Recent economic data suggest that australian banks have raised their mortgage interest rates, because of an...

Recent economic data suggest that australian banks have raised their mortgage interest rates, because of an increase in the cost of borrowing in international capital markets such as the USA and Europe. Assume that the required returns on the Woolworths have increased from 12% to 15%. What impact will this have on the bond value? Explain (no calculations)

Expert Solution

Interest rate and bond value have an inverse relationship; so when on goes up, the other goes down and vice versa.

So let’s understand the concept behind this one:

Investors always compare and search for new investment opportunities in market and when interest rate hike up many new companies will offer bonds with higher rate and bond with fixed rate issued previously becomes less attractive to them. Investors will go for new opportunities as they will get more earning on that one and due to that unattractiveness nobody wants to pay same amount for one less attractive bond.

Example: x company issued new bond with face value 1000 offering coupon rate of 5% per annum this means it would pay 50 per annum as interest. Mr. A purchased those bonds at par value. Now after some time interest rate goes up and new bonds with coupon rate of 7% per annum issued by another company. It means that new bond will pay 70 per annum as interest to the investors. In order to invest in new bonds Mr. A have to sell X Company’s bonds so that he can earn more. Other investors in market also have knowledge that another bond with same price gives more interest compare to x company’s bond. In order to sell X company’s bonds Mr. A have to offer his bonds at lower price – a discounted price - that would enable new investor to generate approximately 7% to the new owner.

In this case required rate of return have increase significantly so bond value will be reduced. Since coupon rate of existing bonds will be fixed till maturity. Investor will search for bond with higher yield and existing bond holders have to sell their bonds at lower rate in order to attract investors. So price of existing bonds will go down.

ekkarill92 answered 5 months ago

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