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 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 want a higher yield and will pay for it. In a sense they are paying it forward to get the higher coupon payment.
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 always want a higher yield, they will pay less for a bond with a coupon rate lower than the prevailing rates. So they are buying it at a discount to make up for the lower coupon rate.
What Makes Them Different?
Said another way, if a bond that is trading on the market is currently priced higher than its original price (its par value), it is called a premium bond. Conversely, if a bond that is trading on the market is currently priced lower than its original price (its par value), it is called a discount bond.
So, a premium bond has a coupon rate higher than the prevailing interest rate for that particular bond maturity and credit quality. A discount bond by contrast, has a coupon rate lower than the prevailing interest rate for that particular bond maturity and credit quality.
An example may clarify this concept. 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 five years is the time left until your 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 that premium the buyer pays will reduce the yield to maturity of the bond, so it is in line with what is currently being offered. (By contrast, 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 takes into account the bond’s current market price, its par value, its coupon interest rate, and its 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. We always want to purchase bonds with the highest YTM, given equivalencies in maturity, credit worthiness, and industry.