What’s the Difference Between Premium Bonds and Discount Bonds? - Rodgers & Associates

What’s the Difference Between Premium Bonds and Discount Bonds?

When a bond is first issued, it is a standard bond—never a premium bond or a discount bond. In other words, the price you pay for a new bond (its original price) is always fixed and is called the par value. A bond becomes “premium” or “discount” once it begins trading on the market. New bonds are sold on the “primary market” and existing bonds are sold on the “secondary market.”

What Is a Premium Bond?

A bond that is trading above its par value (original price) in the secondary market is a premium bond. A bond will trade at a premium when it offers a coupon (interest) rate that is higher than the current prevailing interest rates being offered for new bonds. This is because investors are willing to pay more for the bond’s higher yield. 

What Is a Discount Bond?

A bond currently trading for less than its par value in the secondary market is a discount bond. A bond will trade at a discount when it offers a coupon rate that is lower than prevailing interest rates. Since investors want a higher yield, they will pay less for a bond with a coupon rate lower than the prevailing rates—the upfront discount makes up for the lower coupon rate.

What Makes Them Different?

A premium bond has a coupon rate higher than the prevailing interest rate for that bond maturity and credit quality. A discount bond, in contrast, has a coupon rate lower than the prevailing interest rate for that bond maturity and credit quality.

An example may clarify this distinction. Let’s say you own an older bond—one that was origi­nally a 10-year bond when you bought it five years ago. This bond has a 5% coupon rate and you want to sell it now. When you sell it, your bond will be competing on the market with new bonds with a 5‑year maturity, since there are five years left until the bond matures. 

Let’s assume that those new bonds, compa­rable to yours in credit quality, have a coupon rate of 3%. Investors will “bid up” the price of your bond until its yield to maturity is in line with the competing market interest rate of 3%. Because of this bidding-up process, your bond will trade at a premium to its par value. Your buyer will pay more to purchase the bond, and the premium they pay will reduce the yield to maturity of the bond so that it is in line with what is currently being offered. On the other hand, a bond discount would enhance, rather than reduce, its yield to maturity.

So, the great equalizer is a bond’s yield to maturity (YTM). The YTM calcu­lation considers the bond’s current market price, par value, coupon interest rate, and time to maturity. It also assumes that all coupon payments are reinvested at the same rate as the bond’s current yield. YTM is an accurate calcu­lation of a bond’s return that enables investors to compare bonds with different prices, maturities, and coupons. Given equiv­a­lencies in maturity, credit worthiness, and industry, we want to purchase bonds with the highest YTM.

Should I Use Yield to Maturity When Valuing Callable Bonds? 

There always seems to be at least one caveat when you use the word “always.” We should use a different calcu­lation when dealing with callable bonds. A call feature on a bond adds another dimension to a bond’s value by allowing the issuer to pay the investor the call price (usually par value), in addition to the accrued interest payable at some point before the scheduled maturity of the bond. When the bond has a call feature, it is more appro­priate to use a yield to worst (YTW) calcu­lation. YTW gives the investor the lowest possible yield that a bond can produce without going into default. 

How Does Rodgers & Associates Use Individual Bonds in Our Client’s Portfolios?

In many cases we prefer individual bonds over bond funds or bond exchange-traded funds. Our bond traders are accus­tomed to dealing with premium and discount bonds, as well as the different calcu­la­tions needed when purchasing bonds on the secondary market. 

For retired or soon-to-be-retired clients, a 5‑year short term bond ladder adds a level of predictability to the cashflows within the portfolio. Knowing when a bond is coming due and when it pays interest is advan­ta­geous when planning for larger expenses or when rebal­ancing a portfolio. 

Individual bonds do come with their own risks. Corpo­ra­tions and munic­i­pal­ities can run into financial trouble. Any bond portfolio should be reviewed on a regular basis.  Keeping an eye on price fluctu­a­tions and ratings changes below investment grade can help to avoid larger problems down the road.

Origi­nally posted July 2018