As compared to the right issue, the fund collection through bonds or loan notes is cheaper and quicker for the management of the business. Investors can sale or purchase bonds or loan notes issued by the listed companies in the stock exchange or bond markets. Therefore, the issuing of bonds on short term or long term basis is the most attractive ways of raising funds. However, in the calculation or estimation of the bond face value and the coupon rate, the market interest rate plays an important role. There is a strong relationship between bond prices and market interest rates. If the interest rate is increasing, then the cost of the bond issued in the past, will decrease. Similarly, if the interest rates of the bonds are decreasing in the market, then the price of the bond, issued in the past will increase. (Patton)
The change in bond prices change due to the risk elements in the markets. There are different types of risk involved in calculating the WACC such as market risk, industry risk and most importantly inflation risks. When any of these risks increases, then the risk of investing in the business increases for the investors. Most importantly, it is out of the control of the management of any business to minimize or control the inflation risk and in these circumstances, management offers the issuing of bonds at a premium, convertible and at the floating rate to minimize the risk of the investors. Moreover, the internal gearing of the business also affect the bond rates. If the company is a highly geared company, then the investor will demand higher rates of return or higher premium value at redemption. Therefore, the investors take more interest in buying floating rate bonds or convertible bonds. Investors exercise the convertible option if the redemption amount is lower than the price of shares offered at the start of the loan. Similarly, floating rate bonds adjust the coupon rate, according to the interest rate in the stock market to minimize the risk of the investor. (Patton)
For example, a listed company issued the bond at the face value of $100 and the coupon or interest rate of that bond was 5%. This bond was redeemable at par after five years. This means that the total inflow expected by the investors over the five years is the initial investment of $100 and the 5% interest rate for five years which is $25. However, the interest rate in the market changes frequently and supposes that the interest rate increased from 5% to 6% at the end of second year. This increase in the rate of interest will decrease the value of the bond because the future cash inflows will be lower according to the current rate. Therefore, if the investor wants to sell that bond, then he must sell that bond lower than the total cash inflows of the future. In this case the total cash inflows for the remaining three years are initial investment of $100 and interest of three years which is $15. However, according to the current market rate the interest income from the bond must be $18 according to 6% rate. Therefore, the investor must accumulate the loss of $3 when selling the bond in the stock market. The buyer of that bond will collect $100 at the redemption and the $5 interest income per annum.
Patton, Mike. "Why Rising Interest Rates Are Bad For Bonds And What You Can Do About
It." Forbes. 30 Aug 2013:. Web. 22 Feb. 2014. <http://www.forbes.com/sites/mikepatton/2013/08/30/why-rising-interest-rates-are-bad-for-bonds-and-what-you-can-do-about-it/>.
Roth, Allan. "Why bonds lose value when interest rates rise."Money Watch. 3 Jun 2013:. Web.