Premium bonds vs Par bonds vs Discount bonds: Rate of return explained
Updated: Dec 02, 2020 9:06 AM
The price of a bond and its yield are inversely related for bonds with a given principal amount, time to maturity, and coupon rate.
These days most bond issuers credit the holders’ accounts directly on every coupon payment date.
By Sunil K Parameswaran
The rate of interest paid by a bond issuer is called ‘coupon’. In the days before electronic payments, bonds would come with a booklet of coupons. Each was like a post-dated cheque. Since most bonds pay interest semi-annually, the bondholder was expected to detach the relevant coupon every six months and present it for payment.
These days most bond issuers credit the holders’ accounts directly on every coupon payment date. In 1996, I bought some RBI bonds and actually got a booklet of coupons. Today even in India, the credit takes place electronically. Even today however, bearer bonds come with a booklet of coupons. Unlike registered bonds, where a record is maintained of the ownership at all points in time, bearer bonds belong to whoever has them at a point in time. It is like a currency note. If you drop a Rs 500 note on the floor, you cannot prove that it belongs to you. The same holds true for bearer bonds. As they used to say in school, ‘finders keepers and losers weepers’.
Rate of return
The rate of return that a bond holder gets from it is called the Yield to Maturity (YTM). The price of a bond and its yield are inversely related for bonds with a given principal amount, time to maturity, and coupon rate. The logic is as follows. The issuer is going to pay pre-determined cash flows to the holders. So how can a holder extract a higher return from a given set of cash flows?
Obviously, by reducing the price that he or she pays for the bond. Thus, price and yield are inversely related. Think of coupon as the rate of return offered by the issuer. YTM, on the other hand, is the rate of return demanded by the market.
If the coupon is equal to the YTM the bond will sell for its par value, and such bonds are called par bonds. If the yield is more than the coupon the bond will be less for a price that is less than its par value, and such bonds are called discount bonds.
On the other hand, if the yield is less than the coupon the bond will sell for a price that is higher than the face value or par value. Such bonds are called premium bonds. At maturity, all bonds must trade at par. Consequently, if the yield does not change, the price will gradually approach the par value as we go from one coupon date to the next. Thus, par bonds will trade at par on every coupon date. Premium bonds will steadily decline in price as we approach the maturity date, while discount bonds will steadily increase in price as we approach the maturity date.
This is called the ‘Pull to Par Effect’. The rationale is as follows. As we go from one coupon date to the next, one coupon payment drops out of the pricing equation. This pulls down the price. However, when we go to a subsequent coupon date, the face value gets discounted for one period less. This pulls up the price. For par bonds, the effects neutralise each other, and the price remains unchanged. For premium bonds, the first effect dominates, and the price steadily decreases. For discount bonds the second effect dominates, and the price steadily increases.