New Investor's Guide to Premium and Discount Bonds
A premium bond trades above its issuance price— its par value. A discount bond does the opposite — trading below value.
Bonds Don't Have a Fixed Price
Bonds are issued with a “face value,” or “par value” – the amount that is returned to the investor when the bond reaches maturity. From the time of issuance until the time of maturity, however, bonds trade in the open market – just like stocks or commodities. As a result, their prices can rise above par or fall below it as market conditions determine. A bond issued with a $1000 par value that trades at $1100 is trading at a premium, while one that falls to $900 is trading at a discount. A bond trading at its face value is trading “at par.”
Why a Bond Trades at a Premium or a Discount
When a bond is first issued, it has a stated coupon — the amount of interest that’s paid on its $1000 face value. A bond with a coupon of 3% pays $30 annually, and it will continue to do so regardless of how much the bond’s price fluctuates in the market after its issuance.
Say the bond’s price rises to $1050 after a year (meaning that it now trades at a premium). At this time, the bond is still paying investors $30 a year, but it now trades with a yield to maturity of 2.86% ($30 divided by $1050). On the other hand, if the bond’s price falls to $950, the yield to maturity is 3.16% (or $30 divided by $950).
Why does the bond’s price rise and fall in this manner? Prevailing interest rates are always changing, and existing bonds adjust in price so that their yield to maturity equals or very nearly equals the yields to maturity on the new bonds being issued.
In other words, if a bond has a 3% coupon and prevailing rates rise to 4%, the bond’s price will fall so that its yield rises to move more closely in line with prevailing rates. (Keep in mind, prices and yields move in opposite directions.)
To understand why this occurs, think of it this way: Why would someone ever buy a bond yielding 3% when they could buy an otherwise identical bond yielding 4%? They wouldn’t, so the bond's price needs to fall to bring the yield to a level where an investor may want to own the bond.
With this in mind, we can determine that:
- A bond trades at a premium when its coupon rate is higher than prevailing interest rates.
- A bond trades at a discount when its coupon rate is lower than prevailing interest rates.
There will be a higher proportion of bonds trading at a premium in the market during the times when interest rates are falling. Conversely, a period of rising rates results in a greater percentage of bonds trading at a discount to par.
The discount or premium on a bond gradually declines to zero as the bond’s maturity date approaches, at which time the bond returns to its investor the full face value at issuance. Absent any unusual circumstances, the shorter the time until a bond’s maturity, the lower the potential premium or discount.
A Discount Bond Is No Free Lunch
Not exactly. At first glance, it may seem so: simply buy a discount bond at $970 and benefit as its price rises to $1000. Alternatively, buying a bond at a $1030 that’s going to mature at $1000 seems to make no sense. But keep in mind that this difference in price is made up for by the higher coupon in the case of the premium bond, and the lower coupon in the case of the discount bond.
In other words, the bond trading at a premium will offer higher income payments than the bond trading at a discount, which makes up for the difference in price. There is, therefore, no advantage to buying a bond at a discount, or even a bond trading at par, versus one trading at a premium. There are a few advantages, in fact, in buying bonds at a premium:
- A higher coupon, which puts more money in the investor’s pocket
- Premium bonds are typically less sensitive to fluctuations in prevailing interest rates than similar discount bonds.
If the Bond is Callable, the Equation Changes
The advantages of buying bonds at a premium change and may disappear, however, if the bond is “callable,” which means that it can be redeemed – or called – (and the principal paid off) before maturity if the issuer chooses. Issuers are more likely to call a bond when rates fall since they don’t want to keep paying above-market rates, so premium bonds are those most likely to be called away. This means that some of the premium the investor paid could disappear – and the investor would receive fewer interest payments at the high coupon
Those who want to investigate this issue more deeply can refer to this from the New York Times. Be sure to ask your broker about a bond’s call provisions when contemplating its purchase.
One Final Point
The premium or discount on a bond is not the only consideration when contemplating its purchase. How well does the bond meet your particular financial objectives and risk tolerance? What are the risks of the specific bond?
Pracekladno does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.