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