The Federal Reserve determines U.S. monetary policy by setting short-term interest rates. Long-term interest rates change as a result because financial markets tend to project the direction of future monetary policy. Changes in short-term and long-term interest rates impact companies by increasing or decreasing interest expenses, which affect the bottom line, and by changing the market value of fixed-rate liabilities such as bonds and notes payable.
Companies issue bonds to finance operations. Bonds are recorded in the liabilities section of the company’s balance sheet. A bond may trade at a premium (above) or discount (below) to its par or face value. The trading value depends on interest rates, the coupon rate (percentage of face value paid as interest per year) and other conditions such as the financial health of the issuer.
When interest rate rise, older bonds sell at a discount because their interest rates are lower than the current rate. For example, if interest rates rise from 5 to 6 percent, the price of a 5 percent $1,000 face-value bond will fall to about $833 -- (1,000 x 0.05) / 0.06 -- resulting in a yield (interest payment divided by price and expressed as a percentage) equal to the current 6 percent rate (0.06 x 833 = 0.05 x 1,000). Conversely, when interest rates fall, older bonds sell at a premium because their rates are higher than the current rate. For example, if interest rates fall from 5 to 4 percent, the price of a 5 percent $1,000 face-value bond will rise to $1,250 -- (1,000 x 0.05) / 0.04 -- resulting in a yield equal to the current 4 percent rate (0.04 x 1,250 = 0.05 x 1,000).
On the maturity date, a bond's par value is repaid and interest payments stop. Although a bond may trade at a premium or a discount, the prices generally converge to par as the maturity date approaches. Prices change with interest rates more for longer-term bonds (i.e., bonds with maturity dates farther out than shorter-term bonds) because of the longer stream of interest payments that might be above or below current market rates. This makes the bonds more or less appealing to investors. According to a Charles Schwab analysis of Bloomberg-supplied government bond data, in a six-month period of falling interest rates in the second half of 2008, a 30-year bond's market value rose more than twice as much as a 10-year bond. Similarly, in a six-month period of rising interest rates in the first half of 2009, a 30-year Treasury bond’s market value fell almost three times as much as a 10-year bond.
Businesses should evaluate the impact of interest rate risk on profitability so that they can respond appropriately. A common evaluation technique is sensitivity analysis, which models the impact of changes in one variable (e.g., interest rates) on one or more other variables (e.g., interest expenses and net profit). A common strategy to manage interest rate risk is through an interest rate swap, which changes the nature of a stream of interest payments from variable-to-fixed or fixed-to-variable during periods of rising and falling rates, respectively.