The bond market is anticipated to be relatively unwavering, unlike the stock market. However, there is a scope of instability linked with bonds since the ownership is often transferred from one investor to another.
As we delve into the bond industry, we must comprehend the primary difference between premium and discount bonds. Categorising the primary differences is the key to capitalising on some of its meagre volatility.
For an investor, it is feasible to capitalise on premium and discount bonds based on their investment strategy. Leveraging only a sound investment strategy can help investors reap the benefits of premium bonds and discount bonds.
Before we move further, let’s first learn how the price of a bond is set.
How are Bond Prices Set?
A bond is a type of loan from an issuer. When bonds are purchased, the issuer can use your money in return for interest.
For instance, governments issue municipal bonds to raise capital for public works like road maintenance. In tune with that, companies issue corporate bonds to raise capital for business expansion projects.
Typically, a bond is issued at a fixed par value. A bond trades at par when the current price is equivalent to the issued face value. However, its price varies when a bond enters the open market and is available for trade.
Some key factors influence the pricing of a bond. Such factors include:
- Bond’s maturity term
- Supply and demand
- The credit rating of the bond issuer
Note: As per the RBI, the price of government securities, like bonds, is evaluated based on the supply and demand of securities. Other macroeconomic factors like inflation and market liquidity also influence the price of bonds.
What are Premium Bonds?
A bond trading higher than its original price/par value in the secondary market is termed as Premium Bond. A premium bond is a bond when the given interest rate surpasses the interest rate proposed by new bonds.
One of the easiest ways to determine whether a bond is trading at a premium is by reviewing its price. If you are required to pay more than the face value to buy a bond, it is viewed as a premium bond.
What are Discount Bonds?
A discount bond is a bond that trades less than the par value in the secondary market. A bond will trade at a discount only when the coupon rate has fallen below the prevailing interest rate in the market.
Discount bonds appeal to investors who wish to buy bonds at a lower price.
Premium vs. Discount Bonds: Which is Better?
Discount and premium bonds play a prominent role in diversifying an investor’s portfolio. An investor can buy a premium or discount bond based on two distinguishing factors:
- Risk tolerance
- Investment objectives
You can earn a higher interest rate with premium bonds than the market. Such bonds have a lower risk factor since they are issued mainly by certified companies or government bodies with commendable credit ratings.
However, if there is a spur in market interest rates, paying more for a premium bond is inevitable. As a result, it leads to the overvaluation of a premium bond.
In contrast, purchasing a discount bond below par value can be risky. Hence, it is vital to consider the issuer’s credit quality and the discount bond’s coupon rate before taking the investment plunge.
Advantages of Discount Bonds
Here are some of the advantages of discount bonds:
- Steady cash flow- Discounted bonds are ideal for those investors who seek a short-term investment option in return for regular capital gains. It provides them with the opportunity to discontinue the bond before its maturity.
- Incredible returns- Higher returns are guaranteed if an investor holds the discounted bonds until maturity. It enables an investor to create a proficient and strategic financial plan.
- Market Regulation – When market prices are irregular, or it is difficult to evaluate the different face values, opting for a discount bond is ideal for an investor.
Disadvantages of Discount Bonds
Regardless of the advantages stated above, discount bonds have some disadvantages, including:
- Maturity issues- Discount bonds with longer maturity are more likely to default.
- Poor dividend performance- Discount bonds often indicate bad dividend performance. Hence, investors often deny purchasing the existing debt.
- Low ratings- Discount bonds often impact the ratings of the issuer adversely. However, it is often influenced by the looming market interest rates.
Advantages of Premium Bonds
Here are some of the advantages of premium bonds:
- Opportunity to earn big- Premium bonds provide the golden opportunity to earn big. This ropes in investors from all around.
- Exemption from Tax- Premium bonds are tax-free. It is a boon for high-rate taxpayers. It means no Capital Gains Tax and Income Tax.
- Zero investment risk- There is no risk of losing money in premium bonds since government entities back them.
- Easy accessibility- Investment in government-backed premium bonds can be easily withdrawn at will without paying any charges.
Disadvantages of Premium Bonds
Here are some of the disadvantages of premium bonds:
- No returns on investment- If you do not win a big payout in a monthly prize draw, it is impossible to see a fruitful return on your investment.
- Poor chances of winning- The odds of winning anything big are not significant in premium bonds.
- No fixed income- You will likely earn a small portion of the amount invested. The amount earned may not be able to stand against inflation.
Example of a Discount Bond
When the face value of a bond has depreciated to boost its overall yield, it is called a discounted bond.
For instance, if the bond you have is trading at Rs. 800 than the previously issued face value of Rs. 1000, the bond yield will rise. Hence, it will be a better option for investors but not lucrative for you.
Example of a Premium Bond
A bond is at a premium when it has increased from its primary face value. For instance, if your bond is trading at an existing price of Rs. 1000, which is higher than other new bonds, then you can sell your bonds at a price more than the initial face value of Rs. 900
Why does a Bond Trade at a Premium or at a Discount?
Here is a simple explanation as to why this occurs.
Any investor will not buy a bond yielding 3% when they can buy a similar bond yielding 4%. The bond price needs to decline to help the yield shoot up to a degree where the investor may wish to have the bond.
With this in mind, it is easy to conclude that:
- A bond trades at a discount when the interest rate is less than the prevailing coupon rate
- A bond trades at a premium when the interest rate is more than the prevailing interest rates
How to Invest in Premium and Discount Bonds?
Did you know?
The above fact bears testimony to the truth that adding bonds along with stocks, real estate, and other kinds of investments makes a perfect portfolio.
Hence, while deciding whether to invest in premium or discount bonds, take into regard certain things like:
- Bond Ratings
- Coupon Rate
While determining whether to invest in premium or discount bonds, it is imperative to analyse whether it is a perfect match for your investment strategy or not. By focusing on the interest rate environment, it is possible to determine where the bond prices will move in the near term.
How Does Yubi Use Individual Bonds in Our Client’s Portfolios?
At Yubi, we favour individual bonds over bond exchange-traded funds or bond funds. Our bond traders at Yubi are familiar with and well-versed in dealing with premium and discount bonds.
Not to mention, they also provide several calculations required while buying bonds on the secondary market.
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