Bond ratings Essay Example | Topics and Well Written Essays - 1000 words

Bond ratings - Essay Example Representatives of the rating agencies have consistently stated that no precise formula is used to set a firm's rating; all the factors listed, plus others, are taken into account, but not in a mathematically precise manner. Statistical studies have borne out this contention, for researchers who have tried to predict bond ratings on the basis of quantitative data had had only limited success, indicating that the agencies use subjective judgment when establishing a firm's rating. When the bond ratings get adjusted downwards, because most bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to investment-grade securities, many potential purchasers will not be allowed to buy them. As a result of their higher risk and more restricted market, when the bond ratings get adjusted downwards, the bonds have higher required rates of return as risk premium (Weston, Besley, and Brigham 707-708). 3. Whenever the gong rate of interest is equal to the coupon rate, a bond will sell at its par. Interest rates do change over time, but the coupon rate remains fixed after the bond has been issued. Whenever the going rate of interest is greater than the coupon rate, a bond's price will fall below its par value. ... 4. The yield to maturity is the average rate of return earned on a bond if it is held to maturity (Weston, Besley, and Brigham 291). To calculate the yield to maturity, the following equation could be solved (Weston, Besley, and Brigham 291). = C (PVIFAk, n) + M (PVIFk,n) Where V = Bond value C = coupon payments k = yield to maturity M = par value of the bond n = number of years before the bond matures K could be solved by using a financial calculator or by substituting values for PVIFA and PVIF until a pair that works is found so that the present value of the interest payments combined with the present value of the repayment of the face value at maturity equals the current price of the bond (Weston, Besley, and Brigham 291). Alternatively, an estimate of the yield to maturity could be calculated with the following equation (Weston, Besley, and Brigham 291). 5. The nominal yield to maturity is the contracted, or quoted, interest rate which is used to compute the interest paid per period. The effective yield to maturity is the annual rate of interest actually being earned, as opposed to the quoted rate, considering the compounding of interest. The investor should use the effective yields to maturity when deciding between corporate bonds and other securities of similar risk. This is because throughout the world economy, different compounding periods are used for different types of investments. For example, bank accounts generally compute interest on a daily basis; most bonds pay interest semiannually; and stocks generally pay dividends quarterly. If the investor is to properly compare securities with different compounding