The primary factor that causes bonds to trade at a premium is the fluctuation of interest rates.

How Bonds Work: The Simple Version

Each bond is issued with a set par, or face value. This value indicates the amount that will be paid to the bondholder by the issuing entity once the bond matures. For example, if an investor purchases a $1,000 bond with a maturity date 30 years down the road, the company that issued the bond will pay the investor $1,000 once the 30-year period has passed.

However, like stocks and other securities, bonds are often bought and sold many times before they mature. The initial sale of a bond by the issuing company directly to an investor is done on the primary market, just like newly issued shares of stock. All subsequent buying and selling of bonds is done on the secondary market. When a bond sells for more than its par value, it is said to be trading at a premium. When it sells for less than par, it is trading at a discount.

Many bonds also generate periodic interest payments to the bondholder according to a set rate determined by the issuing company. This rate, called the coupon rate, is expressed as a percentage of the bond's par value and is dictated by the prevailing interest rates set by the central bank at the time of issuance.

Though the national rate may change, a bond's coupon rate remains stable. For example, a $1,000 bond with a 5% coupon rate pays $50 in interest annually, regardless of the bond's selling price or changes in the national rate. The relationship between an existing bond's coupon rate and current interest rates is the primary force behind changing bond prices.

How Do Interest Rates Affect Bond Pricing?

When the central bank changes the national interest rate, it directly affects the coupon rates of newly issued bonds. When interest rates go up, bonds that were issued when interest rates were lower become less valuable. To entice buyers, current bondholders must sell these older, less lucrative bonds at a discount.

Conversely, when interest rates go down, previously issued bonds with higher coupon payments automatically become more valuable. Investors are willing to pay a premium for these bonds because they are guaranteed to generate greater returns than newer bonds.

For example, a $1,000 bond issued when the interest rate is 6% will always pay annual interest of $60. As long as the national rate remains at 6%, the bond is likely to trade for par value, or $1,000. However, if the central bank decreases the national rate to 4%, newly issued bonds only pay $40 per year. The 6% bond then becomes more valuable because its yield to maturity is substantially higher due to its larger coupon payments.

Credit Rating

Though it does not generally have as strong an impact on bond pricing as the national interest rate, the credit rating of a bond's issuing company can also cause it to trade at a premium. Because companies with very high credit ratings are less likely to declare bankruptcy or default on their financial obligations, highly rated bonds are more likely to trade at a premium.

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