New Investor's Guide to Premium and Discount Bonds
Corporate bonds are financial instruments that are somewhat similar to an IOU. You give the issuing company the face value of the bond, and you receive it with a maturity date and a guarantee of payback at the fave value (or par value). Interest is generally paid to the purchaser until maturity; at which time the principal is returned.
There is more going on with bonds than this simple scenario. Bonds can become premium or discount bonds, trading above or below their par value while bond traders attempt to make money trading these yet-to-mature bonds. A premium bond trades above its issuance price—its par value. A discount bond does the opposite—it trades below par 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, 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 $1,000 par value that trades at $1,100 is trading at a premium, while one whose price falls to $900 is trading at a discount. A bond trading at its face value is trading “at par.”
When a bond is first issued, it has a stated coupon—the amount of interest that’s paid on its $1,000 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.
The current yield is the rate of return on a bond. If the bond’s price rises to $1,050 after a year (meaning that it now trades at a premium) the bond is still paying investors $30 a year, but it now trades with a current yield of 2.86% ($30 divided by $1,050). On the other hand, if the bond’s price falls to $950, the current yield is 3.16% (or $30 divided by $950).
Current Yield = Annual Coupon Payment ÷ Current Market Price
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.)
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.
Yield to Maturity
Many investors confuse YTM with current yield. Yield to maturity (YTM) is the speculated rate of return of a bond held until maturity. Calculating YTM is much more involved than calculating current yield.
YTM = ( C + ((FV - PV) ÷ t)) ÷ ((FV + PV) ÷ 2)
- C—Interest/coupon payment
- FV—Face value of the security
- PV—Present value/price of the security
- t—How many years it takes the security to reach maturity
Why a Bond Trades at a Premium or a Discount
To understand why this occurs, think of it this way: Investors would not buy a bond yielding 3% when they could buy an otherwise identical bond yielding 4%. The bond's price needs to fall to bring the yield up 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.
Using the previous example of a bond with a par value of $1,000, the bond's price would need to fall to $750 to yield 4%, while at par it yields 3%. This is a discounted bond, meaning an investor would pay less for the same yield, making it more attractive.
However, premium bonds with higher pricing and a lower rate might earn more if the market rate is lower than the bond rate. This is the attraction to premium bond pricing and rates.
When bond interest rates increase, prices go down. When the interest rate decreases, prices go up.
Premium bonds trade at higher prices because rates may have decreased, and traders might need to buy a bond and have no other choice but to buy premium bonds.
There will be a higher proportion of bonds selling at a premium in the market during the times when interest rates are falling because investors are receiving more income from them. Conversely, a period of rising rates results in a greater percentage of bond purchases at a discount to par for roughly the same reason.
The discount or premium on a bond gradually declines to zero as the bond’s maturity date approaches, at which time it 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
At first glance, it may seem so: simply buy a discount bond at $950 and benefit as its price rises to $1,000. Alternatively, buying a bond at $1,050 that’s going to mature at $1,000 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 (the actual interest rate of the bond).
- In other words, the bond trading at a premium will offer less risk than the bond trading at a discount if rates rise any more, which can make up for the difference in price.
- There is an advantage to buying a bond at a discount, or even a bond trading at par, versus one trading at a premium, which is the initial lower price.
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. This means that some of the capital the investor paid could disappear—and the investor would receive fewer interest payments with the high coupon.
One Final Point
The premium or discount on a bond is not the only consideration when contemplating its purchase. How well the bond meets your particular financial objectives and risk tolerance is as important as the yield and rate.