It is time to talk about bond discount rates! Now, before you get excited at the idea of picking up bonds on the cheap, I have to tell you that discount rates have nothing to do with buying things on sale. Rather, a discount rate helps you figure out how much to pay today for a bond or cash flow in the future. In a previous post I talked about the time value of money (“TVM”). Simply put, TVM is the idea that a dollar today is worth more than a dollar tomorrow. To calculate what tomorrow’s dollar is worth today, the trick is to use a concept called present value. Two components are needed to determine present value: payment timing and yield. Today I want to talk more about what we mean by yield.
Introducing the discount rate
The trick with valuing any future cash flow is figuring out the right yield to use. Typically this yield is referred to as the discount rate, or the rate at which you “discount” future payments to put them into today’s dollars. The challenge is that there is no single discount rate that can be used for all investments. You need to use a different discount rate depending upon how risky the future payment is. Risky investments typically offer a higher yield, and thus require a higher discount rate to value them. Let’s look at an example.
You are considering buying one of two bonds that you see in the market. Both mature in one year and return $1,000. Neither one pays a coupon, so you would buy them today for less than $1,000 each. The difference between the price you pay and the $1,000 you receive at maturity is the return you will earn. The first bond is from the U.S. Treasury, and it has a yield of 0.25%. (Yes, one fourth of one percent. Unfortunately that is the going rate for a one-year Treasury security.) The good news is that the Treasury is an extremely high quality borrower, so you are taking very little risk on your investment. The bond has a price of $997.51, and if you bought it, you would receive $1,000 in one year.
The second bond is from a high risk corporate issuer. The corporation should still exist one year from now, but there is a chance that it might not. If the corporation goes into bankruptcy or defaults, you could lose some or all of your expected $1,000 payment. As you would be taking on more risk than with the Treasury security, you should be paid a higher yield to compensate for that risk. Put another way, the discount rate should be higher. In this case it is 3%, so the bond would have a price of $970.87. This intuitively makes sense: With less certainty that you will get the $1,000, the bond should have a lower price than the Treasury bond.
Discount rate takeaways
An easy way to remember this is that for taking on more risk, you should demand a higher yield and use a higher discount rate. At the end of the day, the discount rate is one of the most important concepts when it comes to bond investing: It helps you value different securities from different issuers, and can also help you evaluate bonds with different maturities. Armed with such knowledge, you can more easily determine the right investment and what you should pay for it. And that is information that you shouldn’t discount.
Want to learn more about risk? Check out my video series: BONDing with Matt Tucker.