Bonds In World War II, U.S. Government Beg ✓ Solved

Bonds In the midst of World War II, the U.S. government beg

In the midst of World War II, the U.S. government began issuing defense bonds, later calling them war bonds once the country entered the war. Although the citizens who purchased the bonds could have received a better return on their investments elsewhere, they took comfort in knowing that their investment would help with their country’s war efforts and there would be a guaranteed return. Even through the deadliest and most costly war in history, people felt assured in the security that was provided through the purchase of bonds. Even today, investors and organizations can rely on the same security that bonds provide. Organizations may also consider the option of issuing bonds in order to raise money for projects and operations. Therefore, it is important for financial managers to understand aspects of bonds, such as how sensitive they are to interest rates and how some features benefit issuers, while others benefit investors. For this Assignment, you will answer a series of questions related to bonds.

To prepare for this Assignment, review this week’s Learning Resources. Submit your responses to the following prompts:

• How are the price and the Yield-to-Maturity (YTM) of a bond related? (75–150 words, or 1–2 paragraphs)
• What is the main reason why long-term bonds are subject to greater interest rate risk than short-term bonds? (75–150 words, or 1–2 paragraphs)
• A company is contemplating issuing a bond and is debating whether or not to include a call provision. What are the costs? How do these answers change for a put provision? (250–225 words, or 2–3 paragraphs)
• How does a company that issues a bond decide on the appropriate coupon rate to set? Explain the difference between the coupon rate and the required rate of return on the bond. (250–225 words, or 2–3 paragraphs)
• Explain why some bonds sell at a premium over their par value while other bonds sell at a discount. Also discuss the relationship between the coupon rate and the YTM for premium bonds. What about for discount bonds and bonds selling at par value? (250–225 words, or 2–3 paragraphs)
• What is the relationship between the current yield and YTM for premium bonds, discount bonds, and bonds selling at par value? (250–225 words, or 2–3 paragraphs)

Paper For Above Instructions

Relationship between Price and Yield-to-Maturity (YTM)

The price of a bond and its Yield-to-Maturity (YTM) have an inverse relationship. When the price of a bond increases, the YTM decreases, and vice versa. This relationship is primarily due to the fixed nature of bond cash flows, which consist of periodic interest payments and the return of the principal at maturity. When market interest rates rise, existing bonds, which pay lower fixed interest, decrease in price to align their effective yields with the new market rates (Fabozzi, 2019). Conversely, when market interest rates decline, existing bonds become more valuable, leading to an increase in price and a corresponding decrease in YTM. This fundamental principle is crucial for investors making decisions in bond markets.

Interest Rate Risk in Long-Term Bonds

Long-term bonds are subject to greater interest rate risk compared to short-term bonds because their cash flows are locked in for a longer duration. The main reason for this heightened risk is the time value of money; the longer the bond's term, the more sensitive its price is to changes in interest rates. For instance, if interest rates rise, the present value of the bond's future cash flows decreases significantly over time, leading to a larger price decline for long-term bonds than short-term ones (Cox & Ingersoll, 1981). This increased volatility results in long-term bonds carrying higher interest rate risk, making it crucial for investors to assess their interest rate outlook when investing in such securities.

Costs of Call and Put Provisions

When a company contemplates issuing a bond with a call provision, it incurs potential costs associated with early redemption, which may lead to a higher yield demanded by investors. This transactional cost emerges because the issuer can redeem the bond before maturity if interest rates decline, thus adversely affecting bondholders who expected long-term income (Brealey, Myers, & Allen, 2019). Conversely, a put provision allows bondholders to sell their bonds back to the issuer at a predetermined price; while initially attractive for investors, this provision requires the issuer to potentially offer lower yields to compensate for this added flexibility (Berk & DeMarzo, 2020). The fundamental differences in risk profiles between call and put provisions influence both companies and investors in their respective strategies.

Determining the Appropriate Coupon Rate

A company deciding on an appropriate coupon rate typically considers several factors: current market interest rates, the credit risk associated with the issuing entity, and comparable securities' yields. The coupon rate is the fixed annual interest rate paid by the issuer, whereas the required rate of return reflects the investors' expected yield based on the perceived risk (Culp, 2006). If the coupon rate is set lower than the required rate, the bond may sell at a discount, while a higher coupon rate may result in a premium. By balancing these elements, companies seek to attract investors while managing their own financing costs.

Premium and Discount Bonds

Bonds may sell at a premium, at par, or at a discount based on their coupon rates compared to current market rates. A bond sells at a premium when its coupon rate exceeds the market interest rates, making it more attractive to investors (Higgins, 1977). Conversely, a bond sells at a discount if its coupon rate is lower than the prevailing market rates. For premium bonds, the relationship between the coupon rate and the Yield-to-Maturity (YTM) shows that the YTM will be lower than the coupon rate. In contrast, for discount bonds, the YTM exceeds the coupon rate. Bonds selling at par have coupon rates equivalently aligned with market interest rates (Cochrane, 2001).

Current Yield and YTM Relationship

The current yield of a bond is calculated by dividing the bond's annual coupon payment by its current market price. For premium bonds, the current yield is less than the YTM as the bond's price is higher than its par value, reflecting the lower yield on investment (Reilly & Norton, 2016). For discount bonds, the current yield exceeds the YTM due to the lower market price relative to the coupon payment, which is fixed. In contrast, bonds selling at par have a current yield equivalent to the YTM, as their prices align with the bond's stated value. This dynamic becomes essential for prospective bond investors to understand when evaluating investment opportunities.

In conclusion, understanding the dynamics of bonds, including their pricing, risk factors, and issuer strategies, is vital for both financial managers and investors alike. The interplay of interest rates, coupon rates, and bond provisions significantly affects investment decisions and the overall stability in financial markets. By grasping these underlying principles, stakeholders can navigate bond investments more effectively.

References

• Berk, J., & DeMarzo, P. (2020). Corporate Finance (4th ed.). Pearson.
• Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
• Cochrane, J. H. (2001). Asset Pricing. Princeton University Press.
• Culp, C. L. (2006). Structured Finance and Insurance: A Guide to Managing Capital Market Risks. John Wiley & Sons.
• Fabozzi, F. J. (2019). Bond Markets, Analysis, and Strategies (10th ed.). Pearson.
• Higgins, R. C. (1977). Analysis for Financial Management (1st ed.). Irwin.
• Reilly, F. K., & Norton, A. (2016). Investments (11th ed.). Cengage Learning.
• Cox, J. C., & Ingersoll, J. E. (1981). The Relation between Forward Rates and Future Short Rates: A Theoretical Analysis. The Journal of Financial Economics, 9(4), 321-353.
• Moody's (2023). Moody's Investors Service. Retrieved from https://www.moodys.com
• S&P Global (2023). S&P Global Ratings. Retrieved from https://www.spglobal.com/ratings