I'm in an accounting class learning about bonds. I cannot figure out if a discount or a premium is more preferable to the other, or if they are the same. Please make it simple!
I'm in an accounting class learning about bonds. I cannot figure out if a discount or a premium is more preferable to the other, or if they are the same. Please make it simple!A discount means the current value of the bond is lower than its original worth. Things are cheaper at a discount store. A premium means the price of the bond is higher than what it originally sold for. You pay more for premium gasoline.Which is better depends on what you're doing with the bonds. Buying bonds at a discount is usually a good idea. People selling bonds tend to prefer getting a premium.
The big problem with paying a premium is that the bond may be called at less than par. This means you take a capital loss when it matures or when it is called.Check those call provisions carefully before paying a premium.
While I don't disagree, I think that the issue of "premium" vs. "discount" is really a red herring ... IF you focus on the proper yield measures when you buy. I'm no expert ... not by a long shot ... so please correct me if I've made a mistake or oversimplified, or please forgive my naivete if it shows too conspicuously! Here's my reading:* When you buy a bond you need to look at the YIELD TO MATURITY (YTM) and the YIELD(S) TO CALL (YTC), and not simply the coupon or current yield or price. (Of course, you should also examine various other - and critically important - characteristics, such as rating, maturity date, tax status, etc.) * If you're holding to maturity, and the bond is non-callable, the YTM takes into account the "premium" or "discount" (viz., it is based upon the current price, coupon and the maturity date). So there's no real "loss" at maturity ... you make a profit with an annualized equivalent return of the YTM. (In fact, if you buy at a premium, I presume there's a nominal capital loss at redemption, offsetting some of the taxes paid on distributions.)* If the bond is callable ... you need to look at the string of call dates and prices and the associated YTCs. Same logic as above, though --- the difference being that the bond may be called, e.g. at the date corresponding to the lowest YTC. The callability of the bond clearly introduces some added risk ... which SHOULD get reflected in a slightly higher yield than a non-callable bond with otherwise identical characteristics.* If you don't hold to maturity, the price will go up or down with the usual factors (interest rates, changes in bond quality, other market conditions) ... but this is pretty much the same whether you paid a premium or a discount, so far as I can tell.Again, my apologies if this list is either naive, misleading or wrong ... but I'd sure appreciate help if it is any of the above! I simply don't see why "premium" or "discount" matters!!... Joel
I've always found it helpful to think about it this way:Buying a bond at a discount means that you are buying a bond with a coupon rate that is lower than current interest rates. You are compensated by receiving the payments as well face value (more than you paid) at call or maturity.Buying a bond at a premium simply means that you buying a bond with a coupon rate higher than current market rates. Since you are receiving a better rate of return than new issues, you pay more than it's worth. There are tax advantages to taking that capital loss as well.So I absolutely agree that the concept of discount vs. premium is a red herring.Hope this helps some...md
Finally, someone who actually understands how the real world works, instead of all of the pretenders out there. Many sophisticated bond buyers, especially institutions, gladly buy premium bonds for the reasons cited previously.
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