Are you aware of the difference between premium bonds and discount bonds?
Investors purchasing Bonds on the primary market (the initial issue of the bond) usually pay the face value of the bond which is usually but not always $100.
After that, on the secondary market, the price of the bond will fluctuate mainly due to supply and demand as well as other economic forces such as interest rate movements.
Premium bonds are bonds that trade higher than their face value. So a bond with a face value of $100 that is purchased for $101 is bought at a premium.
Discount bonds on the other hand are bonds traded below their face value. So that same $100 bond might sell for $99.
A bond that is priced at par, trades at the face value.
A simple example. A bond is issued at a fixed rate of 5%, and matures in one year. This table shows the changes in market rates and impacts of trading this bond.
| Bond Price | Coupon | Yield to Maturity | |
|---|---|---|---|
| Premium | $101 | 5% | 4% |
| Par | $100 | 5% | 5% |
| Discount | $99 | 5% | 6% |
So on maturity, all these three bonds will pay back the face value ($100), plus the coupon rate of 5%. They all send you $105 into your account. But because you paid $1 extra for the premium bond, and $1 less for the discounted bond, the return of the yield to maturity has changed accordingly.
How do you decide which bond to choose when comparing premium vs discount bonds? You have to take into account not just the price you pay, but also the coupon payment, length of the bond, and the overall risk.
In most cases, you’re not buying the bond to sell later, you’re buying the bond to hold to maturity. That’s why the Yield to Maturity is often more important than the price of the bond.
Premium and discount bonds is just one aspect of how bonds work. If you’d like to explore bonds a little more check out the introduction to understanding bonds.