Why buy a bond at a premium?
/There are several reasons why an investor would buy a bond at a premium. These reasons are as follows:
Interest rate differential. An investor would buy a bond at a premium price when the bond’s stated interest rate is higher than the market interest rate. A premium bond is a bond whose current selling price on the open market is higher than its par (or stated) value. This situation arises when the stated interest rate on the face of the bond is higher than the market interest rate currently in existence. Thus, when investors see the higher interest rate being paid on the bond, they will bid up the price of the bond until the stated interest rate divided by the price paid equals the market rate. The amount of the premium that investors are willing to pay for a bond is based on the following calculation:
+ Present value of the scheduled redemption amount of the bond
+ Present value of the stated amount of future bond interest payments
- Undiscounted scheduled redemption amount of the bond
= Amount the investor is willing to pay for the bond
Credit rating requirement. It is possible that an investor will buy a bond at a premium because its investment policy requires it to only purchase bonds at a credit rating above a certain level. Bonds with higher-quality credit ratings are slightly more expensive, since their risk of default is lower. Consequently, they are somewhat more likely to sell at a premium.
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Example of Buying a Bond at a Premium
For example, ABC International sells $1,000 bonds at a stated interest rate of 8%, and at a time when the market interest rate is also 8%. Since the stated and market interest rates are identical, ABC can sell the bonds at the full $1,000 price. Investors are buying the bonds at neither a discount nor a premium.
A year later, market interest rates have fallen to 6%. Since investors can no longer obtain the 8% interest rate on the ABC bonds elsewhere, they bid up the price of the bonds to $1,050. Investors will continue to buy the ABC bonds at a premium until such time as the market interest rate either equals or exceeds the rate on the ABC bonds.
Limitations on Bond Premiums
The amount of a bond premium is limited by two factors. First, if there is only a short interval remaining before the issuer buys back the bonds, then the premium will be quite small, since investors will only be paid the face amount of the bond by the issuer. Second, if a call is imminent, then the price of the bond is likely capped at the price at which the call will be made.
Why Buy a Bond at a Discount?
The reverse of a premium bond is one that sells at a discount to its par value. It is worth buying such a bond when its stated interest rate is lower than the market interest rate. It may also be worthwhile to do so if you think that the issuer’s credit rating will be changed in the near future, resulting in a favorable change in the effective interest rate that will increase your rate of return on the bond.
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