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Chapter Three
Fixed Income Securities

3.1 Introduction
A debt security is a claim on a specified periodic stream of income. Debt securities are
often called fixed-income securities because they promise either a fixed stream of income or one
that is determined according to a specified formula. These securities have the advantage of being
relatively easy to understand because the payment formulas are specified in advance. Uncertainty
about their cash flows is minimal as long as the issuer of the security is sufficiently creditworthy.

3.2 Bond Characteristics

Abond is the basic debt security that is issued in connection with a borrowing
arrangement. The borrower issues (i.e., sells) a bond to the lender for some amount of cash; the
bond is the“IOU”(abbreviated from the phrase "I owe you") of the borrower. The arrangement
obligates the issuer to make specified paymentsto the bondholder on specified dates. A typical
coupon bond obligates the issuer to makesemiannual payments of interest to the bondholder for
the life of the bond. These are calledcoupon payments.When the bond matures, the issuerrepays
the debt by paying the bond’s par value (equivalently, its face value). The couponrate of the
bond determines the interest payment: The annual payment is the coupon ratetimes the bond’s
par value. The coupon rate, maturity date, and par value of the bond arepart of the bond
indenture, which is the contract between the issuer and the bondholder that sets forth the
promises of a corporate bond issuer and the rights of investors.
To illustrate, a bond with par value of $1,000 and coupon rate of 8% might be sold to
abuyer for $1,000. The bondholder is then entitled to a payment of 8% of $1,000, or $80 peryear,
for the stated life of the bond, say, 30 years. The $80 payment typically comes in twosemiannual
installments of $40 each. At the end of the 30-year life of the bond, the issueralso pays the
$1,000 par value to the bondholder.
Bonds usually are issued with coupon rates set just high enough to induce investors to
pay par value to buy the bond. Sometimes, however, zero-coupon bonds are issued that make no
coupon payments. In this case, investors receive par value at the maturity date but receive no
interest payments until then because the bond has a coupon rate of zero. These bonds are issued
at prices considerably below par value, and the investor’s return comes solely from the
difference between issue price and the payment of par value at maturity.

Treasury Bonds and Treasury Notes: Treasury notes are issued with original maturities
ranging between 1 and 10 years, while Treasury bonds are issued with maturities ranging from
10 to 30 years. Both bonds and notes may be purchased directly from the Treasury in
denominations of only $100, but denominations of $1,000 are far more common. Both make
semiannual coupon payments.

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Accrued Interest and Quoted Bond Prices:The bond prices that you seequoted in the financial
pages(the part of a newspaper that has financial information) are not actually the prices that
investors pay for the bond.This is because the quoted price does not include the interest that
accrues between couponpayment dates.If a bond is purchased between coupon payments, the
buyer must pay the seller foraccrued interest, the prorated share of the upcoming semiannual
coupon.In general, the formula for the amount of accrued interest between two dates is:
Annual coupon payment Days since last coupon payment
Accrued interest = ×
2 Days∈the coupon period

Example-1: Accrued Interest:If 30 days have passed since the last coupon payment, and there
are 182 days in the semiannual coupon period, the seller is entitled to a payment of accrued
interest of 30/182 of the semiannual coupon.Suppose that the coupon rate is 8%. Then the annual
coupon is $80 and the semiannual coupon payment is $40. Because 30 days have passed since
the last coupon payment, the accrued interest on the bond is $40x (30/182) = $6.59. The sale, or
invoice, price of the bond would equal the stated price (sometimes called the flat price) plus the
accrued interest. If the quoted price of the bond is $990, then the invoice price will be $990 +
$6.59 = $996.59.
The practice of quoting bond prices net of accrued interest explains why the price ofa
maturing bond is listed at $1,000 rather than $1,000 plus one coupon payment. A purchaserof an
8% coupon bond 1 day before the bond’s maturity would receive $1,040 (parvalue plus
semiannual interest) on the following day and so should be willing to pay a totalprice of $1,040
for the bond. The bond price is quoted net of accrued interest in the financialpages and thus
appears as $1,000. In contrast to bonds, stocks do not trade at flat prices with adjustments for
“accrued dividends.” Whoever owns the stock when it goes “ex-dividend” receives the entire
dividend payment, and the stock price reflects the value of the upcoming dividend. The price
therefore typically falls by about the amount of the dividend on the “ex-day.” There is no need to
differentiate between reported and invoice prices for stocks.

