Question

Explain the two concepts:

The coupon rate depends on the risk characteristics of the bond when issued.

The impact of inflation rate on interest rates.

Answer 1

The coupon rate depends on the risk characteristics of the bond when issued.

Answer:

The bond coupon risk is combination of real rate, inflation rate, credit or default risk premium and other risks.

Formula:

Coupon rate or Interest rate of corporate bond = Real rate + Inflation rate + Default risk premium + Maturity risk premium

The sovereign bonds or government or treasury bonds generally don’t have risk of default however, case is not same with corporate bonds they have default risk. The investors demand for risk premium from the corporate bonds depending upon the risky of the corporate or repayment ability of the corporate. The investors analyze risk characteristics of corporate bonds and demand the risk premium to get adequate reward for taking such risk.

The impact of inflation rate on interest rates.

Answer:

Inflation rate is driven by economy of the particular nation and investors who invest to earn interest they demand for adequate compensating interest which covers the inflation rate in the market hence, interest rates are positively related to inflation rate.

Inflation rate is additive (check the formula) to the interest rate of corporate bonds hence, if inflation rates are increasing the overall interest rate will go up and if inflate rates are decreasing the overall interest rates will go down.

Please comment if any more clarification is required.