10. Debt Valuation

Governments and companies can raise the capital needed to finance their activities by issuing bonds to a public market. A bond is nothing more than a loan. There are several types of bonds. However, there are some elements common to all of them. In reality, any bond can be defined on the basis of five main elements: face value, price, coupon, maturity date, issuer. There is a strict relationship between price and risk of the bond. Specifically, the lower the grade of the bond, the higher the risk and therefore higher the return offered by the issuer to the investors in the bond. Therefore, not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier in certain conditions, than stocks. Usually it is normal to measure the free-risk rate on the basis of the government bonds. Indeed, the default risk of the government tend to be small (mostly for the developed countries). It is because the government will always be able (or should be able) to bring in future revenues through taxation. On the other hand, companies must be able to generate profit in order to survive and face their debt obligations. The difference in risk between government and corporate bonds implies that the corporate bonds must offer a higher yield than government bonds. Therefore, it is necessary to evaluate the government bonds in order to estimate the free-risk rate, as well the company bonds on the basis of its default risk.