Premium Bonds

What happens when interest rates fall? Bond prices rise. If you owned this 8% bond and saw that interest rates had just fallen to 6%, how would you feel about your bond?
Pretty good. After all, it pays 2% more than new debt is paying. Do you want to sell
it? Not really. But you might sell it if investors were willing to pay you a premium.
Current Yield
Bond investors push the price of the bond up as interest rates go down. Maybe your bond is worth $1,200 on the secondary market now dividing our $80 of annual interest by the $1,200 another investor would have to pay for the bond gives us a cur¬rent yield of just 6.7%. That's lower than the coupon rate.

So, wait, did the price of this bond just rise, or did its current yield drop?
Exactly right! When you see a coupon of 8% and current yield of 6.7% (or anything lower than that 8% printed on the bond), you're looking at a premium bond. A discount bond trades below the par value, while a premium bond trades above the par value.

The nominal yield of the bond doesn't change Therefore, the only way to push a yield lower than the nominal yield stated on the bond is to have an investor pay more than par for the bond. Similarly, the only way to push the yield higher than the nominal yield stated on the bond is to have an investor pay less than par for the bond.

Yield to Maturity
If you sell your bond, you obviously don't care about the next investor's yield. But, when this investor's bond matures, how much does she get back from the issuer? Only $1,000. So, she put down $1,200 and will only get back $1,000 at maturity. Her Yield to Maturity (YTM) goes down below both the nominal and current yields.

Yield to Call
Remember when we decided a person who buys a bond at a discount wants the bond to return the principal amount sooner rather than later? Well, if you pay more than the par value for a bond, you're going to lose money when the bond returns your principal, no matter when that happens. So, if you're going to lose money, you want to lose it slowly to increase your yield. That's why a person who purchases a bond at a premium will have a lower yield to call than yield to maturity. He's going to lose money in either case, so he'd prefer to lose it over 10 or 20 years (maturity) rather than just 5 years (call).
So, yield to call is the lowest yield for a bond purchased at a premium. And, if there are successive call dates, the earliest call date will produce the worst or lowest yield to the investor.

Disclosing Yield on Customer Confirmations
When a customer purchases a bond, the broker-dealer sends her a trade confirmation no later than the settlement date. And, on this trade confirmation the firm must disclose either the YTM or the YTC. Should they disclose the best possible yield or the worst possible yield?
Always prepare the customer for the worst or most conservative yield, so there are no bad surprises, right? Okay, for a discount bond, which yield is lower, YTM or YTC? YTM. That's what the firm would disclose to a customer who purchases a bond at a discount.

For a premium bond, which yield is lower? Yield to Call. So, that's what the firm would disclose to a customer who purchases a bond at a premium. The exam might call this calculation "yield to worst," by the way or even "YTW." The worst yield the investor can receive is the one based on the earli¬est call date.

As important as it is to inform customers that even a safe investment in U.S. Treasuries could lead to a large loss of principal, we also don't want to overstate this relationship of interest rates to bond prices. When rates rise, bond prices drop. However, bondholders will reinvest their semiannual interest payments at higher rates, too. So, it's not all bad.

And, even though bond prices rise when rates drop, bondholders reinvest their fixed interest payments at lower rates/yields.

The price swings we just looked at have nothing to do with credit quality. Rather, they are related to the term to maturity. The longer the term to maturity, the more volatile the bond's market price.

Within the world of bonds, the longer the term, the riskier the investment.


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