By Aidan Hackett. Edited by Arjun Chandrasekar.
Bonds are instruments of debt. Companies use bonds as a way to raise capital without diluting shareholders equity. To a business, a bond is a gamble that a certain project will yield enough return to pay back investors, and for investors, bonds are a tool to limit risk and create more stable flows of income.
As is well known, debt is usually funded by banks, and the cost for taking on this debt (taking the bank’s money) is the interest you pay to the bank. Consider a company that wanted to raise $10 million of debt. The first option they have is to go to a bank and pay them interest. Think of this, in effect, as the bank taking on one massive, a big bond from this company. The second thing a company can do is issue bonds, in this case, the bonds would probably be valued at $1,000, and 10,000 bonds would be offered.
Consider what the business would be willing to pay the investors in coupon payments each year (remember, “coupon” is the bond term for interest). If they could get 4% p.a. at the bank, there is no reason they should be willing to pay any more to the investors buying the bonds. Because of this reasoning, the coupon payments a bond pays out to investors will usually roughly equate to the amount of money a company with a similar risk profile will pay to a bank. The Fed has large control over all bond prices due to its control of interest rates.
By extension, if interest rates rise, coupon rates will rise, and if interest falls, coupon rates will fall. Consider a bond with a 4% coupon that costs $1,000 to buy. If interest rises and the current going rate for a bond with the same risk profile is 5%, the 4% bond will now be worthless – a buyer wants it cheaper if they are only getting 4% on $1,000 initially invested (consider the fact they would probably want their payments on that bond roughly be 5%. They may be willing to pay somewhere in the region of $800 for that 4% bond). The same is true for the flipside. If the going coupon rate for a bond were to drop to 2%, then the bond price will rise, in this case, almost double its value. Keep in mind, these examples were assuming the change in interest rates happened very soon after purchase. The price behavior will change the older/closer to maturity the bond is.
The risk profile of the bond
Company A decides to raise some money by issuing bonds. In the past, this company has gone bankrupt, as well as been suspected of some shady dealings. Because of this, investors have reason to believe that the chance of the company going under is high. Company B is a company with a very strong track record, enough cash to cover any major expenses in the short term, and overall, is in good financial shape. Investors think that Company b is going to be here for many years to come. Which company would you be willing to lend money to? Company B is the obvious choice, ceteris paribus. So how would company A raise money? They would offer a “sweeter deal”. By offering a higher coupon rate on their bonds, Company A is now able to raise money, compensating their investors accordingly for their extra risk assumed by lending money to them.
Within companies, there can be different bonds with different coupon rates. Ratings agencies such as Moody’s and S&P assess bonds and give them a risk ranking (terminology varies, but it is generally a progression from AAA to B, below B is “junk”). A company may offer AA bonds and promise to pay off those holders first if anything happens. They may then offer some B+ bonds, promising holders a split of whatever cash is left over at the end of the bankruptcy proceedings. Because of the extra risk assumed, B+ investors are compensated accordingly with higher coupon payments.
Risk influencing bond prices has a lot to do with supply and demand, and a company’s ability to manipulate it by “changing the deal” an investor gets. When the bond has a higher coupon rate, the deal is better to the investors, and so the demand rises. This is also true for pricing. If all of a sudden, a company becomes a lot better or a lot worse with their finances, the bond price can be affected. If a company is in a worse off position than it was when bonds were issued, then the price of the bonds will decrease at every price point. The demand for these bonds has decreased as now an investor can get bonds with the same risk profile and higher coupon rates, or with the same coupon rate and lower risk. This is related to the point on interest rates.
Bond price and bond coupon rates are the product of the same thing – supply and demand. This should come as no surprise as almost everything is a product of supply and demand. By “sweetening the deal” as we put it, companies can work to increase the supply and demand for their bond. Companies tend to have a lot of control over the coupon rate they offer with their bond at the time they issue it. After the bond is issued, however, this supply and demand is open to the economy and market forces. Changes in interest rates, credit scores, and investor sentiment can all lead to changes in price of the bond, caused by the relative attractiveness of the yield.