Definition: A premium on bond occurs when the bond’s par value is lower than the issue price or carrying value. The difference between these two numbers is considered the bond premium.
What Does Bond Premium Mean?
In other words, a premium is the difference between the par value and the market price when the par value is less than the par value. You can also think of this as the difference between the amount of money that investors pay for the bond and the actual price printed on the bond.
Since it usually takes companies months to finalize bond proposals, develop the legal agreements, and place the bonds on the market for the public to purchase, the original bond terms rarely match the current market interest rates. This means the interest rates issued and printed on the bonds aren’t the same as the current market rates.
Obviously, an investor wouldn’t want to purchase a bond that produces a lower return than the going market rate and the company wouldn’t want to issue bonds paying higher than market rates of interest. Bond issuers fix this problem by adjusting the issue price of the bond, so the actual interest paid on the bond equals the market rate.
A bond premium occurs when the market rate is less than the stated rate on the bond. The issuer increases the price of the bond to investors and in turn decreases their interest rate earned on their investment. This increase in bond price above the stated price is referred to as the bond premium.
For example, assume a company wants to issue a $1,000, 10% bond to the public when the market rate of interest is 8 percent. Why would a company want to pay investors 10 percent when the market rate is only 8 percent? They wouldn’t, so the company increases the initial selling price higher than $1,000. This way the investors will actually make 8% on their investment.
A bond discount works the opposite way.