What Is It Called When You Sell a Bond Above Its Face Value?

A bond is a type of loan made by an investor to a borrower, such as a corporation or government. The borrower agrees to pay interest on the loan for a set period and to repay the original amount of the loan at a future date. Investors can sell these bonds to other investors before that future date. This article explains the concepts and terminology behind selling a bond for more than its initial value.

Understanding a Bond Premium

Selling a bond for more than its face value is known as selling it “at a premium.” This occurs in the secondary market where previously issued bonds are bought and sold. The price of a bond can fluctuate throughout its life based on various factors in the broader economy.

The face value, also called par value, is the principal amount the issuer promises to repay the bondholder when the bond matures. Corporate bonds often have a face value of $1,000, while government bonds can be much higher. The premium is the amount by which a bond’s selling price exceeds its face value. For instance, if a bond with a $1,000 face value is sold for $1,050, the premium is $50.

Conversely, a bond that sells for less than its face value is sold “at a discount.” If a $1,000 face value bond sells for $950, it is trading at a $50 discount. A bond that sells for exactly its face value is trading “at par.”

How Interest Rates Affect Bond Value

The value of an existing bond has an inverse relationship with current market interest rates. When market rates fall, the prices of existing bonds with higher fixed interest rates rise as they become more attractive to investors.

A bond’s fixed interest payment is called its coupon rate, which is set when the bond is issued. For example, if a bond was issued with a 5% coupon rate and new, similar bonds are later issued with a 3% rate, the older bond is more desirable. Investors are willing to pay more for the higher income stream, which increases demand and drives the market price of the 5% bond above its face value. The holder of this older bond can then sell it at a premium.

If market interest rates rise above a bond’s coupon rate, its price will fall below face value, causing it to trade at a discount. An investor would not pay face value for a bond with a 3% coupon when they could buy a new bond paying 5%, so the price of the 3% bond must decrease to be competitive.

Calculating the Sale Price of a Bond

A bond’s market price is the present value of its future cash flows, which include regular coupon payments and the final repayment of the face value at maturity. To calculate the price, these future payments are discounted to their current value using the market interest rate, also known as the yield to maturity (YTM).

To illustrate how a premium is calculated, imagine a bond with a $1,000 face value and a 5% annual coupon, with two years remaining until maturity. The bond will make two more annual coupon payments of $50 and will repay the $1,000 face value in two years. Now, assume the current market interest rate for similar bonds has dropped to 3%.

The present value of the first $50 coupon is calculated, followed by the present value of the second year’s cash flow, which includes the final coupon and the face value. The current market price of the bond is the sum of these present values, which would be $1,038.21. Since this price is higher than the bond’s $1,000 face value, it sells at a premium.

Tax Consequences for the Seller

When an investor sells a bond for more than their cost basis, the profit is a taxable capital gain. The cost basis is the price the investor originally paid for the bond, and the gain is calculated as the sale price minus the cost basis. This gain must be reported to the Internal Revenue Service (IRS).

The tax treatment of the gain depends on how long the investor held the bond. If the bond was held for more than one year, the profit is considered a long-term capital gain and is taxed at lower rates than ordinary income. If the bond was held for one year or less, the profit is a short-term capital gain, which is taxed at the investor’s ordinary income tax rate.

For example, if an investor buys a bond for $1,000 and sells it more than a year later for $1,050, they have a long-term capital gain of $50. It is important for sellers to accurately track their purchase price to correctly calculate their cost basis and any resulting tax liability.