Hi everyone… I’m brand new here, and this is my first post in this forum. I’ve been reading the threads and I found them very helpful. I wish I had know the existence of this forum long ago. I need help: “Advantages (from the perspective of the issuer) of issuing discount bonds are 1) CFO overstated, 2) cash interest reduced.” [From 2007 Schweser Lv1 Note Bk 3 pg. 217 table] Can somebody explain why 2) cash interest is reduced? My understanding is that for discount bonds, CPN rate < YTM, so interest expense is higher relative to premium bonds. Thanks.
The key is that they say “cash interest”, not just “interest”. You issue a bond with a 5% coupon to yield 6%, the issuer still pays cash of 5%. The extra yield (and non-cash interest expense) comes from the amortization of the discount.
The book balance of the discount bonds on the balance sheet < that of the par bonds. Bond interest is the market interest rate @ issuance * book value. Since book is less, interest will be less as compared to par bonds.
The book balance of the discount bonds on the balance sheet < that of the par bonds. -I agree Bond interest is the market interest rate @ issuance * book value. - I also agree Since book is less, interest will be less as compared to par bonds. -I disagree. although BV is lower, but interest rate is higher relative to par bond , which results in higher interest expense. For example, cpn=8% and interest rate=8% --> it’s a par bond. For discount bond, interest rate will be higher than 8%. See example in 2007 Schweser note Bk 3. this is exactly what i’m arguing. shldn’t cash interest be increased rather than reduced?
Important thing to remember here is that the “interest rate” that we are talking about is NOT the coupon rate, it is the market rate @ issuance. Which would be the same if the 2 bonds are issued at the same time and the only difference is their coupon rate.