Corporate Bonds: Like the government, corporations borrow money by issuing bonds.
Although some bonds tradeelectronically on the NYSE Bonds platform, most bonds are traded
over-the-counter ina network of bond dealers linked by a computer quotation system. In practice,
the bond market can be quite “thin,” with few investors interested in trading a particular issue at
any particular time.

Call Provisions on Corporate Bonds:Some corporate bonds are issued with call provisions
allowing the issuer to repurchase the bond at a specified call price before the maturity date. For
example, if a company issues a bond with a high coupon rate when market interest rates are high,
and interest rates later fall, the firm might like to retire the high-coupon debt and issue new
bonds at a lower coupon rate to reduce interest payments. This is called refunding. Callable
bonds typically come with a period of call protection, an initial time during which the bonds are
not callable. Such bonds are referred to as deferred callable bonds. The option to call the bond is

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valuable to the firm, allowing it to buy back the bonds and refinance at lower interest rates when
market rates fall. Of course, the firm’s benefit is the bondholder’s burden. Holders of called
bonds must forfeit their bonds for the call price, thereby giving up the attractive coupon rate on
their original investment. To compensate investors for this risk, callable bonds are issued with
higher coupons and promised yields to maturity than noncallable bonds.
CONCEPT CHECK-1: Suppose that Verizon issues two bonds with identical coupon rates and
maturity dates. One bond is callable, however, whereas the other is not. Which bond will sell at a
higher price?

Puttable Bonds:While the callable bond gives the issuer the option to extend or retire the bond
at the call date, the extendable or put bond gives this option to the bondholder. If the bond’s
coupon rate exceeds current market yields, for instance, the bondholder will choose to extend the
bond’s life. If the bond’s coupon rate is too low, it will be optimal not to extend; the bondholder
instead reclaims principal, which can be invested at current yields.

Convertible Bonds:Convertible bonds give bondholders an option to exchangeeach bond for a

specified number of shares of common stock of the firm. The conversionratio is the number of
shares for which each bond may be exchanged. Suppose a convertiblebond is issued at par value
of $1,000 and is convertible into 40 shares of a firm’sstock. The current stock price is $20 per
share, so the option to convert is not profitablenow. Should the stock price later rise to $30,
however, each bond may be converted profitablyinto $1,200 worth of stock. The market
conversion value is the current value ofthe shares for which the bonds may be exchanged. At the
$20 stock price, for example,the bond’s conversion value is $800. The conversion premium is the
excess of the bondvalue over its conversion value. If the bond were selling currently for $950, its
premiumwould be $150.Convertible bondholders benefit from price appreciation of the
company’s stock.Again, this benefit comes at a price: Convertible bonds offer lower coupon
rates and statedor promised yields to maturity than do nonconvertible bonds. However, the actual
returnon the convertible bond may exceed the stated yield to maturity if the option to
convertbecomes profitable.

Floating-Rate Bonds:Floating-rate bonds make interest payments that are tied to some
measure of current market rates. For example, the rate might be adjusted annually to the current
T-bill rate plus 2%. If the 1-year T-bill rate at the adjustment date is 4%, the bond’s coupon rate
over the next year would then be 6%. This arrangement means that the bond always pays
approximately current market rates. The major risk involved in floaters has to do with changes in
the firm’s financial strength. The yield spread is fixed over the life of the security, which may be
many years. If the financial health of the firm deteriorates, then investors will demand a greater
yield premium than is offered by the security. In this case, the price of the bond will fall.
Although the coupon rate on floaters adjusts to changes in the general level of market interest
rates, it does not adjust to changes in the financial condition of the firm.

