The Prudential Insurance Company of America v. Commissioner of Internal Revenue
United States Court of Appeals for the Third Circuit
882 F.2d 832 (1989)
- Written by Brett Stavin, JD
Facts
Although the interest payments payable under a fixed-income debt instrument stay the same throughout the life of the instrument, the market value of the instrument changes based on a number of factors. Specifically, the market value of a debt instrument depends on (1) the interest rate of the debt instrument itself; (2) the prevailing market interest rate; (3) the length of the term; and (4) whether prepayment of the debt is allowed. As to market interest rates, if market interest rates decrease relative to the debt instrument, the debt instrument becomes more valuable because the payments due under the instrument generate a higher income stream than what could be obtained in the market. Conversely, if market interest rates increase relative to the debt instrument, the debt instrument becomes less valuable. As to the length of the term, the longer the term of the debt, the more valuable the instrument becomes because there are more payments due under the instrument, meaning a longer income stream. Therefore, as the maturity date of a debt instrument nears, the value of the debt instrument will decrease. As to prepayment, a debt instrument that does not allow prepayment is worth more than a debt instrument that allows prepayment. This is because allowing prepayment can result in the holder of a debt instrument being unable to realize the increased value of a debt instrument in the market. If market interest rates decrease, instead of the debt instrument becoming more valuable, the borrower will be able to just refinance the debt at a better rate. If no prepayment is allowed, the borrower cannot do so, and the value of the debt instrument will be higher. Additionally, some debt instruments have a prepayment penalty designed to compensate the holder of the debt instrument if a borrower decides to refinance the debt. The amount of the prepayment penalty will typically decrease as the maturity date nears because there are fewer interest payments that would be made under the remaining life of the debt.
Rule of Law
Issue
Holding and Reasoning (Gibbons, C.J.)
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