Qualitative and Quantitative Factors of Bond Ratings - Essay Example

1. The higher the coupon rates, the higher the coupon payments and the higher the bond prices. The coupon rates for the various bonds vary so much because normally, the coupon rate is set equal to the going interest rate when a bond is issued (Weston, Besley, and Brigham 289). 2. Bond ratings are based on both qualitative and quantitative factors. Some of the factors considered by the bond rating agencies include the financial strength of the company as measured by various ratios, collateral provisions, seniority of the debt, restrictive covenants, provisions such as a sinking fund or a deferred call, litigation possibilities, regulation, and so on. Representatives of the rating agencies have consistently stated that no precise formula is used to set a firm's rating; all the factors listed, plus others, are taken into account, but not in a mathematically precise manner. Statistical studies have borne out this contention, for researchers who have tried to predict bond ratings on the basis of quantitative data had had only limited success, indicating that the agencies use subjective judgment when establishing a firm's rating. When the bond ratings get adjusted downwards, because most bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to investment-grade securities, many potential purchasers will not be allowed to buy them. As a result of their higher risk and more restricted market, when the bond ratings get adjusted downwards, the bonds have higher required rates of return as risk premium (Weston, Besley, and Brigham 707-708). 3. Whenever the gong rate of interest is equal to the coupon rate, a bond will sell at its par. Interest rates do change over time, but the coupon rate remains fixed after the bond has been issued. Whenever the going rate of interest is greater than the coupon rate, a bond's price will fall below its par value. Such a bond sells at a discount from its face value, so it is called a discount bond. Whenever the going rate of interest is less than the coupon rate, a bond's price will rise above its par value. Such a bond sells at a premium compared to this face value, so it is called a premium bond (Weston, Besley, and Brigham 289-290). The discount bonds are not a bargain because the discounts are only to compensate for the lower coupon rate compared to going rate of interest. 4. The yield to maturity is the average rate of return earned on a bond if it is held to maturity (Weston, Besley, and Brigham 291). To calculate the yield to maturity, the following equation could be solved (Weston, Besley, and Brigham 291). = C (PVIFAk, n) + M (PVIFk,n) Where V = Bond value C = coupon payments k = yield to maturity M = par value of the bond n = number of years before the bond matures K could be solved by using a financial calculator or by substituting values for PVIFA and PVIF until a pair that works is found so that the present value of the interest payments combined with the present value of the repayment of the face value at maturity equals the current price of the bond (Weston, Besley, and Brigham 291). Alternatively, an estimate of the yield to maturity could be calculated with the following equation (Weston, Besley, and Brigham 291). 5. The nominal yield to maturity is the contracted, or quoted, interest rate which is used to compute the interest paid per period. The effective yield to maturity is the annual rate of interest actually being earned, as opposed to the quoted rate, considering the compounding of interest. The investor should use the effective yields to maturity when deciding between corporate bonds and other securities of similar risk. This is because throughout the world economy, different compounding periods are used for different types of investments. For example, bank accounts generally compute interest on a daily basis; most bonds pay interest semiannually; and stocks generally pay dividends quarterly. If the investor is to properly compare securities with different compounding periods, he or she needs to put them on a common basis. The effective yield to maturity allows the investor to compare them on a common basis because the effective yield to maturity is the rate that would produce the same ending (future) value if annual compounding had been used (Weston, Besley, and Brigham 257). 6. Often, bonds have a provision whereby the issuer can pay them off prior to maturity by calling them in from the investors. This feature is known as a call provision. If a bond is callable, and if interest rates in the economy decline, then the company can sell a new issue of low-interest-rate bonds and use the proceeds to retire the old, high-interest-rate issue (Weston, Besley, and Brigham 284). 7. The riskiness of the bonds depends on their rating, years until maturity, sinking fund provision, and call period. AA rating bonds are riskier than AAA rating bonds. Bonds with more years until maturity are riskier. Bonds with no sinking fund provision are riskier. Bonds with a longer call period are riskier. Hence, the bonds, ranked in increasing order of their relative riskiness, are ABC Energy with a coupon rate of 0%, ABC Energy with a coupon rate of 5%, TransPower, and Telco Utilities. 8. Value of bond = C [1/(k-g) - (1/(k-g))*((1+g)/(1+k))n ] (Schlingemann online) Substituting C, g, and n into the equation for ABC Energy (coupon rate = 5%), ABC Energy (coupon rate = 0%), TransPower, and Telco Utilities, k, the realized return could be obtained through Microsoft Excel solver. ABC Energy (coupon rate = 5%): C = 50, g = 0.05, n = 20, k = 0.08 ABC Energy (coupon rate = 0%): Simple interest rate = (1000 - 208.3)/208.3 = 0.038 Effective annual percentage interest rate TransPower: C = 100, g = 0.05, n = 20, k = 0.11 Telco Utilities: C = 110, g = 0.05, n = 30, k = 0.13 WORKS CITED Schlingemann, Frederik P. "Additional Notes & Examples on Time Value of Money." Katz Graduate School of Business, University of Pittsburgh. 1 November 2006 . Weston, J. Fred, Besley, Scott, and Brigham, Eugene F. Essentials of Managerial Finance. New York: The Dryden Press, 1996. Read More