Expert: Gina Boykin - 7/18/2007

Question
Hello:

Here is my question: Is it better to buy a bond or a stock at a premium or at a discount and why?

I thank you for your reply.

Answer
That depends.  I'll explain why.

Bonds have a face value, typically some multiple of $1000, which is the amount you get when the bond matures.  We'll use as our example a $1,000 5-year bond.  If this bond is sold at par, you will pay $1,000. Let's say the bond is paying 6% interest.  This means you will get $60 a year until maturity.  At maturity you will receive your $1,000 initial deposit back also.

A year later, interest rates have increased to 7% and you're thinking of buying another $1,000 bond.  The 6% bonds will now be sold for a discount to make them more attractive, when people could get 7% elsewhere.  Let's say the quote is 95, which means it is sold for $950.  If you buy another 6% bond, you will receive $60 for 4 years (remember 1 year has passed already) and at maturity you will receive $1,000, even though you only paid $950.  So you received $10 less each year (compared to the 7% bonds) for 4 years, but $50 gain on the bond itself.  See the calculation below:

  interest = -$10 x 4 years = $40 loss
  bond value = $1,000 return - $950 paid = $50 gain
  $50 - $40 = $10 gain

This is just an example, but it shows how you could compare buying a bond at a discount vs. buying one at par.

It is very similar for a bond premium.  If rates went down to 5%, then the 6% bond looks really attractive.  If you buy the 6% bond you would pay a premium - let's say the quote is 104.  You'd pay $1,040 for the bond, receive $60 each year ($10 extra) but only receive $1,000 back at maturity.  Your net gain/loss is calculated as follows:

  interest: $10 x 4 years = $40 gain
  bond value:  $1,000 returned - $1,040 paid = $40 loss
  $40 - $40 = $0 (no gain/loss)

You didn't mention taxes, but that could determine which one is best also.  I'll do a quick summary...

The bond interest is taxed the same, whether you buy at par, premium, or discount.

If you buy at discount, for the gain at maturity (because you will always receive more than you paid) you'll have to pay capital gains tax.

If you buy at a premium, you can "amortize" the premium.  This means you can divide the premium by the number of years you're going to hold the bond and subtract that amount from any interest income you receive.  For example, if you buy a bond at 105 with 5 years left($1,050) you can amortize the premium of $50 by 5 years ($10/yr).  Normally you would have paid taxes on the $60 of interest.  If you amortize the premium, you'll only pay taxes on $50.

Stocks are not sold at premium/discount; however stock options are.  If you are interested in options, please let me know.

I hope I answered your question!

Happy investing :)