Companies that have access to the credit markets routinely issue bonds to raise capital. When they do, they take on a financial obligation that can last for years or even decades. It's therefore important to calculate exactly how much in total bond interest expense a company will take on when it offers a bond. With some bonds, it's simple to figure out total bond interest expense, but with others, it's impossible to know with certainty.
A simple answer for traditional bondsMost bonds involve companies paying a specified interest rate for the stated length of time between when the company issues the bond and its maturity. To figure out the total interest paid, you take the face value of the bond, multiply it by the coupon interest rate, and then multiply that by the number of years corresponding to the term of the bond.
Continue Reading Below
For instance, say a company issues a five-year bond with a face value of $1,000 and a 2% interest rate. The total bond interest expense will be $1,000 x 2% x 5 years, or $100. The company will typically pay that $100 in semiannual interest payments of $10 spaced six months apart.
A tougher answer for other types of bondsBonds other than traditional bonds involve more uncertainty. For example, many bonds don't carry a fixed interest rate, with floating interest rate payments that are determined by reference to changing benchmark rates in the credit markets. For instance, a bond might carry an interest rate equal to the prime lending rate. Based on current rates, such a bond might pay 3.25% interest, or $16.25 for a $1,000 bond's semiannual payment. But in the future, if rates go up, then the interest expense automatically rises to adjust to the changing conditions. It's therefore impossible to know upfront what the total expense will be.
Similarly, inflation-adjusted bonds also have unpredictable payment streams. Typically, these bonds will have a fixed interest rate, but the face value adjusts according to changes in inflation. For instance, a $1,000 inflation-adjusted bond with a 1% coupon rate might pay $5 in a semiannual payment if inflation doesn't change. But if inflation climbs 1% in the first six months, that first payment would be based on a face value of $1,010 rather than $1,000, and so the payment would be $1,010 x 1% / 2 = $5.05.
Finally, not all bonds have a fixed maturity date. Companies can pay off callable bonds earlier than their final maturity date, and so the total interest can be less if the company exercises its right to do so. Similarly, convertible bonds give investors the chance to convert their bonds to stock in a company, and some bonds give bondholders the right to choose the time at which they wish to do so.
With any bond, you can at least get a ballpark range of likely total bond interest expense by looking at worst-case and best-case scenarios. You might not get the precision a fixed bond offers when you consider a variable-rate, inflation-adjusted, callable, or convertible bond, but it will still achieve the purpose of providing a rough sense of how much issuing a bond will cost the company.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in theFoolsaurus. Pop on over there to learn more about our Wiki andhow you can be involvedin helping the world invest, better! If you see any issues with this page, please email us email@example.com. Thanks -- and Fool on!
The article How to Figure Out the Total Bond Interest Expense originally appeared on Fool.com.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.