Bond Discount or Premium Explained Simiply

Bond Discount or Premium

The bond issuer pays the interest rate specified in the indenture, the contract rate Interest rate specified in a bond indenture (or note); multiplied by the par value to determine the interest paid each period; also called coupon rate, stated rate, or nominal rate., also referred to as the coupon rate, stated rate, or nominal rate. The annual interest paid is determined by multiplying the bond par value by the contract rate. The contract rate is usually stated on an annual basis, even if interest is paid semiannually. For example, if a company issues a $1,000, 8% bond paying interest semiannually, it pays annual interest of $80 (8% × $1,000) in two semiannual payments of $40 each.

The contract rate sets the amount of interest the issuer pays in cash, which is not necessarily the bond interest expense actually incurred by the issuer. Bond interest expense depends on the bond’s market value at issuance, which is determined by market expectations of the risk of lending to the issuer. The bond’s market rate Interest rate that borrowers are willing to pay and lenders are willing to accept for a specific lending agreement given the borrowers’ risk level. of interest is the rate that borrowers are willing to pay and lenders are willing to accept for a particular bond and its risk level. As the risk level increases, the rate increases to compensate purchasers for the bonds’ increased risk. Also, the market rate is generally higher when the time period until the bond matures is longer due to the risk of adverse events occurring over a longer time period.

Many bond issuers try to set a contract rate of interest equal to the market rate they expect as of the bond issuance date. When the contract rate and market rate are equal, a bond sells at par value, but when they are not equal, a bond does not sell at par value. Instead, it is sold at a premium above par value or at a discount below par value. Exhibit 14.3 shows the relation between the contract rate, market rate, and a bond’s issue price.

EXHIBIT 14.3 Relation between Bond Issue Price, Contract Rate, and Market Rate