12.6 Bond Dollar Prices: Discount, Par, and Premium
In the case of investment grade bonds (but not in the case of “junk bonds”), corporate issuers usually endeavor to set the coupon so that the initial offering price for the new bond at the time of issuance is Par (100% of the bond’s face value). The coupon and other important terms of the underwriting are written into a legal document called the indenture.
Once the indenture is completed, prospective bonds investors are provided with a “prospectus,” which lays out the terms of the bond, the financial condition of the company, and other important facts. Investors have some time until the bond is issued in which to decide whether they wish to purchase the bond or not. In this short time, market yields are subject to fluctuation. As a result, at the ultimate time of issue, the coupon rate and the contemporary market yield (Yield-To-Maturity or “YTM”) will likely have diverged.
Therefore, it is not terribly common to see new bonds being issued at a price of precisely Par; this of course results in new issue prices being at either discounts or premia to Par. There are these two possibilities. Moreover, over the life of the bond, market yields may diverge still further from the coupons.
For example, when an investor purchases an “old” bond, which may have been issued when market yields – and hence coupons – were lower, it may be looked at as inferior to newer bonds in that its coupon pays less than bonds issued today with the same maturity and credit rating. This is why – mathematically – such lower paying bonds trade at a discount to par. You get less (i.e., a lower coupon rate of interest than the current YTM), so you pay less.Of course, this is also true in reverse.
Similarly, for premium bonds, you pay more, because you get more (coupon than the current YTM). The time value of money discount rate (i.e., YTM) is the great equalizer. You may take two bonds that are similar in all respects except the coupon; they will trade at the same market yield, as they should, by definition, but their dollar prices will differ. Therefore, the “true” price of a bond is the YTM!
While many people believe that bond prices are stable, any volatility can increase investment risk relative to bond portfolios. Volatility may stem from default risks and macroeconomic causes and will be reflected as changes in YTM.
You get more (Coupon than Market Yield) you pay more!
