|Author||Topic: 2 questions on long-term liabilities|
|1. If market rate changes and bonds are carried at amortized cost, why does the book value of the bonds after the first year (or any other point in time) not change? i thought if market rates go up, bonds go down and vice versa.
2. if market rate of interest increases after the bond is issued, what happens to the debt / equity ratio? based on my thinking, debt portion of D/E goes down because as the market interest rate moves up, bond value goes down. however, i don't undestand why equity would go UP? i didn't realize market interest changes would change the equity portion?
thanks for your help guys!
1. you practically answerede your question yourself. bonds carried at amortised cost are not influenced by market rate changes. the inverse relationship between rates and bond price you're talking about is correct, but only applies to bonds carried at fair market value. however, the book value of your bond carried at AC does change, if there is a premium/discount to amortise. it does not change when it is issued at par.
2. leverage ratios should be constructed using market values instead of book values. therefore, if you hold the bond as an asset and rates go up, your decreased asset position will decrease the equity (remember E=A-L), ceteris paribus your gearing (D/E) will increase. if however, the bond represents a liability to you, the increase in rates will decrease your liability's market value (thus, equity up), and ceteris paribus decrease your gearing.
vice versa, for rate decreases.