Premium vs Discount Bonds: Which Should You Buy?

This means that, generally, speaking, the more interest rates go down, the more premium bonds there will be in the market. When the bonds were issued in 2001, Target had to offer a 7% coupon yield to sell them. The yield has dipped to below 3% and the bond has traded, at times, for more than a 30% premium.

An issuer makes coupon payments to its bondholders as compensation for the money loaned over a fixed period. While determining whether to invest in premium or discount bonds, it is imperative to analyse whether it is a perfect match for your investment strategy or not. By focusing on the interest rate environment, it is possible to determine where the bond prices will move in the near term.

Stria Resources (OTC: SRCAF) LITHIUM RESOURCE = “Multi Bagger” UPSIDE Potential

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. Keeping the interest rate environment in focus can also help you to gauge which way bond prices are likely to move, at least in the near term. At Yubi, we favour individual bonds over bond exchange-traded funds or bond funds. Our bond traders at Yubi are familiar with and well-versed in dealing with premium and discount bonds. As we delve into the bond industry, we must comprehend the primary difference between premium and discount bonds.

discount vs premium bond

Risky bonds will trade for a discount because there is less demand for them. If a company issues bonds when it is in a shaky financial position, it will have to pay a higher interest rate to compensate investors for that additional risk. If the company then shores up its balance sheet, the same supply and demand effect will occur. Investors will pile into the bond because it trades at a higher yield than similar bonds, then pump the brakes when the bond trades at a premium and its yield is the same as similar bonds.

Examples of Premium Bonds

Discount bonds mean that their present values are less than the future values. Companies may also offer discounts on their products or services to lure customers or boost sales. Cash discounts refer to an incentive that a seller offers to a buyer in return for paying a bill before the scheduled due date.

  • Below are the details of the bond including its the bond issue number, coupon rate at the time of the offering, and other information.
  • A bondholder may choose to sell their bond at a discount for various reasons, like to liquidate their investment, or because they believe that the issuer’s creditworthiness has deteriorated.
  • In many cases we prefer individual bonds over bond funds or bond exchange-traded funds.
  • A premium bond that can be redeemed early at a price of par will be priced to the redemption date rather than to maturity.
  • Premium on bonds payable is the amount paid above the face value of a bond.
  • Ultimately, the decision between investing in premium or discount bonds depends on one’s investment strategy, goals and overall risk tolerance level.

This lower price is due to the opportunity investors have to buy a similar bond or other securities that give a better return. For example, say an investor bought a $10,000 4% bond that matures in ten years. Over the next couple of years, the market interest rates fall so that new $10,000, 10-year bonds only pay a 2% coupon rate. The investor holding the security paying 4% has a more attractive—premium—product. As a result, should the investor want to sell the 4% bond, it would sell at a premium higher than its $10,000 face value in the secondary market.

What Is a Discount?

This means that investors will receive a lower effective yield compared to the coupon rate, as the premium paid reduces the overall return on investment. In other words, because the issuer is not paying as high of an interest rate to bondholders, these bonds must command a lower price in order to be competitive. Bondholders can expect to receive regular returns unless the product is a zero-coupon bond. discount vs premium bond Also, these products come in long and short-term maturities to fit the investor’s portfolio needs. Consideration of the creditworthiness of the issuer is important, especially with longer-term bonds, due to the chance of default. The existence of the discount in the offering indicates there is some concern of the underlying company being able to pay dividends and return the principal on maturity.

Let’s say a bondholder owns a bond with a coupon rate of 3% while the prevailing market interest rates have risen to 5%. Depending on the length of time until maturity, zero-coupon bonds can be issued at substantial discounts to par, sometimes 20% or more. Because a bond will always pay its full, face value, at maturity—assuming no credit events occur—zero-coupon bonds will steadily rise in price as the maturity date approaches.

The company’s credit rating and ultimately the bond’s credit rating also impacts the price of a bond and its offered coupon rate. A credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. Fixed-rate bonds are attractive when the market interest rate is falling because this existing bond is paying a higher rate than investors can get for a newly issued, lower rate bond. For investors to understand how a bond premium works, we must first explore how bond prices and interest rates relate to each other.

discount vs premium bond

For example, municipal bonds are issued by local governments to raise money for things like road maintenance and public works. Corporate bonds are issued by companies to raise capital that can be used to fund expansion projects. 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.

Leave a Comment

Your email address will not be published.