Premium and discount refer to the price of a bond and can often mean the difference between a gain and a loss on your investment. But the difference between discount and premium doesn't refer to anything to do with the overall merits of the bond. Instead, a premium bond is one trading above its face value and a discount bond is one trading below its face value.
A bond selling at a premium is one that costs more than its face value, while a discount bond is one selling below face value. Usually, bonds with higher than current interest rates sell a a premium, while those with interest rates below prevailing rates sell at a discount.
Understanding Bond Par Value Pricing
Most bonds are available in $1,000 denominations; $1,000 is the face value, or bond par value -- the amount to be repaid at maturity. Bonds prices are expressed as a percentage of par: a price of 100 means that a bond costs 100 percent of the face value, or $1,000 for each $1,000 of face value. A bond priced at 96 means it costs $960 for each $1,000 of face value; a bond priced at 105 means the cost is $1,050 for each $1,000 of face value.
Premium Vs. Discount
A bond with a price below 100 is a discount bond, while price above 100 means the bond is premium. Bond prices move in the opposite direction of interest rates: When interest rates rise, bond prices fall, and vice versa. When a bond is downgraded, its price usually drops. Discounts usually indicate a high-interest-rate environment or lower quality bonds; premiums suggest low interest rates.
Interest Rate Vs. Yield
Bond interest is fixed for the life of a bond. A $1,000 bond with 5 percent interest will pay $50 annually. When bond prices change, the amount of interest payments remains the same, but its yield - the actual return an investor will get on his money - will change.
For example, if the above bond is priced at 96, it will yield 5.2 percent; if it is priced at 105, it will yield 4.7 percent. The yield is always higher than the original rate for discount bonds and lower than the original rate for premium bonds.
Bond yields generally converge to some extent to prevailing interest rates. After all, investors aren't going to be interested in a bond that pays less than they could get by keeping their money in the bank, so prices will fall on low-interest rate bonds as rates go up. Similarly, investors will pay a premium for high rate bonds when overall interest rates are low. Changing credit ratings and perceptions of the bond issuer's creditworthiness also play a role in individual bonds.
Capital Gain Vs. Loss
Most investors buy bonds for current income and hold them till maturity. Regardless of what you pay for a bond, at maturity you will get back its full face value. If you buy a discount bond, you will have a capital gain; if you buy a premium bond, you will have a capital loss. But you could also lose money in a discount bond and come out ahead with a premium bond.
Suppose you buy a discount bond because it looks cheap, but it is cheap because the issuer is in financial trouble. If the issuer goes into bankruptcy, you stand to lose your entire investment. On the other hand, you could buy a premium bond instead of a certificate of deposit if the amount of interest you collect, less the capital loss at maturity, would still be more than the CD interest.