DISCOUNTS AND PREMIUMS

Bonds are not always sold at face value (par).

Some bonds are sold for more or less than their face values: these bonds are sold at premiums or discounts.

Bonds can be discounted by their issuing companies or when bondholders sell them to others on the secondary market. When interest rates in the market rise, a bond's fixed interest payments are less attractive (the coupon rate is too low). To induce an investor to purchase a bond with a low coupon rate, the bond price must be lowered until the current yield equals the market rate.

Discounted bonds that do not pay interest are called zero coupon bonds.

Here is how they work: Let us say you buy a $1,000 bond for only $300. When the bond matures, you are paid $1,000. The $700 difference will be treated as "interest" for tax purposes.

A premium is an increase in price. When interest rates decrease, bonds with high interest rates are in demand. Investors who want to buy these bonds will offer to buy them at premiums.

Now let's review what we have learned.