Premium bond holders risk an overpayment if market interest rates rise significantly. To better explain this, let`s look at an example. Imagine the market interest rate today is 3% and you just bought a bond that pays a 5% coupon with a face value of $1,000. If interest rates fall by 1% from the moment you buy, you can sell the bond at a profit (or premium). Indeed, the bond now pays more than the market rate (because the coupon is 5%). As a result, the Apple bond pays a higher interest rate than the yield on 10-year Treasuries. With the additional yield, the bond will trade at a secondary market premium at a price of $1,100 per bond. In return, bondholders would receive 5% per year for their investment. The premium is the price investors are willing to pay for the additional yield of the Apple bond. It would be nice if bonds were always issued at face value or face value. However, certain circumstances prevent the issue of the par bond. We may be forced to issue the bond at a discount or at a premium.
This video explains the basic concepts, and then we`ll go over examples: When interest rates rise, investors demand a higher yield from the bonds they want to buy. If they expect interest rates to continue to rise in the future, they don`t want a fixed-rate bond with current yields. As a result, the secondary market price of older, low-yielding bonds falls. These bonds are therefore sold at a discount. When it comes to the attractiveness of investing, you can`t tell whether a bond is a good investment based solely on whether it sells at a premium or at a discount. Many other factors should influence this decision, such as interest rate expectations and the solvency of the bond itself. The gap was 2% (5% – 3%), but it has now increased to 3% (5% – 2%). This is a simplified way to look at the price of a bond, as many other factors come into play. However, it shows the general relationship between bonds and interest rates. The effective return assumes that the funds received from the coupon payment are reinvested at the same interest rate as the bond. In a world where interest rates are falling, this may not be possible.
The calculation of the prices of long-term bonds involves the determination of current values on the basis of compound interest. Buyers and sellers negotiate a price that gives the current interest rate for bonds of a certain risk class. The price investors pay for a particular bond issue is equal to the present value of the bonds. Bonds may be sold at a price above or below par value due to changes in interest rates. Like most fixed income securities, bonds are highly correlated with interest rates. When interest rates rise, the market price of a bond falls and vice versa. Fixed income bonds are attractive when the market interest rate falls because that existing bond pays a higher interest rate than investors can get on a newly issued low-yield bond. Conversely, as interest rates rise, new bonds that enter the market are issued at new, higher interest rates that drive up those bond yields. If a company performs well, its bonds will usually attract investor interest.
In the process, the price of the bond rises because investors are willing to pay more for the financially viable issuer`s solvent bond. Bonds issued by well-managed companies with excellent credit ratings are generally sold at a price higher than their face value. Since many bond investors are risk-averse, the solvency of a bond is an important measure. Issuers typically quote bond prices as a percentage of face value – 100 means 100% of par, 97 means a discounted price of 97% of face value, and 103 means 103% higher price of par. For example, one hundred $1,000 par value bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%). Regardless of the issue price, the issuer of the bonds must pay the principal value (or nominal amount) of the bonds to the investor(s) at maturity. A bond that trades at a premium means that its price is trading at a premium to or higher than the face value of the bond. For example, a bond issued at a face value of $1,000 could trade at $1,050 or at a premium of $50. Although the bond has not yet matured, it can be traded on the secondary market. In other words, investors can buy and sell a bond 10 years before the bond matures in ten years. If the bond is held to maturity, the investor will receive the face value, which is $1,000, as in our example above.
Credit rating agencies measure the creditworthiness of corporate and government bonds to give investors an overview of the risks associated with investing in bonds. Credit rating agencies usually issue letters to indicate ratings. Standard & Poor`s, for example, has a credit rating scale ranging from AAA (excellent) to C and D. A debt security rated below BB is considered a speculative rating or junk bond, meaning it is more likely to default on loans. Bondholders may overpay for a premium bond if it is overvalued. For example, a bond with a face value of $1,000 is sold at a higher price if it can be bought for more than $1,000 and sold at a discount if it can be bought for less than $1,000. The coupon of the bond against the risk-free rate is also important for assessing the opportunity cost of investing in bonds versus stocks. Ultimately, anything that could affect the bond`s cash flow, as well as its risk-adjusted return profile, should be weighed against potential investment alternatives. As an example, suppose Apple Inc. (AAPL) issued a bond with a face value of $1,000 with a maturity of 10 years.
The interest rate on the bond is 5%, while the bond is rated AAA by rating agencies. For investors to understand how a bond premium works, we must first look at how bond prices and interest rates relate to each other. When interest rates fall, bond prices rise, while conversely, rising interest rates lead to lower bond prices. When a bond trades at a premium, it simply means that it sells for more than its face value. Bond investments should be valued against expected short- and long-term future interest rates, if the interest rate is appropriate for the relative risk of default of the bond, expected inflation, bond duration (interest rate risk associated with the life of the bond) and price sensitivity to changes in the yield curve. Most bonds are fixed-income instruments, which means that the interest paid will never change over the life of the bond. No matter where interest rates fluctuate or how much they fluctuate, bondholders receive the bond`s interest rate – the coupon rate. Thus, bonds offer the security of stable interest payments. The bond market is efficient and adjusts to the current price of the bond to indicate whether current interest rates are above or below the bond`s coupon.
It`s important for investors to know why a bond trades at a premium – whether it`s because of market interest rates or the creditworthiness of the underlying company. In other words, if the premium is so high, it could be worth the extra return compared to the overall market. However, if investors buy a bond at a premium and market interest rates rise significantly, they run the risk of paying too much for the extra premium. A premium bond is also a specific type of bond issued in the UK. In the United Kingdom, a premium bond is called a lottery bond, which is issued by the UK government`s National Savings and Investment Scheme. Market and contract interest rates are likely to differ. Issuers must set the contractual interest rate before the bonds are actually sold to allow time for activities such as printing bonds. Suppose the contractual rate of a bond issue is set at 12%.
If the market rate is equal to the contract rate, the bonds are sold at face value. However, at the time of the sale of the bonds, the market rate could be higher or lower than the contract rate. The higher price of premium bonds partly offsets their higher coupon rates. Thus, when interest rates fall, bond prices rise as investors rush to buy older, higher-yielding bonds and, as a result, these bonds can be sold at a higher price. Premium bonds are typically issued by well-managed companies with strong credit ratings. As noted above, if the market rate is lower than the contract rate, the bonds will be sold at a price higher than their face value.