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

Bonds / Fixed Income
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If a bond is trading at a premium, this simply means it is selling for more than its face value. Why would a bond trade above par (face value)? Because the fixed coupon rate on the bond trading at a premium exceeds the prevailing market rate, or the rate you could otherwise obtain by buying another bond of comparable credit quality and the same duration. As a result, the excess interest payments on the bond that trades at a premium (relative to comparable bonds offered at par) compensate for its higher price.

The premium has nothing to do with whether the bond is a good investment. Bond investments should be evaluated in the context of expected future short and long-term interest rates, whether the interest rate is adequate given the bond's relative default risk, expected inflation, bond duration (i.e. interest rate risk associated with the length of the bond term) and price sensitivity relative to changes in the shape of the yield curve. You should also consider the bond’s coupon relative to the risk free rate; returns that can be generated in the equity market - are equities priced so low that they become a better risk/reward tradeoff? Consider the opportunity cost of funds tied up in the bond that could otherwise be invested elsewhere; expected or potential foreign currency fluctuations (bonds with bullet payments at maturity are more susceptible to FX risk); these, among many other items, should be considered in assessing whether a given bond is a “good” investment. In the end, anything with the potential to impact cash flows on the bond, as well as its risk-adjusted return profile, should be evaluated relative to potential investment alternatives.

Of course, one should also consider the bond investment’s suitability with their investment objectives, as certain investments will be more suitable than others for different people depending on their unique financial situation, investment goals, and tolerance for risk. Investors seeking current income with a low risk tolerance should probably stick to high-quality bonds, whereas those with a longer-term profile and a healthy appetite for risk might prefer the riskier, yet generally higher, current income that can be earned by investing in a Master Limited Partnership (MLP). Those who can afford to lose their investment in an instrument, provided losses are limited to the cost of the instrument and the potential upside is far greater, may want to consider taking long positions in options. Call options have a risk profile that’s asymmetric, weighted heavily to the upside, while losses are limited to the premium paid.

In summary, to evaluate whether an investment, in this case in a bond trading at a premium, is a “good” one requires in-depth analysis of credit risk, FX and interest rate risk, macroeconomic considerations that could impact repayment patterns, the opportunity cost of the investment, and your unique investment objectives and risk tolerance.

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