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Preferred Stock: Although preferred stock strictly speaking is considered to be equity, it often
is included in the fixed-income universe. This is because, like bonds, preferred stock promises to
pay a specified stream of dividends. However, unlike bonds, the failure to pay the promised
dividend does not result in corporate bankruptcy. Instead, the dividends owed simply cumulate,
and the common stockholders may not receive any dividends until the preferred stockholders
have been paid in full. In the event of bankruptcy, preferred stockholders’ claims to the firm’s
assets have lower priority than those of bondholders but higher priority than those of common
stockholders. Preferred stock commonly pays a fixed dividend. Therefore, it is in effect a
perpetuity, providing a level cash flow indefinitely. In contrast, floating-rate preferred stock is
much like floating-rate bonds. The dividend rate is linked to a measure of current market interest
rates and is adjusted at regular intervals. Unlike interest payments on bonds, dividends on
preferred stock are not considered tax-deductible expenses to the firm. This reduces their
attractiveness as a source of capital to issuing firms. On the other hand, there is an offsetting tax
advantage to preferred stock. When one corporation buys the preferred stock of another
corporation, it pays taxes on only 30% of the dividends received. For example, if the firm’s tax
bracket is 35%, and it receives $10,000 in preferred-dividend payments, it will pay taxes on only
$3,000 of that income: Total taxes owed on the income will be .35 x $3,000 = $1,050. The
firm’seffective tax rate on preferred dividends is therefore only .30 x 35% = 10.5%. Given
thistax rule, it is not surprising that most preferred stock is held by corporations.Preferred stock
rarely gives its holders full voting privileges in the firm. However, ifthe preferred dividend is
skipped, the preferred stockholders may then be provided somevoting power.

Other Domestic Issuers: There are, of course, several issuers of bonds in addition to the
Treasury and private corporations.For example, state and local governments issue municipal
bonds. The outstandingfeature of these is that interest payments are tax-free.

International Bonds: International bonds are commonly divided into two categories, foreign
bonds andEurobonds. Foreign bonds are issued by a borrower from a country other than the one
inwhich the bond is sold. The bond is denominated in the currency of the country in whichit is
marketed. For example, if a German firm sells a dollar-denominated bond in theUnited States,
the bond is considered a foreign bond. These bonds are given colorful namesbased on the
countries in which they are marketed. For example, foreign bonds sold in theUnited States are
called Yankee bonds. Like other bonds sold in the United States, they areregistered with the
Securities and Exchange Commission. Yen-denominated bonds soldin Japan by non-Japanese
issuers are called Samurai bonds. British pound-denominatedforeign bonds sold in the United
Kingdom are called bulldog bonds.In contrast to foreign bonds, Eurobonds are denominated in
one currency, usually thatof the issuer, but sold in other national markets. For example, the
Eurodollar market refersto dollar-denominated bonds sold outside the United States (not just in
Europe), althoughLondon is the largest market for Eurodollar bonds. Because the Eurodollar
market fallsoutside U.S. jurisdiction, these bonds are not regulated by U.S. federal agencies.

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Similarly,Euroyen bonds are yen-denominated bonds selling outside Japan, Eurosterling bonds
are pound-denominated Eurobonds selling outside the United Kingdom, and so on.

