What does it mean when a bond is selling at a premium? Is it a good investment?

Bonds / Fixed Income
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September 2016
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Let's look at each of these questions separately.

Question 1-When a bond is selling at a premium, it means that the price of the bond (par) is higher than $1,000. This will happen when that bond has a higher coupon (or interest rate) than other bonds of the same grade and term. You will see this mainly when interest rates are going down. For example, say Bond A is paying an interest rate of 3% over a maturity term of 10 years. When interest rates go down to a new 10 year term bond, Bond B will come out with say a 2% interest rate. When this happens I'm going sell my Bond A for more than $1,000 because that is what Bond B is selling for. Since I am paying a higher interest rate, I can get more money for my bond.

Question 2-To determine whether it is a good investment you have to look at a few different things. First is the yield of the bond. Bonds have a stated coupon or interest rate and a price. If you are paying more for the bond (buying it at a premium), then the interest rate needs to be higher. The yield tells you what your actual return will be based on what you pay for the bond and what the interest rate is. For example: You buy ten 10 year bonds at a premium of $1,100 each or $11,000 and they are paying a 3% coupon. If you hold the bond to maturity, when it matures it is only worth $1,000 or par. So if you hold the bond for 10 years paying you 3% a year or $3,000 and it matures paying you back $10,000 (10 bonds at $1,000 each), you will have paid $11,000 and have a return of $13,000 which is a yield of 1.8% per year for those ten years. The yield is the most important part in figuring your return on investment(ROI) with a bond. If you could've bought ten bonds at par paying 2%, in this case, you would've been farther ahead.

The second thing to look at is knowing if you are going to hold the bond until maturity. If you are, then you can figure out very easily what the yield will be. But if you are thinking that interest rates are going to continue to go down then you could look at purchasing a bond at a premium to hold and then resell at a higher premium if indeed interest rates do continue to go down. Typically the higher your bond is paying in interest the higher the premium will be for it. Be aware that if interest rates start to go up then your bond will now only be able to sell at a discount because investors can purchase new bonds for par (remember par is $1,000)and  paying a higher rate.

I hope this gives you a little more clarity, there are plenty of other factors to gage when deciding which bond to purchase, so please work with a financial advisor, but this will get you started on the right path.

Thanks and Good luck

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