YTM as a proxy for cost of debt?
Hi @all,
I'm rather new to the world of corporate finance. Currently, I'm studying the cost of capital and during this process, a question regarding the cost of debt came up.
Assume the possible situation: Last year, a company X issued a bond maturing in 2050. Even somewhat unrealistic, we know that this will be the only bond that the company is issuing. X is paying a coupon rate of 4% on the bond, however, the current YTM is 2.5%.
Why should one now assume that the cost of debt equals 2.5% rather than 4%? If I would calculate with 2.5%, I would totally misguide the interest payments, since I`m understating the actual rate, don't I?
I hope that you can help me with this puzzle...
Best regards,
Josh
YTM is more market-based and in an ideal situation, you should also use the market value of your debt if using YTM.I work in a London based BB which means most of deals I am on atm are listed companies (hence they tend to have bonds in issue), I use the average YTM of all bonds issued by the firm. And very often CoD was given by the LevFin/DCM team. In my previous firm, we use a more scientific/ academic way of calculating CoD which involves synthetic credit rating.Hope it helps but will defer to other members for different perspectives.
Look you got to use your judgement here.
If I was in ibanking and working on a pitch, where we need to give directionally right CoDs, I'd tell my analysts to look into the financial statements and see what the implied interest rate is taking into account stock of interest bearing liabilities. I'd 100% take this approach, just use cap iq or FactSet to pull in market based data. This is also more time efficient. Now of course the company is distressed and it's a pitch then I'd be looking at market based data
If I was in ibanking and working on a deal, I'd be more precise when it comes to estimating cost of capital and use marked based yields (that is yield to worst, not yield to maturity)
Here on the buy side as I'm evaluating bonds / debt as an investment opportunity I'd be more precise too and compare the target's yield to worst with its comparable peers.
Hope this helps. Sorry I wasn't as structured
Add the default spread for company and country of operations to the risk free rate to represent the long term cost of borrowing. That will be your cost of debt.
I would not use either YTM or YTW, those are merely market returns for an bond investor purchasing an outstanding FI instrument. You need the cost of actually raising capital for the issuer.
One way to estimate that is to just look at cost of debt (i.e. interest rate on bond) of existing securities and take the weighted avg (take a look at the K or FactSet and BBG can help source this info) on remaining principal. Historical cost of debt often does not reflect a company’s true cost of financing especially if the issuer has long dated securities and it has a constrained balance sheet and incremental debt would be far more expensive than historical averages. Especially now given rates have significantly increased over past 6 months.
As one user above pointed out, go to your lev fin/DCM teams and they can provide an estimate on cost of debt. If you don’t have easy access to your lev fin/DCM teams you can estimate an issuer’s spread by looking at a few credit metrics of the issuer (interest coverage and debt to ebitda) and estimate the credit rating. Damadoran has a database some where on current spreads by credit rating and credit metrics.
YTW is a proxy for cost of debt
might find this useful: https://www.morganstanley.com/im/publication/insights/articles/article_…
Something else for a reason why to use YTM or YTW is that a 2.5% bond issued when rates were zero during Covid wouldn’t be reflective of what investors would pay today. You still model out the actual interest payments at the coupon rate but at refinance you’d assume the YTW Or YTM. It’s a reasonable proxy towards what their new debt would have to be issued at.
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