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Issuing Bonds at a Discount or a Premium

Issuing Bonds at a Discount or a Premium
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  • 0:00 What Are Bonds?
  • 1:08 Bonds Sold at a Discount
  • 2:59 Bonds Sold at a Premium
  • 4:47 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define a bond and discuss how bonds are issued at a premium and discount. You'll also learn the advantages and disadvantages of each.

What Are Bonds?

Monique graduated from college a few years ago and is a manager at Cakes and Bakes Corporation. She has quite a bit of money saved and would like to start investing. She calls one of her college friends who is now a financial advisor. They meet for lunch, and she explains to him that she is interested in investing.

Her friend starts by asking her what her ideas are about investing. Monique expresses she wants a long-term, safe investment where the risk of losing money is low. The financial advisor tells her those are characteristics similar to a bond.

A bond is an investment product where the investor loans a corporation money. In return, the investor would like periodic annual payments and the total amount returned in the future. Based on those annual payments, sometimes an investor is willing to purchase the bond at a discount, an amount less than the borrowed amount, or they may purchase the bond at a premium, an amount greater than the borrowed amount.

In this lesson, we'll explain the reason why corporations sell bonds and why bonds are issued at a discount and premium. You'll also learn the advantages and disadvantages of each.

Bonds Sold at a Discount

A corporation needs money to expand and grow and typically, they have three options: sell stock, receive a loan from a bank, or sell bonds. Bonds are similar to an IOU; the investor loans money to the corporation and the corporation promises to pay the money back. The amount of money the corporation borrows is considered the principal.

While the investor is waiting for the bond to be paid back, which sometimes can take years, they want something in return. Investors require the corporation to pay them interest annually until the principal is paid back. These payments are called coupon interest payments. Interest is the cost of borrowing money.

Let's say a corporation issues bonds of $100,000 with $5,000 coupon interest payments to be paid back in 10 years. The investor knows they will receive $100,000, however, how much should they pay for the bond? The present value is calculated to determine the purchase price. The present value is how much the bond is worth today.

Let's say an investment broker calculates the present value of the bond at $69,277. Since the present value is less than the future value ($69,277 is less than $,100,000), the bond will be sold at a discount.

The investor knows they'll make $30,723 (which is $100,000 - $69,277) plus $50,000 of annual interest payments ($5,000 * 10 years). The financial advisor asks Monique if she understands bonds selling at a discount and then says, ''Now let's look at an example where the future value is less than the present value.'' Monique asks the financial advisor, ''Why would an investor pay more for the bond than it is actually worth?''

Bonds Sold at a Premium

Sometimes an investor will pay more for a bond than its current value. In essence, the present value of the bond will be greater than the future value, which means the bond is selling at premium.

Let's say the same $100,000 bond has a present value of $130,722. That means the investor will pay $130,722 for the bond, but will only receive $100,000 at maturity. Clearly, the investor will lose $30,722.

Remember, there's another component of the bond - the coupon interest payments. If the investor will receive $15,000 of annual interest payments and it takes 10 years for the bond to mature, then they will receive a total of $150,000 in interest payments ($15,000 x 10). Overall, the investor would have made a profit of $119,278 (or $150,000 - $30,722), which is much better than buying the bond at a discount.

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