3.3 Pricing Bonds

Because a bond’s coupon and principal repayments all occur months or years in the
future, the price an investor would be willing to pay for a claim to those payments depends on
the value of dollars to be received in the future compared to dollars in hand today. This “present
value” calculation depends in turn on market interest rates. The nominal risk-free interest rate
equals the sum of (1) a real risk-free rate of return and (2) a premium above the real rate to
compensate for expected inflation. In addition, because most bonds are not riskless, the discount
rate will embody an additional premium that reflects bond-specific characteristics such as default
risk, liquidity, tax attributes, call risk, and so on.We simplify for now by assuming there is one
interest rate that is appropriate for discounting cash flows of any maturity, but we can relax this
assumption easily. In practice, there may be different discount rates for cash flows accruing in
different periods. For the time being, however, we ignore this refinement.To value a security, we
discount its expected cash flows by the appropriate discountrate. The cash flows from a bond
consist of coupon payments until the maturity date plusthe final payment of par value. Therefore,
Bond value=Present value of coupons + Present value of par value
If we call the maturity date T and call the interest rate r, the bond value can be written as:
T
Coupon Par value
Bond value=∑ t
+
t=1 (1+r ) (1+r )T
The summation sign in the above equation directs us to add the present value of each
coupon payment; each coupon is discounted based on the time until it will be paid. The first term
on the right-hand side of the equation is the present value of an annuity. The second term is the
present value of a single amount, the final payment of the bond’s par value. You may recall from
an introductory finance class that the present value of a $1 annuity that lasts for T periods when
1
[
the interest rate equals r is r 1−
1
( 1+ r) ]
T . We call this expression the T -period annuity factor

1
for an interest rate of r. Similarly, we call T the PV factor, that is, the present value of a
(1+r )
single payment of $1 to be received in T periods. Therefore, we can write the price of the bond
as:

Price=Coupon × 1−
[
1
r
1
]
( 1+r ) T
+ Par value ×
1
( 1+r )T
¿ Coupon× Annuity factor ( r , T ) + Par value × PV factor (r , T )

Example-2: Bond Pricing: Assume an 8% coupon, 30-year maturity bond with par value of
$1,000 paying 60 semiannual coupon payments of $40 each. Suppose that the interest rate is 8%
annually, or r = 4% per 6-month period. Then the value of the bond can be written as:

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Price=$ 40×
1
0.04 [
1−
1
(1.04 ) 60
]+ $ 1,000 ×
1
( 1.04 )60
=$ 904.94 + $ 95.06=$ 1,000

¿ $ 40 × Annuity factor ( 0.4 , 60 ) + $ 1,000 × PV factor (0.4 , 60)

In this example, the coupon rate equals the market interest rate, and the bond priceequals
par value. If the interest rate were not equal to the bond’s coupon rate, the bondwould not sell at
par value. For example, if the interest rate was to rise to 10% (5% per6 months), the bond’s price
would fall by $189.29 to $810.71, as follows:
Bond Price = $40 x Annuity factor(5%, 60) + $1,000 x PV factor(5%, 60)
= $757.17 + $53.54 = $810.71
At a higher interest rate, the present value of the payments to be received by the
bondholder is lower. Therefore, bond prices fall as market interest rates rise. This illustrates a
crucial general rule in bond valuation. You should not confuse the bond’s coupon rate, which
determines the interest paid to the bondholder, with the market interest rate. Once a bond is
issued, its coupon rate is fixed. When the market interest rate increases, investors discount any
fixed payments at a higher discount rate, which implies that present values and bond prices fall.
CONCEPT CHECK-2: Calculate the price of the 30-year, 8% coupon bond for a market
interest rate of 3% per half-year. Compare the capital gains for the interest rate decline to the
losses incurred when the rate increases to 5%.

Corporate bonds typically are issued at par value. This means that the underwriters of the
bond issue (the firms that market the bonds to the public for the issuing corporation) must choose
a coupon rate that very closely approximates market yields. In a primary issue, the underwriters
attempt to sell the newly issued bonds directly to their customers. If the coupon rate is
inadequate, investors will not pay par value for the bonds. After the bonds are issued,
bondholders may buy or sell bonds in secondary markets. In these markets, bond prices fluctuate
inversely with the market interest rate. The inverse relationship between price and yield is a
central feature of fixed income securities. Interest rate fluctuations represent the main source of
risk in the fixed-income market. As a general rule, keeping all other factors the same, the longer
the maturity of the bond, the greater the sensitivity of price to fluctuations in the interest rate.
This is why short-term Treasury securities such as T-bills are considered to be the safest. They
are free not only of default risk but also largely of price risk attributable to interest rate volatility.

