Question

Both stated rates and effective rates vary significantly between debt issues. Why would debt issued by the same company have different rates?

Answer 1

Stated Rate:- The Stated Rate is the simple rate that a company pays on issue of the debt. This rate does not take the effect of compound interest into account. It is a simple percentage or amount of regular return that an investor can expect from a debt instrument.

Effective Rates:- It is a key tool for evaluating the true return on an investment or the true interest rate on a loan. the effective annual rate is a rate that can be used to compare different interest plans. If the two plans are compared, the interest plan with higher effective annual rate would be considered the better plan. The interest plan with the higher effective annual rate would be the better earning plan.

Why the Debt issued by Company have different Stated & Effective Rates:-

As stated earlier, a stated rate is just a simple rate of interest and does not take into account the effect of compounding interest whereas effective rate of interest is different from stated rate of interest due to the effects of compounding interest. These rates are usually different because the interest on debt is paid on regular interval (i.e. it may be annually or semi-annually or quaterly or monthly) and interest is paid at coupon rate/stated rate. This means interest is being paid at a simple rate.

But effective rate of interest is not for interest payments. It is the rate that will discount the bond's future interest payments and its maturity value to the bond's current selling price. It is investors' Yield to maturity'. Since this rate is used to discount the future values to compare with current market values, this rate is determined or depended upon certain market/industry circumstances. Therefore, it is different from the stated and contractual rate that appears on the face of the bond.

In simple words, stated rates are for making payments of interest whereas effective rates are for evaluating total return on the debt including the effect of maturity, inflation and discount factors. Stated rates do not take into account discounting factors, inflation effects whereas effective rates take these factors into consideration. Hence, no doubtly, these rates will differ because both of these rates are for different purposes.