Corporate bonds are financial instruments that work like an IOU. First, you give the company that issued it the face value of the bond. Then, you receive it with a maturity date and a guarantee of payback at the face value (or par value). Interest is most often paid to the buyer until maturity. The principal is also paid back at this time.
There is more going on with bonds than this simple scenario. Bonds can become premium or discount bonds. They could trade 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 issue price. This is called 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." This is the amount that is given to the investor when the bond reaches maturity. From the time they are issued until they mature, bonds trade in the open market, just like stocks. As a result, their prices can rise above par or fall below it as the market's ups and downs dictate. A bond issued with a $1,000 par value that trades at $1,100 is trading at a premium. A bond 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. This is the amount of interest that's paid on its $1,000 face value. A bond with a coupon of 3% pays $30 annually. It will continue to do so no matter how much the bond's price changes in the market after it is issued.
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. The trade yield changes to 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 the prevailing rates. Keep in mind that 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. Existing bonds adjust in price so that their yield when they mature equals or very nearly equals the yields to maturity on the new bonds being issued.
Yield to Maturity
Many investors confuse YTM with the current yield. The yield to maturity (YTM) is the speculated rate of return of a bond held until maturity. Finding the YTM is much more involved than finding the 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 see 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 the prevailing interest rates.
- A bond trades at a discount when its coupon rate is lower than the 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 a better option.
Still, 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 goes down, prices go up.
Premium bonds trade at higher prices because rates may have gone down, and traders might need to buy a bond and have no other choice but to buy premium bonds.
There will be a higher amount of bonds selling at a premium in the market during those times when interest rates are falling. This happens because investors are getting more income from them. In a time of rising rates, bonds are bought at a discount to par for roughly the same reason.
The discount or premium on a bond declines to zero over time as the bond's maturity date gets near. This is when it returns to its investor the full face value of when it was issued. Absent any unusual events, the shorter the time until a bond matures, the lower the potential premium or discount.
A Discount Bond Is No Free Lunch
At first glance, discount bonds may seem like an easy choice. Just buy a discount bond at $950 and benefit as its price rises to $1,000. 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 pros of buying bonds at a premium change and may disappear. Still, the bond is "callable," which means that it can be redeemed—or called—(and the principal paid off) before it matures 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. Then, 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 thing to look at when thinking about its purchase. How well the bond meets your financial goals and risk tolerance is as vital as the yield and rate.