What does it mean when a bond is selling at a premium? Is it a good investment?
The face value of a single bond is typically $1,000. This means that at the bond's maturity date, the holder will get the final interest payment plus $1,000 per bond. When a bond is trading at a premium, it is priced above $1,000 per bond. This can happen if the bond is paying a coupon that is above the prevailing interest rate for the duration in question. This premium paid will represent a capital loss if the bond is held to maturity because it will still pay back $1,000 at maturity (provided the issuer does not default). With that being said, a bond trading at a premium is not necessarily a good or bad investment. It really depends on your objectives and the circumstances causing the premium to exist. The converse is when a bond trades below face value. This is called a discount. And, there are reasons for this condition such as interest rates, credit rating outlook, etc. And, it is worth noting that premium/discount amounts can and do vary over the course of a bond's life span.
Glad you ask the question before you jump into the bond wagon. Here’s a simple example of learning bond. If a bond sells at its par value or face value, $1,000, with a 5-year term and 5% interest, you will get your $1,000 principal back, plus the annul $50 interest at its maturity. However, life is not always that simple and straight forward as we hope it to be. Depending on the supply and demand, bond’s price can vary, thus the premium or discount price.
For example, when the interest rate falls, older bonds may become valuable because they were sold in a higher interest rate environment and therefore with a higher coupon rate. Consequently, investors holding those bonds can commend a "premium" to sell them. On the other hand, if interest rate rises, older bonds may become less valuable. In order to get rid of them, investors may have to sell for less, thus the "discount” price.
Bond prices are quoted as a percent of the bond’s face value, and an easy way to learn the price of a bond is simply adding a zero to the price quoted. For instance, when you hear a bond is quoted at 99, it means the price for the bond is $990 for every $1,000 of face value. Because the bond price is below the face value, it’s said the bond is traded at a discount. On the other hand, if the bond is trading at 101, it means you will pay $1,010 to get that $1,000 face value bond. Thus, you’re paying a premium. Happy learning!
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.
A bond’s investment prospects cannot be judged based on price alone. It is likely that you will have to incorporate more facets into your research in order to add bonds to your investment portfolio. Factors such as the bond’s credit quality, source for payments, tax status, and maturity are also important. If you desire to invest in individual bonds as opposed to mutual funds, I’d advise The Bond Book. It is a good way to get yourself familiar with the asset class. www.investinginbonds.com is also a good resource.