Discount Margin vs. Spread

Discount margin and spread are two different concepts in investing. A spread is the difference between a bid and an ask price and usually refers to stocks, but it may refer to any security on the market. The discount margin is the rate of return on a floating-rate bond above the value of a fixed-rate bond that an investor stands to earn by taking on extra risk. The concept of spread is simple and general; the concept of a discount margin is more complex.

Financial markets consist of millions of people and institutions constantly negotiating possible prices, sales and other deals for a dizzying array of financial products. Financial information services provide a constant stream of market rate data, but behind seemingly uniform market movements is a flurry of asking prices and bids. The difference between any asking price and any bid on a security is a spread. Market makers match buyers and sellers, negotiate with each on a price and pocket the spread.

The concept of a discount margin applies only to floating-rate notes, also called FRNs. An FRN is a type of bond for which the interest rate changes over time according to an index. Bonds typically have a fixed rate of interest and pay the holder that interest every year until maturity or until the date when the issuer buys back the bond by paying the holder the amount the original holder paid. FRNs fall in a subcategory of bonds whose interest rate changes. FRNs have a rate tied to an investment index, such as the performance of the Standard and Poor's 500. When the index goes up, so does the FRN's rate, and when it goes down, so does the amount of interest.

On one hand, FRNs protect against the risk of inflation better than other bonds because their rate floats, automatically adjusting to inflation. On the other hand, predicting the future value of FRNs is much more difficult than predicting the future value of fixed bonds, and that uncertainty makes FRNs riskier. As a result, FRN prices on secondary bond markets fluctuate considerably. In calculating the discount margin, investors compare the price of a fixed bond with the current interest rate of an FRN. The rate above the return of a fixed-rate bond that an investor stands to gain by taking on extra risk with an FRN is the discount margin.

A spread and a discount margin both deal with small differences in pricing that finance specialists try to exploit for profit. Market makers profit from spreads by acting as middlemen, while experienced investors try to gain a few extra percentage points of return by shouldering the additional risk inherent in FRNs. Market makers don't lose money on spreads, but only agents representing financial institutions can be market makers. On the other hand, individual investors may invest in FRNs, but they stand to lose money if the discount margin goes negative.