Corporate bond interest in terms of cost of capital

Please discuss corporate bond interest in terms of cost of capital versus investor yields. Also, discuss municipal bond interest in terms of investor yields.

 

Corporate bond interest in terms of cost of capital

A company can raise capital for a project or to cover other expenses, issuing bond in the market. Depending on the credit rating and other risk factors the company will have to offer coupon rate on the bond.

A corporate can issue bond at a fixed bond rate, say 5%, par value of $1000, the corporate will have to pay the bondholder $50 as coupon payment. Bonds come with a maturity date too. It is usually few years. The coupon rate in most of the cases are fixed, but could be floating too. In case of a floating coupon rate the bond rate usually changes with US treasury or some other benchmark rate. The coupon rate the corporate offers is usually the cost of capital (Investopedia, n.d.).

Corporate bonds usually yield higher than inflation and make good return on investment for investors. But the income from bonds are usually taxable. But from the corporate’s perspective the cost of capital will depend on the coupon rate it offers. The coupon rate is determined based on the credit risk, market risk and other associated risk factors. These risk factors are measured by credit rating companies like Moody’s, Fitch or S&P.

Now, interest on these bonds or investor yield depends on the price an investor pays for the bond and on the remaining future cash flow. Bonds price changes based on interest rate ( that is risk free rate), when interest rate goes up, bond prices fall, and when interest rate drops , bond prices goes up.

For example, say a Company ABC Inc., issued bonds of par value $1000 with coupon rate 5% on 1/1/2018, and bonds are due to mature in 3 years. Now you can quickly project a future cash flow –

The bondholder will receive $150 in coupon payment over 3 years, so $50 each year. In this case yield to investor is 5% pretax, if the investor has to pay 30% tax, then his or her income from the bond would be $35 every year, yielding 3.5%.

No that calculation was done based on par value $1000, is the investor purchases the bond from secondary market for $1050, in that case $50 in coupon payment would result in only 4.76% pre-tax , and 3.37% post tax yield.

Now one might wonder why the bond prices go up or down based on risk free rate. Say, you can buy risk free government bond at 3% interest rate, and the corporate bond offers 5%, many investors pay premium to on the par value of the corporate bond to earn the extra interest, that increases the bond value. Likewise, when risk free rate goes up and the difference between risk free rate and corporate coupon rate comes down, investors switch from risky corporate bonds to safer government bonds, hence bringing down the bond price.

 

Municipal bond interest in terms of investor yields

Municipal bonds or muni bonds work on same concept of corporate bonds with some basic differences. Municipal bonds are issues by municipalities or local governments to fund their local infrastructure projects or fund other expenses. There are 3 types of muni bonds

  1. GO or General Obligation bonds, where municipality has to repay the full obligation after bond matures, these type of bond yield lowest because these are most secure muni bond instrument.
  2. Revenue bonds which come with a promise of repayment from a specified stream of income.
  3. Assessment bonds – these are linked to property tax assessment in the municipal area.

Of course muni bonds are also rated by same credit rating agencies. But, major difference from corporate bond is that income from muni bonds are tax exempt (Pat s, n.d.), so you do not pay any federal or state tax on muni bond. But, muni bonds are vulnerable to interest rate hikes as corporate bonds are.

For an example, if any corporate issues bonds of par value $1000 with coupon rate 5%, and a municipality bond is available at par value $1000 with coupon rate 3.75%, an investor might find muni bond attractive, because the corporate bond would yield him 3.5% post tax, but since there is no tax on muni bond, it would yield him extra 25 basis point or 3.75%.

 

 

References:

Retrieved on 5/6/2018. Retrieved from https://www.investopedia.com/ask/answers/020415/what-difference-between-cost-capital-and-required-return.asp

Pat s(n.d.). What Are Municipal Bonds – Pros & Cons of Investing. Retrieved from https://www.moneycrashers.com/municipal-bonds-investing/

 

 

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