A bond premium occurs when market interest rate is lower than the bond’s coupon rate and the bond sells at a price higher than the face value. When bonds are originally issued, they are sold as par, premium, or discount bonds. A bond’s par value is the same as its face value, which is the amount the bond issuer will pay to investors when the bond premium reaches maturity.
Factors Affecting Bond Premium
Bond pricing can be influenced by different factors, including supply and demand, the bond issuer’s credit rating and the bond’s maturity term. The amount by which the bond proceeds exceed the face value of the bond is the bond premium. Suppose an agency needs $1,000,000 to fund maintenance expenses. To fund the expense, the agency plans to sell 10-year bonds with a face value of $1,000,000 at a coupon rate of 3.00% to yield approximately 4.24%. In the current market, based on the coupon and yield, the bond prices would be $90 per $100 face value (i.e., a discount bond), producing only $900,000. When it comes to buying premium vs. discount bonds, there is no wrong answer.
Research fundamental elements of bond-level basics to better understand their usage. A discount bond is one that is being traded at a price less than its face value. So, investors can buy these bonds at a lower price than they will receive when the bond matures. The discount is usually caused by a lower coupon rate than the rates being offered in the market today. If its current price is equal to this original value, then investors consider it to be trading at par. But once a bond hits the open market and is available to trade, this price can, and very often does, change.
Instead, all new bonds enter the market as standard bonds. Their value—and their status as “premium” or “discount”—are the result of market factors and investor sentiment. It’s possible for investors to capitalize on both premium and discount bonds, depending on their investment strategy. Also, keep in mind that your potential for returns from premium bonds can change if they become callable. This means that the issuer can choose to allow the bond to be redeemed before the maturity date. Premium bonds may become callable if interest rates rise because it may not make sense financially for the issuer to continue paying investors above-market rates.
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What Causes Bond Prices to Change?
If a bond’s coupon rate is set higher than the expected rate of return, the demand for bond will be higher and it can be sold at a price higher than the par value. For example, a $500 premium vs discount bonds bond that trades for $525 is a premium bond. This happens when the bond’s coupon rate exceeds the prevailing interest rate. So, for example, the prevailing interest rate might be 4%, while the bond’s coupon rate is 6%. This superior coupon rate is why the bond trades at a premium in secondary markets. Interest rates in the market and the coupon rates on bonds are usually what cause the difference in bond prices.
- To see how premium and discount bonds work, let’s look at two real examples.
- Here are the most important pros and cons of investing in premium bonds that you should be aware of.
- It’s also worth noting the difference between taxable and tax-exempt bonds.
Understanding Bond Premium
- If what you have to pay to purchase a bond is above its face value then it’s a premium bond.
- For example, municipal bonds are issued by local governments to raise money for things like road maintenance and public works.
- The selection between the two depends on how much risk you can handle and what strategies you use for earning higher returns.
- A simple way to tell whether a bond is trading at a premium is to check its price.
Existing bonds, on the other hand, are sold on the secondary market. A premium bond is a bond that trades on the secondary market above its original par value. I am often asked this question, and the answer is that what separates a premium bond from a discount bond depends entirely on the bond’s par value. If the required return on a bond is higher than the coupon rate, the demand for the bond is low and it must be issued at a price lower than the face value. When buying discount municipal bonds, investors should be aware of how the bond discount is amortized over time, affecting the interest expense reported.
Investing in premium municipal bonds can also provide tax advantages, as the interest earned may be exempt from federal taxes. Understanding how the bond premium works is essential, as it may require an investor to account for the accrued interest when trading these bonds. Find more information regarding bond amortization methodology to supplement your knowledge. If the market interest rate is 4% and a bond pays 6%, investors will pay more than the bond’s face value to get the higher return. When deciding whether to invest in bonds, it’s also important to look at the bigger picture to determine whether it’s a good fit for your investment strategy.
Evaluate Bonds to Make Smart Investments
This occurs when the coupon rate of the bond falls below the prevailing interest rate. In this case, if the prevailing interest rate is 6% and the coupon rate is 4%, it’s more likely to trade at a discount. It’s also worth noting the difference between taxable and tax-exempt bonds. Most corporate bonds are taxable, meaning you’ll pay federal (and sometimes state and local) taxes on the interest income.
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Consider the strategy behind buying at a discount or buying at a premium, and seek to capitalize on either the annual yield or the face value of the bond. Just make sure you’re not buying a bond that’s overvalued for its coupon or discounted so low that it’s effectively junk. Your choice between premium and discount bonds will be influenced by what you want to achieve, the market situation and your personal risk tolerance. Knowing these factors allows you to match your bond investments with your financial goals. To see how premium and discount bonds work, let’s look at two real examples. The aim is to point out how interest rates, the price you pay and the total return matter.
Ask the Adviser: What’s the difference between premium bonds and discount bonds?
When market interest rates fall to 4%, new bonds have lower interest rates. As a consequence, investors could be ready to buy the older bond for $1,100 or more which makes it a premium bond. If you purchase a premium bond (at a price above its par value), the extra amount you pay is called the bond premium. This can lower your annual tax bill, but it also means you won’t claim a capital loss tax deduction when the bond matures. Let’s consider a 10-year bond with a face value of $1,000, a coupon rate of 6% (annual coupon payment of $60), and a market price of $900. When the market interest rate is higher than a bond’s coupon rate, the bond sells at a price lower than its face value and the difference is called bond discount.
Why Do Bonds Sell at a Discount?
Whether a bond is a discount or premium bond depends on prevailing market rates and the issuer’s credit quality. Understanding these nuances is essential for making informed investment decisions. You can, however, run the risk of paying too much for a premium bond if market interest rates rise. With discount bonds, you have to keep in mind that buying a bond below par value could also increase risk but in a different way.
Exchangeable debt bonds, also known as exchangeable bonds, are a unique type of bond that allows… Money velocity is a pivotal concept in understanding the health and vibrancy of financial markets…. Imagine two 10-year bonds, both issued by stable companies, each with a face value of $1,000. As a result, they are a good choice for investors aiming for growth. Because tax laws vary from one region to another, you should understand how bonds are taxed.
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