Difference between a discount bond and a premium bond

Sample Solution

1. Discount vs. Premium Bond:

The key difference between discount and premium bonds lies in their purchase price compared to their face value (par value), which is the amount the issuer promises to repay at maturity.

• Discount Bond: A discount bond is purchased for less than its face value. This happens when the market interest rate is higher than the coupon rate (interest rate) offered by the bond. Investors are willing to accept a lower upfront price in exchange for receiving the face value at maturity.

Example: Imagine a bond with a face value of $1,000 and a coupon rate of 4%. If current market interest rates are 6%, investors might be willing to buy this bond for $900 (discount). They receive a lower interest payment (4%) but benefit from the capital appreciation of $100 ($1,000 face value - $900 purchase price) when the bond matures.

• Premium Bond: Conversely, a premium bond is purchased for more than its face value. This occurs when the market interest rate is lower than the coupon rate offered by the bond. Investors are willing to pay extra for the guaranteed higher interest payments compared to what they could get elsewhere.

Example: Consider a bond with a face value of $1,000 and a coupon rate of 8%. If current market interest rates are 5%, investors might be willing to pay $1,100 (premium) to buy this bond. They receive a higher interest payment (8%) but forgo some potential capital appreciation as they pay more than the face value upfront.

Full Answer Section

2. Yield to Call (YTC):

The yield to call (YTC) is the internal rate of return (IRR) an investor would earn on a callable bond if they held it until the issuer calls it back before maturity. It considers the purchase price, the coupon payments, and the call price (the price the issuer can redeem the bond at before maturity).

Why it's Important:

YTC is crucial for bond investors, especially for callable bonds, because it helps them understand the potential total return if the bond is called early. Here's why:

• Compares Investment Options: It allows investors to compare the potential return of a callable bond to other investment options with similar maturities.
• Decision-Making: Knowing the YTC helps investors decide whether to buy a callable bond, considering the potential for early redemption and the resulting return.
• Selling Before Call: If the YTC is lower than the current market interest rate, investors might consider selling the bond before it's called to avoid potential lock-in at a lower return.

By considering the YTC, bond investors can make more informed decisions about purchasing and holding callable bonds.