Alternatives to bond's yield

CFA Level I FRA
#1

Dear all,

I have just started reading for Non-Current Liabilities (Schwesers Notes) and wish to make some clarifications pertaining to bond terminologies, in particular:

  • Bond yield;
  • Cost of debt and
  • Effective rate of interest

Question 1 : Are they the same? I recalled from my undergraduate days that cost of debt is the discount rate we utilise in discounting the debt’s future cash flows to present. From my reading thus far, bond yield seems to be the same as cost of bond (debt). Is bond yield fixed or it will change from time to time?

Question 2 : In addition, does the above bear any link with effective rate of interest?

Thanks and regards,

Ernest

#2

A bond’s YTM can change; almost any time the price of the bond changes, the YTM changes.

Thus, if you’re looking at the market value of a company’s debt, then the YTM (hence, the cost of debt) changes.

If you look at the book value of a company’s, and the company uses the effective interest rate method for amortizing primia and discounts, then the YTM won’t change; if the amortize premia/discounts straight line, then the YTM may change slightly.

#3

Thanks, can I come to the below conclusions:

Concusion 1: Effective rate of interest is used when pricing bonds; and the interest rate depend on various factors for example liquidty risk,investor’s risk appetite, timing of bond’s cash flows etc. This interest rate will then be the bond’s YTM which will change from time to time as market move i.e. change in market value of debt means YTM change.

Conclusion 2: When computing book values for bond liabilities, there are 2 methods in doing so:

  1. discounting the remaining cash flows from the bond at the market rate of interest @ issuance (i.e. YTM @ issuance)
  2. reducing the beginning book value of the bond liabilities by amortization premiums (for premium bonds) ;increasing the beginning book value of the bond liabilities by amortization discounts (for discount bonds)

Thanks.

#4

I came across one question in Schweser Notes - Topic is Non-Current Liabilities so asking on this same post… A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%. If the market rate changes to 8% and the bonds are carried at amortized cost, the book value of the bonds at the end of the first year will be:

A. $9,484,581. B. $9,661,279. c. $9,737,568. The answer is C 9737568… The explaination given is … 6. C The new book value = beginning book value + interest expense -coupon payment = $9,661,279 + $676,290 - $600,000 = $9,737,569. Alternatively, changing N from 4 to 3 and calculating the PV will yield the same result. The change in market rates will not affect amortized costs. My question is … While I read the answer… I dont understand where have they incorporated the change in market rate to 8% in the answer… Because all the calculation is done with 7% rate… like 9,661,279*7% = 676,290 and 600,000 is coupon at 6%… Does it mean when market rate change…that change will not impact amortized cost and book value of bond ?

#5

From what I understand from Schweser Notes and guidance from S2000magician, the change in market rate of interest will not affect the book value of the bond liabilities. The book value of the bond liabilities (on the balance sheet) is based on the market rate of interest @ issuance.

*edited: I think what I mentioned earlier does not really hold true; I was reading the notes and it mention about fair value reporting option; in which case the change in interest rate will affect the bond values.*

#6

That’s exactly what it means. The book value depends only on the YTM when the bonds were issued.