In this article, we’re going to learn about a bond’s “trading status”. And this brings clarity about Discount vs Premium Bonds; everything from what exactly these mean, and why they mean what they mean.
Let’s get into it.
Bond’s Trading Status
All bonds can trade at:
- Par, or
Here at Fervent, we refer to these 3 different “trade types” as the bond’s “Trading Status”.
Yes, we had to invent a name for it, because believe it or not, there isn’t a clear-cut term for this.
Anyway, now that we have a term to describe it, let’s think about what determines a bond’s trading status.
This Article features a concept that is covered extensively in our course on Bond Valuation Mastery.
If you’re interested in learning and mastering Bond Valuation, then you should definitely check out the course.
Determinant of the trading status
So what determines whether we a is a , one that trades at Par, or if it’s a ?
The trading status is a function of:
- the Price of the bond, and
- its Par value (aka )
If the Price is greater than the Par value (), we say that the bond trades a Premium, or that it’s a “Premium Bond”. Because you’re paying a premium relative to the Par.
If on the other hand, the Price is equal to the Par value (), then we say that the bond trades at Par. Some call this a “” (again, because it trades at Par)
Finally, if the Price is lesser than the Par value (), then we say that the bond trades at a Discount, or that it’s a “Discount Bond”. Because you’re paying less than the par value.
Let’s look at an example to make sure that you really understand this.
Suppose we’ve got three bonds which we’ve just conveniently called A, B and C…
All three bonds have a Face value of $1,000 dollars, and the for each one is as follows: $963.53 for A; $1,000 for B; and $1,241.97 for C.
Can you can identify which bond is trading at a par? Which one’s trading at premium? And which one’s trading at a discount?
Hopefully it’s quite clear that A is trading at a Discount; B is trading at par; and C at a Premium.
That’s because A’s Price is lesser than the Par value. So it’s trading at a discount.
B’s price is equal to the Par value, which is why it is trading at par.
And finally, C’s price is greater than the Face value, so it’s trading at a premium.
Okay, now that you understand what a bond’s trading status is, and how we can tell if we’re looking at a discount vs premium bonds, or one that’s trading at Par…
Let’s understand why this information is useful.
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Exploring Discount vs Premium Bonds
In terms of why this information is useful…
Generally speaking, a Premium bonds is less risky. And a Discount bonds, generally speaking, is more risky.
Thus, if you see two bonds; one is trading at a Premium and the other’s trading at a Discount, then you know which one’s riskier than the other.
And depending on your risk tolerance, and your risk attitude, you can choose accordingly.
Regardless of what you choose though, it’s important that you know, that when you buy a bond that’s trading at a discount, it doesn’t mean that you’ve made a good deal.
Discount Bond Bargain
In other words, buying a Discount bond doesn’t mean that you’ve got a bargain.
Similarly, if you were to buy a bond at a Premium, it doesn’t mean that you’ve made a bad deal.
And it doesn’t mean that you’ve overpaid for something.
That’s because a Bond’s price is a function of its inherent risks and rewards.
If a bond trades at a Discount, it’s trading at that for a reason – because it’s highly risky.
Similarly, if a bond trades at a Premium, it’s trading at that for a reason.
And that’s because it’s less risky.
This will also be reflected in the ‘s (aka Yield, or Yield to Maturity, or ).
The of a will always be greater than the () of a .
Note that this is NOT the same as the . In other words, the ‘s is NOT its !
Types of Bonds
While there are whole host of different types of bonds, we can, generally speaking, categorise them into one of three main types:
- straight / vanilla (a bond that offers a and as its ),
- (a bond that only offers a as its ),
- perpetual / consol (a bond that only offers a as its )
Now, while Premium bonds can take the form of straight / vanilla bonds and perpetual bonds, only a discount bond can be a zero coupon bond.
In other words, it is impossible for a premium bond to be a zero coupon bond. We go into the rationale for zero coupon bonds in a lot more detail in this article.
So if you are interested in exploring those, do give them a read.
Of course, if you’re really interesting in mastering bond valuation, you should check out the course below.
Okay, hopefully this makes sense.
In summary, we learned that bonds can trade at a Premium, Par, or Discount.
And we refer to this as a Bond’s Trading Status”.
We learnt that, generally speaking, Premium bonds tend to be less risky.
And Discount bonds tend to be more risky.
Do you want to learn how to value bonds from scratch? And become a PRO at it while you’re at it?