A:

When the terms premium and discount are used in reference to bonds, they are telling investors that the purchase price of the bond is either above or below its par value. For example, if a bond with a par value of $1,000 is selling at a premium when it can be bought for more than $1,000 and is selling at a discount when it can be bought for less than $1,000.

Bonds can be sold for more and less than their par values because of changing interest rates. Like most fixed-income securities, bonds are highly correlated to interest rates. When interest rates go up, a bond's market price will fall and vice versa.

To better explain this, let's look at an example. Imagine that the market interest rate is 3% today and you just purchased a bond paying a 5% coupon with a face value of $1,000. If interest rates go down by 1% from the time of your purchase, you will be able to sell the bond for a profit (or a premium). This is because the bond is now paying more than the market rate (because the coupon is 5%). The spread used to be 2% (5%-3%), but it's now increased to 3% (5%-2%). This is a simplified way of looking at a bond's price, as many other factors are involved; however, it does show the general relationship between bonds and interest rates.

As for the attractiveness of the investment, you can't determine whether a bond is a good investment solely based on whether it is selling at a premium or a discount. Many other factors should affect this decision, such as the expectation of interest rates and the credit worthiness of the bond itself.

For more on bonds, check out our Bond Basics tutorial.

RELATED FAQS

  1. What does tier 1 capital tell investors about a bank's operations?

    Learn about which financial instruments have par values and what this means about the market price of the most common of ...
  2. What are some common examples of marketable securities?

    Learn about marketable securities and the most common types of both debt and equity securities, including common stock, bonds ...
  3. How can I create a yield curve in Excel?

    Find out more about the yield curve, what the yield curve is and how to create the yield curve for U.S. Treasury bonds using ...
  4. What are the different formations of yield curves?

    Find out more about the yield curve and yield curve formations, what yield curves measure and the three main types of yield ...
RELATED TERMS
  1. Agency Swap Program

    A form of securitization whereby single-family residential mortgages ...
  2. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
  3. Exchange Traded Derivative

    A financial instrument whose value is based on the value of another ...
  4. Hedge Fund

    An aggressively managed portfolio of investments that uses leveraged, ...
  5. Next Generation Fixed Income (NGFI) Manager

    A Next Generation Fixed Income (NGFI) manager is a fixed income ...
  6. Next Generation Fixed Income (NGFI)

    Next generation fixed income is an innovative approach to investing ...

You May Also Like

Related Articles
  1. Active Trading Fundamentals

    What does tier 1 capital tell investors ...

  2. Bonds & Fixed Income

    What are some common examples of marketable ...

  3. Mutual Funds & ETFs

    How To Short The U.S. Bond Market

  4. Mutual Funds & ETFs

    The EMAG Emerging Mkts Bond ETF: Worth ...

  5. Mutual Funds & ETFs

    5 Dividend ETFs with Growth Potential

Trading Center