Question

1. What would cause a bond to sell above or below its contract rate (stated rate)? 2. Why would a company issue bonds, instead of selling stock or borrowing from a bank? 3. Is it necessary to make adjusting entries for interest expense at year end? Why? 4. Which method of amortization is better--Straight Line or Effective Interest method? Why? 5. Why should a company collect the accrued interest on bonds when they are sold after issue date?

Answer 1

1) Bonds that are sold above its contract rate or also called as face value are said to be sold at premium. And bonds that are sold at a price lower than its contract rate, they are said to be sold at discount.

Markets are not always the same. The price of the bond at the time of maturity is decided at the time it is being bought. But in future, market sentiments and economic environments may change and hence bond price also fluctuate.

Bonds are issued initially at par value. In a secondary market, a bond's price can fluctuate. The most influential factors that effect a bond's price are yield, prevailing interest rates and the bond rating. Essentially a bond's yield is the present value of its cash flows, which are equal to the principal amount and all the remaining coupons.

The yield is the discount rate of the cash flows. Therefore a bond's price reflect the value of the yield left within the bond. The higher the coupon total remaining, the higher the price.

Inflation is yet another cause. It produces higher interest rate, which in turn requires a higher discount, thereby decreasing a bond's price.

Bonds with a longer maturity see a more drastic lowering in price in this event because, additionally, these bonds face inflation and interest rate risks over a longer period of time, increasing the discount rate needed to value the future cash flows. Meanwhile, falling interest rates cause bond yields to also fall, thereby increasing a bond's price.

When interest rate falls, bond price increases. This is because when interest rates rise, investors can get a better rate of return elsewhere, so the price of original bonds adjust downward to yield at the current rate.

Credit risk also contributes to a bond's price. Bonds are rated by independent credit ratings agencies. Bonds with higher risks and lower credit ratings are considered speculative and come with higher yields and lower prices. If a credit rating agency lowers a particular bond's rating to reflect more risk, the bond's yield must increase and its price should drop.

To conclude we can say that the price of a bond adjusts to keep the bond competitive in light of current market interest rates.