When a firm issues coupon bonds that are traded on the open market these bonds can trade at either a premium or discount during the lifetime of the bond. If, for instance, the bond trades at a premium then it can be assumed that the market required rate of return on this bond is lower than what the firm is paying and demand>supply so it trades at a premium. Does this mean that the market now views the bonds as less risky and the cost of debt for the firm is lower than the initial coupon rate? If I wanted to figure out the cost of debt, say for a WACC calculation, would I have to look at the recent trading history of the bond and average it? Or is this an over simplification and there is actually more risk than simply that of bankruptcy involved?
1 Answer
I'm no expert of WACC or company finance, etc. But from a pure bond pricing/trading perspective, bond price embodies at least two risks:
- interest rate
- credit (i.e., the company defaults)
If a bond price moves, it could either because of interest rate, or because of credit(i.e., the market views the bond as less or more risky).
Following the assumption above, instead of looking at the bond prices, you should look at zspread(over UST for example if you're looking at US corporate bonds) to represent the credit riskiness.
Practically the zspread is a combination of credit and liquidity premium. I don't have a good suggestion of what to do to separate these two. Maybe you can look at a group of corporate bonds of the same sector and rating to get the general credit riskiness, and view the rest spreads as liquidity premium.