Bond Pricing between Coupon Dates

In principle, the fact that the bond is between coupon dates does not affect the pricing
problem. The procedure is always the same: Compute the present value of each remaining
payment and sum up. But if you are between coupon dates, there will be fractional periods
remaining until each payment, and this does complicate the arithmetic computations. As we
pointed out earlier, bond prices are typically quoted net of accrued interest. These prices, which
appear in the financial press, are called flat prices. The actual invoice price that a buyer pays for
the bond includes accrued interest. Thus,

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InvoicePrice=FlatPrice + Accrued interest

When a bond pays its coupon, flat price equals invoice price, because at that moment
accrued interest reverts to zero. However, this will be the exceptional case, not the rule.

3.4 Bond Yields

Most bonds do not sell for par value. But ultimately, barring default, they will mature to
par value. Therefore, we would like a measure of rate of return that accounts for both current
income and the price increase or decrease over the bond’s life. The yield to maturity is the
standard measure of the total rate of return. However, it is far from perfect, and we will explore
several variations of this measure.

Yield to Maturity
In practice, an investor considering the purchase of a bond is not quoted a promised rate
of return. Instead, the investor must use the bond price, maturity date, and coupon payments to
infer the return offered by the bond over its life. The yield to maturity (YTM) is defined as the
interest rate that makes the present value of a bond’s payments equal to its price. This interest
rate is often interpreted as a measure of the average rate of return that will be earned on a bond if
it is bought now and held until maturity. To calculate the yield to maturity, we solve the bond
price equation for the interest rate given the bond’s price.
Example-3: Yield to Maturity:Suppose an 8% coupon, 30-year bond is selling at $1,276.76.
What average rate of return would be earned by an investor purchasing the bond at this price?
We find the interest rate at which the present value of the remaining 60 semiannual payments
equals the bond price. This is the rate consistent with the observed price of the bond. Therefore,
we solve for r in the following equation:

$ 1,276.76=$ 40 × 1−
[
1
r
1
( 1+r )]60
+ $ 1,000 ×
1
( 1+r )60
$ 1,276.76=$ 40 × Annuity factor ( r , 60 ) + $ 1,000 × PV factor (r , 60)
These equations have only one unknown variable, the interest rate, r. You can use a
financial calculator or spreadsheet to confirm that the solution is r = .03, or 3%, per half-year.
This is the bond’s yield to maturity.
The financial press reports yields on an annualized basis, and annualizes the
bond’ssemiannual yield using simple interest techniques, resulting in an annual percentagerate,
or APR. Yields annualized using simple interest are also called “bond equivalentyields.”
Therefore, the semiannual yield would be doubled and reported in the newspaperas a bond
equivalent yield of 6%. The effective annual yield of the bond, however,accounts for compound
interest. If one earns 3% interest every 6 months, then after1 year, each dollar invested grows
with interest to $1x(1.03)2 = $1.0609, and theeffective annual interest rate on the bond is 6.09%.
The bond price used in the function should be the reported flat price, without accrued
interest.The bond’s yield to maturity is the internal rate of return on an investment in the bond.
The yield to maturity can be interpreted as the compound rate of return over the life of the bond
under the assumption that all bond coupons can be reinvested at that yield. If the reinvestment

