It's a wide world of bonds, and they are not all created equal. Discount and premium bonds are two types, and they are quite distinct from the average corporate or government bond. What makes them different is that they do not trade at face value, unlike most other types of bonds.
Bonds are debt instruments where you, the bondholder, lend money to a company or the government in exchange for interest payments. Usually you buy a bond at face value, collect interest along the way and then get back the face value when the bond matures. Discount and premium bonds are variations on that theme.
Premium Bond Basics
In the U.S. a premium bond is one that is purchased or traded at a higher price than its face value, also known as the par value. Why anyone would buy bonds at a premium when most bonds are sold at par is a function of interest rates. When interest rates decline, new bonds offer lower rates. Investors are then willing to buy older, higher interest bonds at a premium.
Discount bonds are purchased at a price below their par value, but upon maturity they return the full face value. Discount bonds are typically zero coupon bonds. Instead of paying period interest with coupons, zero coupon bonds make no periodic payments. They are sold at a deep discount from their par value, but upon maturity they pay out the face value plus all the interest accumulated along the way. They usually have long maturity periods and therefore are appropriate for long-term investment goals.
The Tax Issue
When it comes to discount bonds, one kick in the pocketbook is that taxable zero coupon bonds still require you to pay taxes on the interest each year, even though you don't collect it. For this reason zero coupon bonds are more popular as tax free municipal bonds or within tax-deferred retirement accounts, where there is no tax issue. Buying taxable bonds at a premium creates a complicated tax situation that should be discussed with a tax professional because each bond brings a unique set of tax circumstances.
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