Discount vs Premium Bonds - Trading Status Explained

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:

Discount,
Par, or
Premium

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.

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This Article features a concept that is covered extensively in our course on Bond Valuation Mastery.

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Determinant of the trading status

So what determines whether a bond is a Discount Bond, one that trades at Par, or if it’s a Premium Bond?

The trading status is a function of:

the Price of the bond, and
its Par value (aka Face value)

RELATED: How do Bonds Work?

If the Price is greater than the Par value ( $P > Par$ ), 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 ( $P = Par$ ), then we say that the bond trades at Par.

Some call this a “par bond” (again because it trades at Par)

Finally, if the Price is lesser than the Par value ( $P < Par$ ), 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.

Example

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 bond price for each one is as follows:

$963.53 for A
$1,000 for B, and
$1,241.97 for C

Can you identify which bond is trading at 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, Premium bonds are less risky. And Discount bonds, generally speaking, are more risky.

On a similar note, Discount bonds tend to have lower/poorer bond ratings vis-a-vis Premium bonds.

RELATED: Bond Ratings Explained

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 $\neq$ 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 bond’s interest rate (aka Yield, or Yield to Maturity, or YTM).

The YTM of a Discount Bond will always be greater than the YTM (interest rate) of a Premium Bond.

Note that this is NOT the same as the coupon rate. In other words, the bond’s interest rate is NOT its coupon rate!

Types of Bonds

While there are a whole host of different types of bonds, we can generally speaking, categorise them into one of three main types:

straight / vanilla bond (a bond that offers a coupon payment and par value as its cash flow),
zero coupon bond (a bond that only offers a face value as its cash flow),
perpetual bond or consol (a bond that only offers a coupon payment as its cash flow)

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 a separate article, including zero coupon bond pricing so do give that a read if you want to learn more.

And we also explore Consols and Straight / Vanilla bonds in different articles.

So if you are interested in exploring those, do give them a read.

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