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rate does not equal the bond’s yield to maturity, the compound rate of return will differ from
YTM. Yield to maturity is widely accepted as a proxy for average return.
Yield to maturity differs from the current yield of a bond, which is the bond’s annual
coupon payment divided by the bond price. For example, for the 8%, 30-year bond currently
selling at $1,276.76, the current yield would be $80/$1,276.76 = .0627, or 6.27%, per year. In
contrast, recall that the effective annual yield to maturity is 6.09%. For this bond, which is
selling at a premium over par value ($1,276 rather than $1,000), the coupon rate (8%) exceeds
the current yield (6.27%), which exceeds the yield to maturity (6.09%). The coupon rate exceeds
current yield because the coupon rate divides the coupon payments by par value ($1,000) rather
than by the bond price ($1,276). In turn, the current yield exceeds yield to maturity because the
yield to maturity accounts for the built-in capital loss on the bond; the bond bought today for
$1,276 will eventually fall in value to $1,000 at maturity. For premium bonds (bonds selling
above par value), coupon rate is greater than current yield, which in turn is greater than yield to
maturity. For discount bonds (bonds selling below par value), these relationships are reversed
(see Concept Check-3).It is common to hear people talking loosely about the yield on a bond. In
these cases,they almost always are referring to the yield to maturity.
CONCEPT CHECK-3: What will be the relationship among coupon rate, current yield, and
yield to maturity for bonds selling at discounts from par? Illustrate using the 8% (semiannual
payment) coupon bond, assuming it is selling at a yield to maturity of 10%.

Yield to Call
Yield to maturity is calculated on the assumption that the bond will be held until
maturity.What if the bond is callable, however, and may be retired prior to the maturity date?
Howshould we measure average rate of return for bonds subject to a call provision?Now
consider a bond that has the same coupon rate and maturity date but is callableat 110% of par
value, or $1,100. When interest rates fall, the present value of the bond’sscheduled payments
rises, but the call provision allows the issuer to repurchase the bond atthe call price. If the call
price is less than the present value of the scheduled payments, theissuer may call the bond back
from the bondholder.This analysis suggests that bond market analysts might be more interested
in a bond’s yield to call rather than yield to maturity, especially if the bond is likely to be called.
The yield to call is calculated just like theyield to maturity except that the time until call replaces
time until maturity, and the call price replaces the par value. This computation is sometimes
called “yield to first call,”as it assumes the issuer will call the bond assoon as it may do so.
Example-4: Yield to Call:Suppose the 8% coupon, 30-year maturity bond sells for $1,150 and
is callable in10 years at a call price of $1,100. Its yield to maturity and yield to call would be
calculated using the following inputs:
Yield to Call Yield to Maturity
Coupon payment $40 $40
Number of semiannual periods 20 periods 60 periods
Final payment $1,100 $1,000
Price $1,150 $1,150

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Yield to call is then 6.64%. [To confirm this on a calculator, input n = 20; PV = (-)1150;
FV = 1100; PMT = 40; compute i as 3.32%, or 6.64% bond equivalent yield.]Yield to maturity is
6.82%. [To confirm, input n = 60; PV =(-)1150; FV = 1000;PMT = 40; compute i as 3.41% or
6.82% bond equivalent yield.]
We have noted that most callable bonds are issued with an initial period of call
protection. In addition, an implicit form of call protection operates for bonds selling at deep
discounts from their call prices. Even if interest rates fall a bit, deep-discount bonds still will sell
below the call price and thus will not be subject to a call. Premium bonds that might be selling
near their call prices, however, are especially apt to be called if rates fall further. If interest rates
fall, a callable premium bond is likely to provide a lower return than could be earned on a
discount bond whose potential price appreciation is not limited by the likelihood of a call.
Investors in premium bonds therefore may be more interested in the bond’s yield to call than its
yield to maturity because it may appear to them that the bond will be retired at the call date.
CONCEPT CHECK-4:
a.The yield to maturity on two 10-year maturity bonds currently is 7%. Each bond has a call
price of $1,100. One bond has a coupon rate of 6%, the other 8%. Assume for simplicity that
bonds are called as soon as the present value of their remaining payments exceeds their call
price. What will be the capital gain on each bond if the market interest rate suddenly falls to 6%?
b.A 20-year maturity 9% coupon bond paying coupons semiannually is callable in 5 years at a
call price of $1,050. The bond currently sells at a yield to maturity of 8%. What is the yield to
call?

