Here Is a New Investor's Guide to Premium and Discount Bonds (2024)

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 reachesmaturity. 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."

Current Yield

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)

Where:

  • C: Interest/coupon payment.
  • FV: Face valueof 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.

Note

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 andrisk tolerance is as vital as the yield and rate.

Here Is a New Investor's Guide to Premium and Discount Bonds (2024)

FAQs

Is it better to buy a bond at a premium or discount? ›

Discount bonds may be a better choice if you're hoping to produce capital gains in the long term when you receive the return of principal at maturity. Premium bonds generally offer higher coupon rates, which could provide a more stable income stream.

Is it good time to buy bonds now? ›

Answer: Now may be the perfect time to invest in bonds. Yields are at levels you could only dream of 15 years ago, so you'd be locking in substantial, regular income. And, of course, bonds act as a diversifier to your stock portfolio.

What is a premium bond Quizlet? ›

What is a premium bond? A bond that sells above its par value. When going rate of interest is below the coupon rate.

Why do investors buy premium bonds? ›

More income

If you're a serious, long-term investor whose primary consideration is income, premium bonds may be attractive to you because they can provide higher cash flows over the life of the bond.

Are premium bonds really worth it? ›

Whether Premium Bonds are worth it depends on personal preference. If you're looking for an alternative to a standard savings account and like the idea of potentially winning a sum of tax-free cash, Premium Bonds could work for you. What's more, your money is 100% protected, so there's no risk of losing anything.

What are the disadvantages of discount bonds? ›

Discount Bonds Disadvantages

Maturity problems: Discount bonds with longer maturities may have higher expectations or chances of default because of an uncomfortable place in the current market for buying or selling bonds.

Is now a good time to buy bonds in 2024? ›

There are indications that interest rates may start to fall in the near future, with widespread anticipation for multiple interest rate cuts in 2024. Falling rates offer the potential for capital appreciation and increased diversification benefits for bond investors.

Should you sell bonds when interest rates rise? ›

If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond's price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates.

Who pays the premium on a bond? ›

A taxpayer pays a premium for a bond if the bond's purchase price is greater than its face value. The premium is the difference between the purchase price and face value. A taxpayer who pays a premium for the purchase of a bond may, and in some cases must, amortize that premium.

How do you tell if a bond is a premium bond? ›

Bonds trade at a premium when the coupon or interest rate offered is higher than the interest rate that's being offered for new bonds. A simple way to tell whether a bond is trading at a premium is to check its price. If what you have to pay to purchase a bond is above its face value then it's a premium bond.

Is a bond premium an asset or liability? ›

An unamortized bond premium is a liability for issuers as they have not yet written off this interest expense, but will eventually come due. On financial statements, unamortized bond premium is recorded in a liability account called the Unamortized Bond Premium Account.

Is it better to buy bonds at a premium or discount? ›

Premium bonds trade above par value while discount bonds trade below it. Discount bonds can be riskier but the lower the price, the higher the potential for gains. Premium bonds can deliver higher returns with less risk, but they can be problematic if they become callable.

What are the chances of winning premium bonds with $50,000? ›

If you have £1,000 invested, the odds of winning are one in 4,954,991. And if you have the maximum £50,000 in bonds, your chances increase to one in 96,839. Each £1 bond has an equal chance of winning. So to boost your chances, the more you buy, the more your chances improve in the monthly prize draw.

What is a better investment than premium bonds? ›

If you're happy to take more risk for the possibility of better returns, then a Stocks and Shares ISA might be better for you. If you might need emergency access to your money, bear in mind that Premium Bonds can take up to three banking days to process withdrawals.

Why would someone buy a bond at a discount? ›

Discount bonds can also provide enhanced tax-efficiency. Since a discount bond is purchased below par value, investors have the potential to earn not only regular coupon or interest payments, but also a capital gain when the bond matures.

What are the disadvantages of premium bonds? ›

Cons. No interest - As there's no guarantee of winning with premium bonds, you might not make any money on your savings.

Do premium bonds depreciate faster than discount bonds? ›

Because premium bonds are farther from the cutoff than par and discount bonds, they tend to retain their value.

Should you buy bonds when rates are high or low? ›

Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.

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