How do you calculate the actual or real interest rate on a bond investment?
The actual or real interest rate on a bond can be calculated by using present value software or a financial calculator. The actual, real, or effective interest rate is the rate that will discount all of the future cash receipts back to the amount of cash paid to buy the bond. This interest rate is also known as the yield to maturity, yield, and market interest rate.
The future cash receipts for a typical bond are the semiannual interest payments (interest rate stated on the bond X face amount of bond X 1/2 year) and the maturity amount of the bond. The interest payments form an ordinary annuity and the maturity amount is a single payment.
If the bond's stated interest rate is less than the current market interest rate, the bond's market value is less than the maturity or face amount of the bond. In financial jargon, the bond will sell at a discount.
If the bond's interest rate is more than the current market interest rate, the bond will have a market value that is more than the maturity or face amount of the bond. In other words, the bond will sell at a premium.