How to Tell If a Bond Is Trading at a Premium or Discount

Bonds represent a type of investment where an individual lends money to an entity, such as a corporation or government, for a defined period. In return, the bond issuer promises to pay regular interest payments to the investor over the life of the bond. At the end of the bond’s term, the original amount loaned, known as the principal, is returned to the investor.

Key Bond Terminology

When discussing bonds, several terms are essential for understanding their valuation.

The “par value,” also known as face value or maturity value, is the principal amount of the bond that the investor will receive back when the bond matures. This amount is typically $1,000 for most corporate and government bonds.

The “coupon rate” is the fixed annual interest rate that the bond issuer pays on the bond’s par value. This rate determines the dollar amount of interest payments a bondholder receives each year. For instance, a bond with a $1,000 par value and a 5% coupon rate will pay $50 in interest annually.

“Yield,” specifically “Yield to Maturity” (YTM), represents the total return an investor can expect to receive if they hold the bond until its maturity date. YTM considers the bond’s current market price, its par value, the coupon interest payments, and the time remaining until maturity.

Identifying a Bond Trading at a Premium

A bond is considered to be trading at a premium when its current market price is higher than its par value. For example, if a bond with a $1,000 par value is currently trading for $1,050, it is trading at a premium. This situation typically arises when the bond offers a more attractive interest rate compared to what new bonds are offering in the current market.

Investors can identify a premium bond by comparing its fixed coupon rate to its yield to maturity. A bond generally trades at a premium when its coupon rate is higher than the prevailing market interest rates, as indicated by its yield to maturity. The bond’s higher coupon payments make it more desirable than newer bonds issued at lower market rates.

Consider a bond initially issued with a 5% coupon rate when market interest rates were also around 5%. If market rates subsequently decline to 3%, the existing 5% coupon bond becomes highly appealing because it pays a higher interest income than newly issued bonds. Investors are willing to pay more than the bond’s par value to acquire these higher interest payments, thus driving its price above $1,000.

Identifying a Bond Trading at a Discount

A bond is trading at a discount when its current market price is lower than its par value. For example, a bond with a $1,000 par value selling for $950 is trading at a discount. This pricing occurs when the bond’s promised interest payments are less attractive than what investors can earn from newer bonds in the current market.

To identify a discount bond, one should examine the relationship between its coupon rate and its yield to maturity. A bond typically trades at a discount when its fixed coupon rate is lower than the prevailing market interest rates, as reflected by its yield to maturity. The bond’s lower interest payments make it less appealing compared to newly issued bonds offering higher yields.

Imagine a bond that was originally issued with a 3% coupon rate when market rates were also at 3%. If market interest rates subsequently increase to 5%, the existing 3% coupon bond becomes less attractive because new bonds offer a higher interest income. Investors will only be willing to purchase this bond at a price below its par value to achieve a competitive yield.