The price of a bond fluctuates until it’s called, or matures. Depending on the market, a bond may be sold at a discount, at a premium, or at par value. A municipal bond buyer must determine which bonds are best suited for their investment portfolio. Understanding the difference between discount bonds and premium bonds is the beginning to determining the true value of potential municipal bond investments.
What Are Discount Bonds
When current market interest rates are higher than the coupon rate, then a bond will sell below par, or at a discount. Discount bonds trade for less than par value in the secondary market. As stated previously, they have a lower yield, which means the potential for investment income is smaller with discount bonds than with premium bonds. Discount bonds are also priced lower than premium bonds, which gives an investor the opportunity to buy more bonds at a lower price.
What Are Premium Bonds?
With premium bonds the reverse occurs. Premium bonds trade above par value in the secondary market. The bonds trade at a premium when they offer a coupon rate that is higher than current market interest rates. Some investors look to purchase premium bonds when they want a higher yield. The retail investor has an aversion to investing in premium bonds. However, sophisticated investors including institutions have historically invested in premium bonds because they recognize the value.
A Closer Look: Discount Bonds vs. Premium Bonds
- When interest rates fall due to market conditions, it is likely that more bonds will be trading at a premium.
- As interest rates rise, there will be more discount bonds available in the market.
- Because of the higher coupon rates that come with premium bonds, investors can potentially have more investment income to invest as rates increase. This is one example of a potential advantage to premium bonds when investors believe that rates are going higher.
- Owning premium bonds makes an investor less susceptible to market fluctuations and inflation from higher interest rates.
- Some bonds are callable, which means they can be redeemed early if the issuer chooses. This is more likely to happen with premium bonds if interest rates fall.
Contact a GMS municipal bond specialist today at 877-567-9811 to determine which discount bonds or premium bonds are suitable for your investment portfolio.