2.8 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 to decide whether they wish to purchase the issue or not. In this short time, market yields are subject to fluctuation, as they are wont to do. 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 either discounts or premia. Moreover, over the life of the bond, market yields may diverge further from the coupons, resulting in some price volatility. Changes in credit ratings will also affect market yield and hence price.
While many people believe that bond prices are stable, any volatility can increase investment risk relative to bond portfolios. Volatility may stem from both bond market and macroeconomic causes and be reflected as changes in YTM.
When an investor purchases an “old” bond, which may have been issued when market yields – and hence coupons – were lower (or higher), it may be looked at as inferior (superior) in that its coupon pays less (more) than bonds issued today with the same maturity and credit rating. This is why, mathematically, such lower (higher) paying bonds trade at a discount (premium) to par. You get less (i.e., a lower coupon rate of interest than the current YTM), so you pay less. 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. Therefore, the “true” price of a bond is the YTM! 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.
