Estimating a Firm’s Cost of Debt from Traded Bonds
Summary
The document asks whether a firm’s coupon rate or a bond’s recent market price should determine the cost of debt used in a WACC calculation. The response explains that bond prices reflect both changes in general interest rates and changes in the issuer’s credit risk. A bond trading above par therefore does not by itself show that the market considers the firm less risky; the price may also reflect movements in rates.
For assessing credit risk, the answer points to the bond’s z-spread over a benchmark such as US Treasuries, rather than relying on price history alone. It cautions that this spread combines credit and liquidity premia, making the two difficult to separate. Comparing bonds from issuers with similar sectors and ratings is suggested as a way to gauge typical credit risk, with residual spread differences potentially related to liquidity. The response is a brief bond-market perspective and does not give a complete WACC procedure or a detailed method for isolating liquidity effects.
Key ideas
- A traded bond’s price reflects both interest-rate movements and issuer credit risk.
- A premium or discount alone does not identify a change in the firm’s default risk.
- A benchmark z-spread can help represent the market’s required compensation beyond government yields.
- The z-spread includes both credit and liquidity premia.
- Comparable bonds by sector and rating can provide context for interpreting spreads.
Tags
Full text
# Calculating a firm's cost of debt using bond issues # Calculating a firm's cost of debt using bond issues 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? ## Answer by Lipton (score 2) https://quant.stackexchange.com/a/37838 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.
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