest rate swaps.Wharton Financial Institutions Center, Wharton School of theUniversity of Pennsylvania.
Parameswaran,S. (2011). Fundamentalsof Financial Instruments: An Introduction to Stocks, Bonds, ForeignExchange, and Derivatives.New York: John Wiley & Sons.