Buying Bonds (Premium vs Discount)
Apr 10, 2023
For new investors the process of buying bonds can be complex, as it involves various terminologies and buying scenarios. Today, we will discuss buying bonds at a premium versus a discount. Let’s start at the beginning, when a bond is issued, it is available for purchase at its face value, which is the amount of money the issuer promises to repay bondholders at maturity. The face value of a bond is fixed and is also known as the par value.
Buying Bonds at Premium
Once the bond is available in the market, it begins trading at a premium or discount depending on the market interest rate and bond coupon rate. When you buy a bond at a premium in the secondary market, you pay a price higher than its par value (original price). Bonds trade at a premium compared to their par value when the coupon offered on the bond is higher than the prevailing market interest rate. As a result, potential investors would be willing to pay a higher amount to secure a higher interest rate.
For example, US Government issues a treasury bond with a 5% coupon rate at $1000. If the market interest rate is lower than 5%, investors would be willing to pay more money for purchasing the US Treasury bond leading to the bond trading at a premium. In the case of the US Government Treasury Bonds in the above example, any price above the par value of $1000 will be considered as the purchase of a bond at a premium.
Buying Bonds at Discount
When you buy a bond at a discount in the secondary market, you pay a price lower than its par value (original price). Bonds trade at a discount when the coupon rate offered on the bond is lower than the prevailing market interest rate. In the case of the US Government Treasury Bonds in the above example, any price below the par value of $1000 will be considered as the purchase of a bond at a discount.
If you look closely, the concept of a bond trading at a premium or discount is simple economics. When the bond coupon rate is higher than the market interest rate, more investors are willing to purchase the bond at a higher price, resulting in higher demand and the bond trading at a premium. The opposite scenario is true when a bond is trading at a discount. As such, both market and bond coupon rates play a significant role in bond trading at a premium or discount.
Bond Price and Yield to Maturity
Buying a bond at a discount or premium also influences the yield to maturity (YTM). Yield to maturity is the overall interest rate earned by an investor who buys a bond at the current market price and holds it until maturity. Yield to maturity is quoted as an annual rate and may differ from the bond's coupon rate, as it is a function of the bond's purchase price. When you buy a bond at a premium, the YTM will be lower than the coupon rate because you are paying more than the face value of the bond. Conversely, when you buy a bond at a discount, the YTM will be higher than the coupon rate because you are paying less than the face value of the bond.
Once investors understand these concepts, they can become more confident in investing in bonds and, of course, never be afraid to ask questions. A licensed financial advisor should be able to provide bond prices and yield before investing.
Anna-Joy Tibby is the Assistant Vice-President, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
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