Question

IBM is planning to issue $1,000 bonds with a stated interest rate of 7% and a maturity date of July 15, 2022. If interest rates fall in the economy so that similar financial investments pay 5%, what will IBM have to do?

1) not be able to issue the bonds because no one will buy them.
2) receive a higher issue price as buyers compete for the bonds.
3) have to accept a lower issue price to attract buyers.
4) have to reprint the bond certificates to change stated interest rate to 5%.

Answer 1

IBM's bonds with a 7% interest rate will become more attractive to investors and command a higher issue price if market interest rates fall to 5%, since they provide a higher return than new bonds issued at the lower interest rate.

The correct answer is 3).

Step-by-step explanation:

If IBM is planning to issue $1,000 bonds with a stated interest rate of 7% and interest rates in the economy fall to 5%, a situation opposite to what the bond market typically anticipates arises. In this scenario, the existing bonds that offer higher interest rates than the new market rate become more attractive to investors. Here's why: the IBM bonds pay more interest compared to the current market rate, prompting investor demand to increase. As a result, IBM is likely to receive a higher issue price as buyers compete for the bonds, which offer a higher return than newly issued bonds at the prevailing 5% rate.

Using the given example about the local water company's bond as a reference, in a regular scenario when market interest rates rise above the bond's rate, the bond issuer would indeed have to accept a lower issue price to attract buyers since the bond would yield less than the new bonds at the current rate. This demonstrates how bond prices and market interest rates have an inverse relationship. However, since in this specific IBM case the market rates have fallen, not risen, the outcome is that the company's bonds have gained value.