Question Of The Week

FAR: Bonds

In Year 1, Lee Co. acquired, at a premium, Enfield, Inc. 10-year bonds as a long-term investment. At December 31, Year 2, Enfield's bonds were quoted at a small discount. Which of the following situations is the most likely cause of the decline in the bonds' market value?

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A. Enfield issued a stock dividend.
B. Enfield is expected to call the bonds at a premium, which is less than Lee's carrying amount.
C. Interest rates have declined since Lee purchased the bonds.
D. Interest rates have increased since Lee purchased the bonds.

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Explanation

When bonds are issued, they have a stated coupon rateThe interest rate printed on a bond. This rate represents the amount of cash the investor will receive in each payment. that remains constant over the bond's life. For bonds to be competitively priced with investments providing better returns, the price is adjusted to effectively yield the market rateThe actual rate of interest the issuer pays on a bond based on the issue price. The effective rate is often called the market rate of interest or yield..

This creates an inverse relationship between market interest rates and bond prices. As market rates increase, the bond price decreases and vice versa.

When a bond's stated rate is greater than the market rate (ie, 10% coupon > 8% market rate), it is priced at a premium.
When the stated rate is below the market rate (ie, 12% market rate > 10% coupon), it is priced at a discount.

Lee Co. purchased Enfield, Inc.'s 10-year bonds at a premiumThe difference between a bond's par value and the actual cash received when the market rate is less than the bond's stated rate. in Year 1, indicating the bonds' coupon rate was higher than the market rate. By the end of Year 2, the bond's market value (ie, price) declined. Increased market rates make fixed rate bonds less attractive to investors who can get better returns from other investments, resulting in the bond's price being quoted at a discount The difference between the par value of a bond and the actual cash received when the market rate is greater than the bond's stated rate. (Choice C).

(Choice A) Issuing a stock dividend impacts the stock's value, not the bond's value.

(Choice B) If Enfield calls the bonds (ie, buys back the bonds prior to maturity) at a premium, this indicates an increase in the bond's value.

Things to remember:
For bonds to be competitively priced with investments providing better returns, the price is adjusted to effectively yield market rate. This creates an inverse relationship between market interest rates and bond prices. As market rates increase, the bond price decreases and vice versa.

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