When bonds change in value depending on the going market rate of interest, compa

Question

When bonds change in value depending on the going market rate of interest, companies are permitted, but not required, to recognize changes in value of such liabilities. Under what conditions would a company want to recognize such changes? What are the reporting requirements when such changes are recognized?

Specific rules dictate the process and judgment for determining fair value. If a company's debt is traded in a public market, what should the valuation be based on? If the debt does not have a clearly determinable market, how should the valuation be calculated?

Explanation / Answer

the bond price and interest rate have inverse relationship ans when the price of the bond increase the interest rate goes lower. And how to effects the

A company that issued debt prior to an upside/downside) in market rates experiences an economic gain (or loss) when the rates change. This economic gain or loss is not reflected in a company's financial statement. Market-value changes will not appear on the income statement or balance sheet. As a result, the book value of a company's debt will not be equal to its market value. From a company valuation point of view, the book value of equity (total assets - liability) will not reflect the current economic reality. With this if we compared two companies - one that issues $1m in debt at 10% and another that issues the same debt amount at 8% three months later - the debt-to-equity ratio of both companies will be the same. However, the company that issued the debt at a lower rate will be in a much better financial position. Times interest earned and other ratios will enable an analyst to uncover these differences.

What if rates go up?

Now let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying an 8% coupon—or $80 a year in interest—buyers will be reluctant to pay the $1,000 face value for your 7% ABC Company bond. In order to sell, you'd have to offer your bond at a lower price—a discount—that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875.1

When rate falls

if rates dropped to below your original coupon rate of 9%, your bond would be worth more than $1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.1

Of course, many other factors go into determining the attractiveness of a particular bond: the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. But the important thing to remember is that change occurs in market interest rates virtually every day. The movement of bond prices and bond yields is simply a reaction to that change.

1. for examples assumes a 9% coupon, $1,000 face value, and a 10-year maturity. The illustration is approximate and is not intended to represent the return of any particular bond or bond fund.

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