Discount vs. Premium Bond: Prices, Yields, and Taxes

A bond represents a loan from an investor to a borrower, such as a corporation or government entity. The borrower agrees to repay the loan’s principal, known as the par or face value, on a future maturity date. A typical par value for corporate bonds is $1,000. Throughout the bond’s life, the issuer also makes periodic interest payments to the bondholder. These payments are determined by the coupon rate, a fixed percentage of the par value. For example, a $1,000 bond with a 5% coupon rate pays $50 in interest annually, often in semi-annual installments.

The Role of Market Interest Rates in Bond Pricing

A bond’s price in the secondary market fluctuates with changes in prevailing market interest rates. This relationship is inverse: when market interest rates rise, existing bonds with lower coupon rates become less attractive, and their prices fall. Conversely, when market rates decline, older bonds with higher coupon rates become more desirable, causing their prices to increase.

This dynamic creates two categories of bonds. A bond trades at a discount when its market price is below its par value, which occurs when market interest rates are higher than the bond’s coupon rate. For instance, if new bonds are issued at 5%, an existing bond with a 4% coupon rate must be sold at a lower price to compensate for the smaller interest payments.

A bond trades at a premium when its market price is above its par value. This happens when the market interest rate falls below the bond’s coupon rate. If new bonds offer a 3% return, an existing bond paying 4% is more valuable, and investors will pay more than the par value for this higher income stream. This price premium ensures the bond’s overall yield aligns with current market rates.

Calculating Bond Yield

An investor’s actual return is measured by its yield to maturity (YTM), not just its coupon rate. YTM is the total annualized return an investor can expect if the bond is held until it matures, accounting for its current market price, par value, coupon payments, and time to maturity. It provides a comprehensive measure of a bond’s value, reflecting that bonds are often bought at prices different from their face value.

For a discount bond, the YTM is higher than the coupon rate. An investor purchases the bond for less than its par value but receives the full par value at maturity. This built-in capital gain, combined with the coupon payments, increases the total return. The lower purchase price effectively boosts the overall yield above what the coupon rate alone would suggest.

Conversely, for a premium bond, the YTM is lower than the coupon rate. An investor pays more than the face value but only receives the par value at maturity, resulting in a capital loss that partially offsets the higher coupon payments. This amortization of the premium reduces the net return, making the YTM less than the stated coupon rate.

Price Movement Toward Maturity

A bond’s market price will move toward its par value as the maturity date approaches, a movement known as “pull to par.” This occurs because at maturity, the issuer is obligated to redeem the bond for its exact par value. The price discrepancy between the market value and face value therefore diminishes over time.

For a discount bond, the price gradually increases over its remaining life, reaching par value on the maturity date. The difference between the lower purchase price and the par value represents a form of return as the bond’s value accretes, or grows, toward par.

In contrast, the price of a premium bond decreases over time, converging to its par value at maturity. The premium paid by the investor amortizes, or wastes away, over the life of the bond, ensuring its value aligns with its redemption value.

Tax Treatment of Bond Discounts and Premiums

The tax implications for discount and premium bonds are distinct. For bonds bought at a discount, tax rules differentiate between Original Issue Discount (OID) and market discount. OID occurs when a bond is first issued for less than its redemption value. This discount is treated as taxable interest income that must be reported annually over the bond’s life.

A market discount arises when a bond’s price falls in the secondary market after its issue date. An investor can choose to include this discount in taxable income annually. The alternative is to report the entire amount as ordinary income when the bond is sold or matures.

A de minimis rule exempts small discounts from these requirements. If the discount is less than 0.25% of the bond’s face value multiplied by the number of full years to maturity, it is treated as a capital gain at disposition, not ordinary income.

For taxable bonds purchased at a premium, an investor can elect to amortize the premium over the bond’s remaining life. This annual amortization reduces the taxable interest income reported from the bond’s coupon payments. This election applies to all taxable bonds the investor owns and can only be revoked with IRS consent. Amortizing the premium also requires the investor to reduce their cost basis in the bond each year, affecting the calculation of capital gain or loss.

For tax-exempt bonds, the amortization of the premium is mandatory. The amortized amount is not deductible and cannot be used to offset other taxable income. The investor must still reduce their cost basis in the tax-exempt bond by the amortized premium each year to correctly calculate any capital gain or loss upon sale.