Question

1. In 2008, one of your associates made a $100,000 investment in high-risk junk bonds of one of the marginal airlines in the US. The bonds had a stated interest rate of 14%, which was the market rate of these bonds when purchased. Over time, the fair value of these bonds has decreased, even though interest rates have decreased.

What has happened?

2. Dill Corporation, a publicly traded conglomerate, purchased in 2004 $50 million of the $100 million 30-year bond issue of Duff Inc. The bonds, which bear a stated interest rate of 6%, were purchased at par. When you examine the balance sheet of Dill, you noticed that the bonds are now listed at less than $50 million. You also noticed a reduction of total stockholders’ equity relating to these same bonds. However, when you looked at Duff’s balance sheet for the same date, those bonds were listed as a long-term liability of $100 million.

What on earth is going on here?

What does it mean that Dill has a reduction in stockholder’s equity for these bonds?

Answer 1

Interest rates have an inverse relationship with the price of the bonds. With the decrease in interest rates the value of bond increases and vice versa. It is all because the fixed payments of interest will be higher than the value of bonds issued at current rate of interest prevailing in the market.

Active investors regularly checks the fluctuations in the increase or decrease of their returns. They keep an eye on their current investment along with any other opportunity that is more fruitful at same price. If the prevailing rates change in the market it attracts the mind of investors either with a increase or decrease. the longer be the maturity of the bonds the higher be the price volatility.

It is all because the future cashflows that are paid are at distant time frame. If the rate of interest rises, those bonds with long term maturity are discounted and the price falls significantly. Higher interest brings in more payments before maturity than a bond with lower interest. The most price volatility bonds are the ones which have longer maturities.

Thus, the inverse relationship is defined. In the question given, there is direct relationship shown between the bond price and the interest rates which is aparently not possible.