Another way to view the discount margin is to think of it as the spread that, when added to the bond's current reference rate, will equate the bond's cash flows to its current price. A discount margin is the spread a security's yield relative to the yield of its benchmark that equates the security's future cash flow to its current market price. Understanding a Discount Margin—DM Bonds and other securities with variable interest rates are usually priced close to their par value.

This is because the interest rate coupon on a variable rate bond adjusts to current interest rates based on changes in the bond's reference rate. A security's yield relative to the yield of its benchmark is called a spread, and different types of yield-spread calculations exist for the different pricing benchmarks.

The discount margin is one of the most common calculations: It estimates the security's spread above the reference index that equates the present value of all expected future cash flows to the current market price of the floating rate note. There are three basic situations involving a discount margin: If the price of floating rate security, or floater , is equal to par, the investor's discount margin would be equal to the reset margin. Due to the tendency for bond prices to converge to par as the bond reaches maturity, the investor can make an additional return over the reset margin if the floating rate bond was priced at a discount.

The additional return plus the reset margin equals the discount margin. Calculating the Average Life on a Bond To calculate the average life, multiply the date of each payment expressed as a fraction of years or months by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

This bond would have an average life of two years against its maturity of four years. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security. If the borrower fails to make a payment, the investors associated with the security will experience losses.

In the financial crisis of , a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena. Special Considerations While certainly not as dire as default risk , another risk bond investors face is prepayment risk. This occurs when the bond issuer or the borrower in the case of mortgage-backed securities pays back the principal earlier than scheduled.

These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal. This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.

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