Premium Vs. Discount Bonds
As an investor, you may explore bond market investments to collect interest payments. In addition to interest payments, you can also trade bonds for a profit. Bonds generally fluctuate in value according to the prevailing interest rate environment. For success with fixed income investments, learn to differentiate between premium and discount bonds.
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Identification
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Your bond agreement is actually a loan made out to a corporation or government entity. During the loan term, you earn interest payments until the bond principal is repaid at maturity. For bonds, par value is quoted at $1,000, where you can expect to receive a $1,000 principal payment at maturity. Prior to their respective maturity dates, premium and discount bonds trade at prices above and below par value.
Features
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Changes within the interest rate environment affect bond prices. According to the Securities and Exchange Commission (SEC), higher prevailing interest rates reduce valuations for existing bonds. At that point, you may purchase newer bonds that make higher interest payments. Prices for existing bonds are then discounted.
Alternatively, prices for existing bonds increase when prevailing interest rates are moving lower. New bonds would then make relatively low interest payments. In response, investors would aggressively buy the old bonds to lock in their higher rates. The increased demand causes the old bonds to gain value and sell for premium prices.
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Considerations
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For interest rate comparisons, learn to differentiate between coupon rates and yield to maturity. Coupon rates only take interest payments at par value into consideration. For example, a one-year bond that makes $150 worth of interest payments over the next year features a 15 percent coupon rate ($1,000 x .15 =$150). Yield to maturity calculations, however, are based upon the bond's purchase price. You may have actually purchased this bond at a premium for $1,050, and still collect $150 in interest payments. At maturity, you will receive $1,000 in principal, which is actually a $50 loss from the original investment ($150 - $50 = $100 total profits). Your yield to maturity is therefore roughly 9.5 percent ($100 total profits / $1,050 original investment = 9.5 percent).
Strategy
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Work to trade bonds according to the economic cycle. In a recession, prevailing interest rates generally fall because of weak loan demand. At that point, lenders are forced to drop their interest rate demands to compete for business. When the economy performs well, interest rates usually move higher as people are motivated to take out loans and invest money. When trading bonds, you can purchase and hold bonds throughout a high interest rate environment. These bonds may then be sold for a premium when the economy deteriorates into a recession and interest rates fall.
Warning
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Short-term interest rate movements are nearly impossible to predict, as they are influenced by numerous economic factors. These factors include foreign exchange rates, Federal Reserve monetary policy, real estate valuations, and government spending. To manage interest rate risks, you may consider buying into a diversified bond fund. The bond fund should hold bonds of various maturity dates, industries, and geographic regions, so that you may make money in different economic scenarios.
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References
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