What is the difference between premium and discount bonds?

In an economic scheme of things, the government and the RBI leverage Bonds within the Open Market Operations to regulate the current liquidity and stabilize borrowing and lending rates. However, bonds also play a role as an investment instrument that offers high returns and hedges against the falling stock market. If you are an active investor or want to start investing, bonds are an ideal instrument to ensure portfolio diversification. However, before you begin your investing journey with bonds, it is vital to familiarize yourself with certain terminologies such as premium and discount bonds, bond par value pricing, and the difference between premium and discount bonds.

What is bond par value pricing?

Suppose you have a bond with a denomination (the price you pay to buy it) of Rs 1,000. This, Rs 1,000, is called its face value or the par value, which the bond issuer will return to you at the the time of maturity. Every bond comes with a fixed interest rate, called the coupon rate. In the example above, the bond may come with an interest rate of 5%, which translates to an annual interest of Rs 50.

After the bonds are issued, they enter the secondary market and are traded just like shares, where the demand and supply forces determine their current price. As a result, the face value of the bond you hold may fall to Rs 950 or may rise to Rs 1,100.

Why do some bonds sell at a premium, some at par, and some at a discount?

The fundamental reason for bond pricing fluctuations is the demand and supply, and the resulting interest rates of the same. However, the difference between a bond sold at par, premium, and discount is as follows:

At Par: If a company issues a bond at a coupon rate of 5% and the prevailing bond yields in the market are also 5%, investors will not differentiate between bonds of the same face value as the returns will be the same for each bond. In this case, if you sell your bond, it will be sold at par.

At Premium: This is when the bond you hold has appreciated or increased from its initial face value. For example, if your bond is trading at a current price of Rs 1,100, which is higher than other new bonds, you can sell your bond at a premium (higher than the actual face value of Rs 1,000).

At Discount: A discounted bond is when the bond you hold has depreciated in its face value to increase the overall bond yield. For example, if the bond you hold is trading at Rs 750 than the initial issue face value of Rs 1,000, the bond yield will increase, making it a better option for investors but a loss-making option for you.

Investing in bonds can seem complex, but it is an ideal way to ensure systematic annual earnings. As they have an inverse relationship with the prices of stock, you can square off your equity losses with the profits you make in bonds. To learn further how to invest in bonds, visit the IIFL’s website or download the IIFL Markets app to open a free Demat account and start investing.

Frequently Asked Questions

What does it mean when a bond is selling at a premium?

It means that the bond’s face value has appreciated in the secondary market since it was initially issued.

What is a premium bond?

A premium bond is when it is trading higher than its face value, or the cost is more than the initial face value.

What is a discount bond?

A discount bond is when a bond is trading below its face value. It can also have a coupon rate below the prevailing interest rates in the market.