Understanding Discount and Premium on Bonds

Definition of Discount and Premium on Bonds

Discount and Premium on Bonds are terms used to describe the relationship between a bond’s face (par) value and its market price. A bond is sold at a discount when its market price is lower than its face value, and it is sold at a premium when the market price exceeds the face value.

Detailed Explanation

Bonds are debt instruments issued by governments or corporations to raise funds. Investors purchase bonds to earn interest (coupon payments) over a period. However, due to changing interest rates or market conditions, bonds may trade below or above their nominal value, creating a discount or premium.

Discount on Bonds: Occurs when the bond’s coupon rate is lower than the prevailing market interest rate. Investors pay less than the bond’s face value.
Premium on Bonds: Occurs when the bond’s coupon rate is higher than the prevailing market interest rate. Investors are willing to pay more than the face value.

These concepts are vital in bond pricing, investment decisions, and accounting for debt instruments.

Understanding Through Sub-sections

Factors Affecting Discount and Premium

Market Interest Rates: The primary driver; higher market rates cause discounts, lower rates lead to premiums.
Credit Rating of Issuer: Higher-rated bonds may command a premium due to lower risk.
Time to Maturity: Longer maturity bonds are more sensitive to interest rate fluctuations.
Inflation Expectations: Expected inflation reduces bond value, leading to discounts.

Formula or Calculation

The calculation of bond price at discount or premium is based on the present value of future cash flows:

$\text{Price of Bond} = \sum \frac{\text{Coupon Payment}}{(1 + r)^t} + \frac{\text{Face Value}}{(1 + r)^n}$

Where:

$r$ = market interest rate per period
$t$ = period number
$n$ = total number of periods
Discount Amount = Face Value − Market Price
Premium Amount = Market Price − Face Value

Example Calculation

Scenario: A company issues a bond with a face value of $1,000, annual coupon 6%, maturity 5 years. Market interest rate = 8%.

Calculation:

Since coupon rate < market rate, bond is sold at a discount.
Present value of coupons + face value = Market Price (e.g., $925).
Discount = $1,000 − $925 = $75

If the market rate were 4% instead, bond price = $1,075 → Premium = $75.

Accounting Treatment for Discount and Premium on Bonds

Journal Entries

1. Bond Issued at Discount


Cash A/C .................... 925
Discount on Bond A/C ....... 75
       To Bonds Payable A/C ........... 1000

2. Bond Issued at Premium


Cash A/C .................... 1075
       To Bonds Payable A/C ........... 1000
       To Premium on Bond A/C ........ 75

Amortization of Discount or Premium

Straight-line method: Distribute discount/premium evenly over bond life.
Effective interest method: Allocate discount/premium based on carrying amount and market rate.

Key Features / Characteristics

Discount Bond: Sold below face value, higher yield to maturity.
Premium Bond: Sold above face value, lower yield to maturity compared to coupon.
Market Price vs Par Value: Determines whether bond is at discount or premium.
Time Value of Money: Core concept affecting bond pricing.

Importance in Business

Helps investors make informed investment decisions.
Assists companies in pricing debt securities.
Impacts interest expense and financial reporting.
Affects bond portfolio management and risk assessment.

Advantages and Disadvantages

Advantages:

Provides flexibility in financing.
Allows investors to earn higher yields (discount bonds).
Reflects market interest conditions.

Disadvantages:

Premium paid reduces effective yield.
Discount indicates higher risk if issuer defaults.
Requires careful accounting for amortization.

Usage

Used in bond issuance and pricing.
Applied in investment analysis and portfolio management.
Critical in financial reporting for amortization and interest expense calculations.

Real-Life Case Studies

Apple Inc. Bonds (2020): Issued $5 billion 10-year bonds at a slight premium due to low market interest rates, reflecting investor appetite for high-quality corporate debt.
Government Bonds in India: RBI often issues bonds at discount during high-interest-rate periods to attract investors.

Diagram / Table Example

Bond Type	Face Value	Market Price	Discount / Premium	Reason
Discount Bond	$1000	$950	$50 Discount	Market rate higher
Premium Bond	$1000	$1050	$50 Premium	Market rate lower

Practical Example

An investor buys a 5-year bond with 5% coupon at $950. At maturity, face value = $1000. Profit = $50 + coupon payments → demonstrates discount benefit.

Common Mistakes or Misunderstandings

Confusing coupon rate with market rate.
Ignoring amortization of discount/premium in accounting.
Assuming a premium bond always yields higher return—yield may be lower than coupon rate.

Real-Life Applications

Corporate Finance: Determines cost of debt financing.
Investment Banking: Used for pricing corporate bonds and municipal bonds.
Portfolio Management: Helps evaluate risk and return.
Legal Implications: Proper disclosure of discount/premium required under IFRS/GAAP standards.

FAQs

Q1: Can a bond switch from discount to premium?
A: Yes, if market rates change significantly.

Q2: Are zero-coupon bonds always sold at a discount?
A: Yes, because they do not pay periodic interest.

Q3: How is discount/premium recorded in accounts?
A: As a separate account amortized over bond life to adjust interest expense.

Q4: Does premium reduce effective yield?
A: Yes, paying more than face value lowers the bond’s yield to maturity.

Expert Tip from Learn with Manika

Always compare market interest rates with bond coupon rates before investing. Understanding discount and premium ensures smarter financial decisions and accurate accounting.

Related Terms

Bond Yield
Coupon Rate
Effective Interest Rate
Zero-Coupon Bond
Market Interest Rate
Bond Amortization
Present Value of Bonds