Discount Bond Definition

For example, if the market rate of interest is higher than the coupon rate, the bond value will be less than its face value, and the bond is issued at a discount. The yield to maturity is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds, the yield to maturity and required rate of return are interchangeable terms. For the example given, the coupon rate on the bond is still 10 percent, and the YTM is 8 percent. A bond’s promised yield is an indicator of what an investor can expect to earn if all of the bond’s promised payments are made and market conditions do not change. The realized yield is the actual, after-the-fact return the investor receives.

Before making any investment, you should review the relevant offering’s official statement for additional tax and other considerations. While premium bonds have the potential to deliver higher cash flow and reduce rate risk, investors should be aware of some of their unique characteristics. For example, a bond with a duration of 4 years would fall approximately 4% if rates were to rise 1%. The faster flow of interest payments to the bondholder that premium bonds offer reduces their duration and the possibility that they will lose value if rates increase in the future. In essence premium bonds offer a different composition of total return than discount bonds, as well as a lower effective duration, all else being equal. When the bond is issued, the company must debit the cash account by the amount that the business receives for the bond sale. A liability, titled “bond payable,” must be created and credited by an amount equal to the face value of the issued bonds.

Another issue that is important to address is the common misperception that investors “lose” the premium they pay for the bonds when it matures. This is not true as the higher coupons associated with premium bonds allow investors to recoup the higher cost of the bond through the interest payments. The investment landscape is full of confusing jargon, but one area that seems to baffle investors more than others is fixed income. In today’s interest rate environment, clients repeatedly ask questions relating to bond pricing. Specifically, clients ask why they pay a premium for bonds, and how this impacts the return on their investment. In this brief post, we will look at some bond basics to help explain why buying premium bonds can actually be beneficial to your portfolio.

premium bond vs discount bond

You can buy a bond at either a discount or premium to its face value. A “discount bond” sells for less than its face value, or par, which is the price the issuing company or governmental agency will ultimately pay when it redeems the bond. At any point in time the liability on the balance sheet will equal the present value of the remaining cash flow payments to the creditor discounted at the effective market interest rate. A bond discount represents the amount in excess of the issue price that must be paid by the issuer at the time of maturity. In effect it increases the lower-than-market interest rate the issuer is paying on the bond. It must be allocated over the life of the bond as an increase of interest expense each period.

The issue of purchasing premium bonds mostly pertains to municipal bonds, since there is a healthy supply of corporate bonds trading close to par. The reason why municipal bonds often trade at premiums is rather straightforward. Issuers realize that bond holders often favor a higher level of tax-advantaged income meaning they will issue bonds paying above market coupon rates. If a bond is trading at a premium it means that it is paying a coupon above the level of current market interest rates, hence the buyer has to pay more for the higher interest.

For example, if a bond’s price is 110 and par value is $1,000, the bond’s price would be $1,100 or a 110% of the par value. If it trades at 100, the bond trades at par, and if it trades under 100, it is a discount bond. A bond carries a stated coupon which is the amount of interest the bond will pay the holder each year (often paid semi-annually). Lastly, the yield-to-maturity for a bond tells the holder what annual return they will receive if they were to purchase the bond at prevailing market prices, and hold it until maturity.

If The Bond Is Callable, The Equation Changes

The realized yield is more relevant, of course, but it is not knowable ahead of time. Like many things in investing, the risk that rising interest rates pose to bonds can be measured and managed and premium bonds are one of the tools that can be used to manage that risk. To measure the amount of risk that changing rates pose to various bonds, investors look at a metric known as duration. Duration measures the sensitivity of a bond’s price to changes in interest rates and lets an investor compare how sensitive various bonds would be to changes in interest rates. For example, a bond whose duration is 4 years is roughly twice as sensitive to rate changes as a bond with a 2-year duration. Duration also gives an investor an estimate for how much the price of a bond might change if interest rates rose or fell. To understand how premium bonds can offer protection against future rate moves, let’s imagine 3 bonds, each with a $10,000 face value.

  • Bond price is the present value term when valuing the cash flows from a bond; YTM is the interest rate used in valuing the cash flows from a bond.
  • In all cases, the current yield plus the expected one-period capital gains yield of the bond must be equal to the required return.
  • Because premium bonds have higher coupon rates, they provide investors with higher interest payments, returning cash at a faster rate.
  • For premium bonds, the coupon rate exceeds the YTM; and for discount bonds, the YTM exceeds the coupon rate.
  • Current yield is defined as the annual coupon payment divided by the current bond price.

The amount by which the bond proceeds exceed the face value of the bond is the bond premium. In a rising interest rate environment, premium bonds will sustain less downward price pressure, making them more attractive to investors who are looking for more stability. When interest rates rise above the coupon rate of the bond, the bond will trade at a discount. This allows them to earn a sufficient return on their investment. The premium or discount on a bond is not the only consideration when contemplating its purchase.

