Question

1. What is the relationship between interest rate level and bond price? Why must this relationship be true? How has the current rate environment impacted the prices of bonds? 2. What are some factors to consider in evaluating a company's ability to make payments on outstanding debt? Please explain the factors rather than just providing a list. DB POSTING REMINDERS: • Please remember the initial post should be written as early in the week as possible, and the peer responses are due by Saturday evening. When you make your initial post, please fully answer the question and make substantive responses - i.e. at least 400 words that really dive into the topic and show that you've read the text and done research to support your opinions.

Answer 1

Solution:-

(1)

Relationship between interest rate levels and bond prices:

There is an inverse relationship between interest rates and bond prices. Bond prices are essentially valuations of bonds, so let's understand how financial assets are valued.

The valuation of bonds or any other financial assets is based on the expected rate of return from that asset which is determined by the following two factors:

• The risk free rate in an economy (i.e. benchmark interest rates)
• Risk involved with the asset

Hence, the value of all financial assets, including bonds, is benchmarked on the risk free interest rates in the economy. Higher the interest rates, higher would be the expected rate of return from various assets and lower the prices. Similarly, lower the interest rates, lower the expected return and hence higher the prices.

This is the reason that bond prices move along with interest rates. When interest rates go up, the bond prices go down to adjust their returns upwards in line with increased rates. When interest rates go down, the bond prices go up to adjust their returns lower in line with decreased interest rates.

The current rate environment has seen interest rates fall to record low levels in recent years, primarily due to effects of shlow economic growth worldwide. The central banks have adoped loose monetary policies, cutting interest rates to push economic growth higher. This has resulted in bond prices to go up to adjust their yields lower in line with the low interest rates.

(2)

The primary factors that help evaluate a company's ability to make payments on its outstanding debt are as follows:

• The credit rating of the company's debt as given by agencies such as Moody's. S&P, Fitch, etc is the best indicator of company's ability to repay the debt
• One of the primary factors is its debt service coverage ratio. The debt service coverage ratio shows the margin the company has to pay its interest as well as principal payments. Higher the debt service coverage ratio, higher would be the company's ability to repay its debt and vice-versa. the debt service coverage ratio is determined by factors such as growth, operating margins, return on capital, etc
• The companies usually like to keep a predetermined debt-equity ratio in their capital structures. They keep paying the interest expense and when the principal becomes due, they like to refinance the debt to pay off the old debt and replace it with new so that the desired debt-equity ratio can be maintained. The financial situation of the company determines its ability to refinance and thus the ability to pay off the existing debt.
• Existing cash reserves is a factor that gives an indication of ability to repay debt. Higher the cash reserves the better it is
• The financial situation of the industry must also be looked at for understanding the company's ability to repay debt. If the industry is booming and growth is high, the company is more likely to meet its debt obligations and vice-versa