3.5 Risks in Bond

Investing in debt securities is generally considered less risky than investing in equity
securities, but bondholders still face a number of risks. These risks include credit risk,
interest rate risk, inflation risk, liquidity risk, reinvestment risk, and call risk. A change
in a bond’s risk will affect its required rate of return and its price. The required rate of
return can be thought of as the yield to maturity required by an investor. Riskier bonds
typically have higher yields to maturity, reflecting the higher required rate of return.

Interest Rate Risk: Interest rate risk is the risk that interest rates will change. Interest rate risk
usually refers to the risk associated with decreases in bond prices resulting from increases in
interest rates. This risk is particularly relevant to fixed-rate bonds and zero-coupon bonds. Bond
prices and interest rates are inversely related; that is, bond prices increase as interest rates
decrease and bond prices decrease as interest rates increase.
Credit Risk: Sometimes referred to as default risk, is the possibility of a bond issuer failing to
repay the principal and interest in a timely manner.
Reinvestment Risk: The reinvestment risk applies to the risk of achieving lower returns on an
investment than before. This risk is apparent more in the case of callable bonds. As the issuer can
call these bonds back before maturity and it may happen that the reissued bond may not provide
the same returns to the investor as the previous one.

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Inflation Risk: Nearly all debt securities expose investors to inflation risk because the promised
interest payments and final principal payment from most debt securities are nominal amounts—
that is, the amounts do not change with inflation. Unfortunately, as inflation makes products and
services more expensive over time, the purchasing power of the coupon payments and the final
principal payment on most bonds declines.Floating-rate bonds partially protect against inflation
because the coupon rate adjusts. They provide no protection, however, against the loss of
purchasing power of the principal payment. Investors who are concerned about inflation and
want protection against it may prefer to invest in inflation-linked bonds, which adjust the
principal (par) value for inflation. Because the coupon payment is based on the par value, the
coupon payment also changes with inflation.
Liquidity Risk: It refers to the risk of being unable to sell a bond prior to the maturity date
without having to accept a significant discount to market value. Bonds that do not trade very
frequently exhibit high liquidity risk. Investors who want to sell their relatively illiquid bonds
face higher liquidity risk than investors in bonds that trade more frequently

3.6 Ratings of Bonds

Bond ratings are critical to a company's ability to issue debt at an acceptable interest rate.
The credit rating agency evaluates the credit worthiness of a company or an individual
considering a variety of factors like their assets, liabilities, past history etc.A typical rating
system is shown in the table below:

Unrated debt is extremely difficult, if not impossible to sell. Corporations desiring to sell bonds
must submit their proposals to an independent rating company like Moody's Investor Service or
Standard & Poor’s Corporation for the debt to be assigned a rating. This rating, coupled with
market rates of interest and the special features of the debt, will determine how much the
company will have to pay in interest.
Any time new information relevant to the company's ability to repay the debt (i.e.
changes in the company's financial health) is discovered and determined to be of sufficient
impact, that company's debt rating might be changed. Obviously, good information should result
in a better rating or upgrade and bad information should result in a downgrade.
Bonds of companies that suffered downgrades would decline in value to equate the yield
to the new level of risk. Conversely, bonds that were upgraded should increase in price. Bond
ratings are important for firms raising capital via a debt offering. Companies that are financially

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sound enough to get a higher rating will be able to sell debt with lower interest payments than
their riskier counterparts. Bond rating agencies also actively monitor outstanding debt they have
rated for changes in status. Companies placed on watchlists are companies who are facing
potential changes in the rating of their debt.

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