New Investor’s Guide To Premium And Discount Bonds

At the time of issuance, the firm receives proceeds from issuing the bond. A bond payable is valued at the present value of its future cash flows . These cash flows are discounted at the market rate of interest at issuance. Therefore, the value of the bond depends on the market rate of interest.

So, a premium bond has a coupon rate higher than the prevailing interest rate for that particular bond maturity and credit quality. A discount bond by contrast, has a coupon rate lower than the prevailing interest rate for that particular bond maturity and credit quality.

Issuers are more likely to call a bond when rates fall since they don’t want to keep paying above-market rates, so premium bonds are those most likely to be called. This means that some of the capital the investor paid could disappear—and the investor would receive fewer interest payments with the high coupon. The current price for the bond, as of a settlement date of March 29, 2019, was $79.943 versus the $100 price at the offering.

That means it has been paying $50 a year (5% of $1,000) for the past 20 years and is now ten years away from maturity. Therefore, the company needs to make sure it’s financially viable prior to such a large payout. Issuing bonds at a premium and a discount can have advantages and disadvantages for the company, also.

Every time interest is paid, the company must credit cash for the interest amount paid to the bond holder. The company must debit the bond premium account by the amortization rate. The difference between the amount paid in interest and the premium’s amortization for the period is the interest expense for that period. For the issuer, recording a bond issued at a discount can be a premium bond vs discount bond little more difficult than recording a bond issued at par value. Because the issuer receives less cash for the bond than the face value, this difference must be recorded in the company records as a discount expense. When a bond is sold at a discount, the market rate of the bond exceeds the contract rate. As a result, the bond must be sold at an amount less than its face value.

Overall, the investor would have made a profit of $119,278 (or $150,000 – $30,722), which is much better than buying the bond at a discount. Let’s say a corporation issues bonds of $100,000 with $5,000 coupon interest payments to be paid back in 10 years. premium bond vs discount bond The investor knows they will receive $100,000, however, how much should they pay for the bond? Interest rate risk refers to the fact that bond prices fluctuate as interest rates change. Lower coupon and longer maturity bonds have a greater interest rate.

The bond’s yield based on that first call date, rather than its stated maturity, is called its “yield to worst.” Those larger interest payments appeal to smart investors because they may offer some degree of protection from the risks posed by changes in interest rates. Interest rate risk is one of those things that keeps experienced bond investors up at night. What those institutional investors understand is that premium bonds pay more interest sooner than non-premium bonds do. That matters because it can help protect the investors who hold the bonds from changes in interest rates in the future.

Default Risk With Discount Bonds

premium bond vs discount bond

They think of premium bonds as offering a cushion against the risks posed by interest rate changes. That same protection against surprises from future interest rate moves that makes premium bonds appealing to institutional investors is also available to individual investors. When the business pays interest, it must also amortize the bond premium at that time. To calculate the amortization rate of the bond premium, a company generally divides the bond premium amount by the number of interest payments that will be made during the term of the bond.

How well the bond meets your particular financial objectives and risk tolerance is as important as premium bond vs discount bond the yield and rate. Corporate bonds are financial instruments that are somewhat similar to an IOU.

Bond Valuation

You can also see that the premium bond returns more of its cash flow over the life of the bond versus the par bond. In a rising rate environment, we can reinvest this higher cash flow at higher yields, and we would expect the premium bond to outperform the par bond. According to IRS rules, investors purchasing bonds at a market discount must pay ordinary income tax on some portion of the discount. In this way, discount premium bond vs discount bond bondholders own bonds in which a portion of the return is taxable and a portion is tax-exempt. Discount bonds not only require a tax outlay, but they are also more difficult for investors to understand and model. Continuing with the example above, if the annual coupon rate is 7% instead of 6% and the market interest rate is 6.4%, your bond will sell at $1,043.82 raising a total amount of $52.19 million.

What Is A Discount Bond?

How is bond premium handled on tax return?

Subtract the bond premium amortization from your interest income from these bonds. Report the bond’s interest on Schedule B (Form 1040A or 1040), line 1. Under your last entry on line 1, put a subtotal of all interest listed on line 1. Below this subtotal, print “ABP Adjustment,” and the total interest you received.

As a result, should the investor want to sell the 4% bond, it would sell at a premium higher than its $10,000 face value in the secondary market. Sometimes bonds are issued at a discount in an effort to attract buyers. But most discounts develop mainly as a result of changes in interest rates. To understand how that happens, start with a hypothetical 30-year corporate bond with a $1,000 face value issued 20 years ago with a 5% coupon interest rate.

In addition, that discounted amount must be amortized over the term of the bond. When the company amortizes the discount associated with the bond, it increases its interest expense beyond what it actually pays to the bondholder. When interest rates are rising, higher coupon bonds generate more coupon cash flow than lower coupon bonds. This means investors can reinvest more in bonds that will pay even higher yields. When selling discount bonds, investors may receive a lower price due to the tax implications of bonds that are sold below the “de minimis” cutoff.