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Interest rates are an essential tool used by the state and central banks to regulate economic growth. When the economy grows faster than required, the government intervenes and raises interest rates to discourage businesses from borrowing to expand and individuals from borrowing to buy, thereby slowing the economy. When economic growth stops or does not occur quickly enough, the government usually lowers interest rates to stimulate economic growth. As a result, changes in interest rates also affect financial markets. The purpose of this essay is to identify the relationship between the level of interest rate and the price of bonds and to study the factors taken into account when assessing the company’s ability to make payments on outstanding debt.
The interest rate is inversely related to the bond price. This implies that when interest rates rise, bond prices fall, and the other way around. This happens when the bonds have a fixed interest rate — the coupon interest rate. Therefore, when interest rates rise, bond yields — the interest that an investor gets from buying a bond must also increase so as not to lose demand compared to higher interest rates. The interest rate affects people to save in order for their incomes to grow (Mushtaq & Siddiqui, 2016). Since the coupon’s interest rate is fixed, the bond’s yield can only be raised by reducing the bond’s price.
In general, the amount of reduction in the price of bonds depends on their validity period. In practice, the duration is used to determine the sensitivity of a bond to changes in the interest rate. The longer the term of the bond, the more it is affected by changes in interest rates (Gallant, 2021). This relationship must be true since investors have certain risks associated with securities. The current situation with low-interest rates has attracted many new customers to the bond market, which has positively impacted the country’s economy.
In order to assess the company’s ability to make payments on outstanding debt, it is necessary to consider such factors as the debt ratio, the debt to equity ratio, and the debt to tangible net capital ratio. If the company’s debt is substantial, then the company may default. Therefore, the company’s debt ratio is an essential factor in accounting. The debt ratio shows what percentage of the company’s assets were financed from debt funds.
To assess the capital structure of an enterprise, it is necessary to correlate debt to equity. In the long run, the debt-to-equity ratio has an impact on the firm’s earnings (Nukala & Rao, 2021). As a result, it will be needed to get a ratio in which liabilities are a means of financing the company compared to equity. If a company is bought by an investor who seeks to sell the company’s assets in the event of a default, it is necessary to assess the debt to tangible equity.
In conclusion, it is imperative to understand that the market is far-sighted; therefore, everything that is known about the market at the moment is reflected in prices. Therefore, if it is known that interest rates are likely to rise and if the financial media increasingly mentions this, then you can be sure that experienced corporate investors who lead the trades and, therefore, dictate prices also know this information. All is needed to look at the current market situation to see if the market expects an increase in interest rates and how it will react.
References
Gallant, C. (2021). Interest rate risk between long-term and short-term bonds.Investopedia. Web.
Mushtaq, S. & Siddiqui, D.A. (2016). Effect of interest rate on economic performance: evidence from Islamic and non-Islamic economies. Financial Innovation, 2(9), 1-14. Web.
Nukala, V.B. & Rao, P.S.S. (2021). Role of debt-to-equity ratio in project investment valuation, assessing risk and return in capital markets. Future Business Journal, 7(13), 1-23. Web.
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