Definition of Bond Discount Rate
The bond discount rate is an important factor that investors look at before they decide whether or not to buy a bond. The discount rate should not be confused with a discounted bond. A discounted bond is a bond sold at a price lower than par on the market because the bond is not as valued or trustworthy as it once was. A discount rate shows the present value of the bond's total worth.
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Bonds
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Companies and governments created bonds to raise money. These bonds act like a loan, and the investors buy them with money the organization uses for its purposes, while promising payment when the bond matures, plus an interest rate. The interest rate is how the investor makes a profit if the bond is held until maturity.
Discount Rate
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The discount rate is the interest rate that is used to calculate the present value and future payments, typically calculated using the simple formula: (1 + discount factor/number of coupon payments per year) ^ n. The discount factor is typically the coupon rate of the bond, and the payments per year is usually just one, unless the bond interest rate is applied semi-annually. The total number of times the interest rate is applied is represented by "n", showing the total term of the bond.
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Present Value
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The discount rate is used to create a present value for the bond's total worth. Generally, the father out future payments on the bond are, the less they are worth in present value, because of factors like the timeliness of money and inflation. The investor will only be paid the interest at the end of the term, but each interest payment is treated like a single payment occurring in cycles throughout the life of the bond. In a 30-year bond, the value of a payment made in one year will be higher than the value of the last payment in 30 years.
Purpose
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Present value is calculated in order to find out whether a bond is worth buying or not. Investors use present value calculations to analyze many different types of investment, but discount rates on bonds are some of the most common, since bonds are traded more often than other types of debt. Discount rates are applied to bonds so often that most brokers and bond websites have automatic calculators or indicators showing present value.
Market Prices
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Present value has an important leveling affect on market prices. An investor will not want to buy a bond for more than its present value, while a bond for sale for less than its present value will be bought quickly, or looked at with suspicion. However, discount rates constantly change, and the value of a bond is never set in stone on the secondary market, so some speculation is necessary apart from present value calculations.
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References
- Photo Credit savings bonds image by judwick from Fotolia.com
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Comments
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not answering my question can an individual purchase a bond without a financial advisor or bank do it trying to eliminate middle man for a better interest rate.
