Investors purchase bonds in order to earn interest income. Each bond includes a stated interest rate. The stated interest rate determines the amount of each interest payment the company makes to the bondholder. The investor calculates the interest income by multiplying the face value of the bond by the interest rate and the timeframe to which the interest applies. The market interest rate refers to the interest rate that investors require in order to invest in a bond, or the interest rate that the investor could receive from another investment. When the market interest rate drops, investors will pay less for bonds.
1. Review the terms of bond. Identify the face value, the stated interest rate and the timeframe of the bond.
2. Identify alternative investment opportunities. Read the terms of each investment and note the interest rates offered. The average interest rate offered to the investor represents the market rate of interest.
3. Locate the present value factor for $1 of bond value. Use the market interest rate and the number of periods for which the bond applies to find the factor.
4. Calculate the present value of the face value of the bond. Multiply the face value by the present value factor for the bond.
5. Locate the present value factor for an annuity. Use the market interest rate and the number of periods for which the bond applies to find the factor.
6. Calculate the present value of the bond’s interest payments. Multiply the individual interest payment by the present value factor for an annuity.
7. Add the present value of the face value of the bond from Step 4 to the present value of the interest payments from Step 6. This determines the purchase price when the interest rate drops.
- As the market interest rate drops, the purchase price of a bond increases. As the bond price increases, the interest payments remain the same. The investor calculates the interest rate by dividing the interest payment by the purchase price of the bond, reducing the interest rate of the bond.
- Do not underestimate the amount of potential risk associated with the bond. Each corporation earns its own credit rating. Some companies pose a higher risk to the investor.