What it means
Bond prices are quoted as a percentage of face value, so a price of 105 means $1,050 for every $1,000 of principal. Anything above 100 is above par, or trading at a premium; anything below 100 is below par, or at a discount.
The main driver is the gap between the coupon rate written into the bond and the yield the market currently demands. If a bond pays 6% and comparable new issues only pay 4%, buyers will bid the older bond up until its effective return matches the market.
Credit quality matters too. A borrower whose finances have improved since issue may see its debt trade above par simply because the risk of not being repaid has fallen.
For the buyer the premium is a real cost that has to be amortised over the bond's remaining life. The cash coupons look attractive, but part of each payment is really the return of that premium, which is why the yield to maturity on a premium bond is always lower than its current yield.
Callable bonds add a trap. If the issuer can redeem early at or near par, a bond trading well above par may be called away, handing the holder back less than the market price they paid, so yield to call rather than yield to maturity becomes the number that matters.
In practice
Real-world examples.
Example
A pension fund holds a 7% government bond issued when rates were high. With new issues now yielding 3%, the bond trades at 118, and the fund's accounts show a large unrealised gain even though the bond will still repay only $1,000 per unit at maturity.
Example
A manufacturer issued 8% notes during a difficult period and has since been upgraded twice. The notes now trade at 106, so the company considers calling them at 102 and refinancing with new debt at 5%.
Example
A treasurer buying corporate bonds at 104 works out yield to call rather than yield to maturity. The issuer may redeem at par in eighteen months, which would cut the realised return to about 2.6% a year, roughly half the headline current yield of 5.2%.
Formula
Calculation
Premium = market price - par value
Current yield = annual coupon / market price
Approximate yield to maturity = (annual coupon + (par value - price) / years to maturity) / ((par value + price) / 2)
A corporate bond with a $1,000 face value pays a 6% coupon, so $60 a year, and trades at 110, or $1,100. The premium is $1,100 - $1,000 = $100, and the current yield is $60 / $1,100 = 5.45%.
With five years left to maturity the holder loses that premium at $100 / 5 = $20 a year, so effective annual income is $60 - $20 = $40. The approximate yield to maturity is $40 / (($1,000 + $1,100) / 2) = $40 / $1,050 = 3.81%, well below both the 6% coupon and the 5.45% current yield.Case study
Seen in the real world.
This is an illustrative and clearly fictional example. Halloway Mutual, an invented insurance company, bought $10,000,000 of face value corporate bonds at 112 because the 7% coupon comfortably beat the 3% available on new issues. The investment committee recorded a purchase price of $11,200,000 and focused on the $700,000 of annual coupon income.
What the committee had not priced properly was the call feature. Two years later the issuer redeemed the bonds early at 103, paying Halloway $10,300,000 against the $11,200,000 it had paid, a capital loss of $900,000 set against $1,400,000 of coupons received.
The net gain of $500,000 over two years worked out at about 2.2% a year, less than the fictional insurer would have earned on plain deposits. The illustrative lesson is that a bond trading above par is only a sound buy once the premium and the issuer's right to call have both been costed in.
Watch out
Common mistakes.
- Reading a price above par as a sign the bond is cheap, when the premium is simply the market pricing in an above-market coupon.
- Quoting the coupon rate as the expected return, when yield to maturity on a premium bond is always lower.
- Ignoring the call schedule, which can end the income stream early and crystallise a loss on the premium paid.
Questions
People also ask.
Why would anyone pay more than a bond will repay?
Because the coupon payments received in the meantime are worth more than the premium given up, provided the bond is held to maturity and the issuer does not default.
Does a bond trading above par mean the issuer is in good health?
It often points that way, but the bigger driver is the general level of market interest rates rather than the borrower's own finances.
Is the premium tax deductible for the buyer?
In many systems it can be amortised against the interest income over the bond's life, though the treatment varies by jurisdiction and is worth checking.
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