There is nothing that we Jamaicans love more than a discount. So when we hear that a bond is trading at a discount, the typical response is “Gimme some of that one!” In fact, I have some clients that won't even consider a bond unless it is trading at a discount.
But I am here to tell you that for the typical bond buyer — the vast majority of individual investors who don't trade bonds but rather buy them with the intention of holding them to maturity — it really doesn't matter whether you buy bonds at a discount or premium. What matters is the Yield-to-Maturity (YTM).
The YTM provides the way to compare the relative return of premium bonds vs discount bonds. Just because a bond is trading at a discount does not mean it is giving you a better return on your money. Shocking, I know, but let me explain.
Bonds are issued with a “face value,” or “par value” which is the amount that is returned to the investor when the bond reaches maturity. From the time of issuance until the time of maturity bonds trade in the open market — just like stocks or commodities. As a result, their prices can rise above par or fall below it. A bond issued with a $1,000 face value that trades at $1,100 is trading at a premium, while one that falls to $900 is trading at a discount. A bond trading at its face value is trading “at par”.
At first glance it may seem simple. Why buy a bond that is trading at $1,100 when it is going to mature at $1,000 (a capital loss), when you could buy a discount bond at $900 and get $1,000 (a capital gain) when it matures? It is not that simple, because there is more to it than that. You also have to consider the interest that you earn during the life of the bond.
When a bond is first issued, it has a stated coupon rate. The coupon is the amount of interest that is paid on a bond's face value annually and it will continue to do so regardless of how much the bond's price fluctuates in the market after its issuance. The interest that you earn plus the principal amount that you get back at maturity will determine your overall return on your investment. It may just turn out that the premium bond is the better deal. This is where the Yield-to-Maturity will come into play, as it will help you to compare the relative return.
Bond #1: A-rated one-year bond with a five per cent coupon, at a cost of $990 (ie trading at a discount).
Bond # 2: A-rated one-year bond with an eight per cent coupon, at a cost of $1010 (ie trading at a premium).
If you buy Bond #1 you will spend $990 and it will pay you $50 in interest, plus you will gain $10 at maturity (because you get back $1,000 at maturity). That's a total return of $60 on an investment of $990.
If you buy Bond #2 you will spend $1,010 and it will pay you $80 in interest, but you will lose $10 at maturity (because you only get back $1,000 at maturity). That's a total return of $70 on an investment of $1,010.
Based on how much you spent initially and how much you get back in total (interest + principal) at maturity, Bond#2, which is trading at a premium, has a YTM of 6.93 per cent while the Bond # 2, which is trading at a discount has a YTM of 6.06 per cent. So you actually get a better return on the premium bond.
So this Christmas, when shopping for an investment deal, remember that a bond trading at a discount isn't always the better deal after all.