How do I know whether a bond is offered at a discount or a premium and what’s the difference?

Answer 1

These types of questions can be tricky without an understanding of the basics of bonds. First, it is important to understand who is issuing the bond and why. Bond issuers are usually organizations seeking to raise funds, but not necessarily wanting to issue stock and give away ownership in the organization. Therefore, bonds are a form of debt that will appear in the liability section of the organization’s balance sheet.

With that in mind, bond issuers are looking for investors (purchasers of the bonds). Investors will pay the issuers a stated amount up front with the expectation that they will earn more money at the end of the bond term through a combination of interest payments and getting their initial investment back. OR by getting a lump sum in the future that was greater than their initial investment.

The question of Discount or Premium indicates the bond is offering the investor/purchaser a series of interest payments over the life of the bond in addition to paying the investor back their initial investment at the end of the bond term.

For example, if Company ABC offers 10 year bonds with a face value of $1000, and a stated interest rate of 6% paid annually, they are promising investors to pay them 6% on their investment once a year. At the end of year 10, the issuer will also pay back the $1000 face value they originally borrowed from the investor.

The question of discount or premium is a matter of the stated interest rate vs the current market rate. In other words, what could an investor earn on a similar bond or investment in the open market. If the market is paying less than 6% interest, than this bond would appear more attractive to investors since they would earn more money than they could in the market. As a result, investors may be willing to pay a Premium (more than the face value of the bond) to be able to earn 6% interest. ABC may sell these $1000 face value bonds for $1100 or more depending on the market conditions.

A discount is the opposite scenario. The bond issuer is offering 6%, but the market is currently offering interest rates at 8%. In this scenario, the bond is less attractive to investors and the organization may have to offer the bonds at a discount (less than the $1000) face value to entice investors to buy their bonds. ABC company may be selling these $1000 face value bonds for $900 or less depending on market conditions.