Premium vs Discount Bonds: Which Should You Buy?

Bonds can serve a dual purpose in a portfolio. They help balance risk and generate income from interest payments ahead of its maturity date. A bond’s value can change, however, once it trades on the open market. Premium bonds are bonds that trade above a fixed par value while discount bonds trade below it. Both can offer opportunities for investors but it’s important to understand how premium and discount bonds work.

A financial advisor can help you navigate all the opportunities available for fixed-income investing.

How Bond Prices Are Set

A bond is a loan that’s made by the issuer. When you purchase bonds, you’re allowing the issuer to use your money. In return, the issuer pays it back to you with interest. For example, municipal bonds are issued by local governments to raise money for things like road maintenance and public works. Corporate bonds are issued by companies to raise capital that can be used to fund expansion projects.

When a bond is issued, it gets a fixed par value. If its current price is equal to this original value, then investors consider it to be trading at par. But once a bond hits the open market and is available to trade, this price can, and very often does, change. Bond pricing can be influenced by different factors, including supply and demand, the bond issuer’s credit rating and the bond’s maturity term.

Bond pricing and bond yields are correlated. For example, when a bond’s price falls on the open market, its yield rises. Keep in mind, too, that a bond with a longer maturity term can also be riskier because it’s more susceptible to fluctuating interest rates than a short-term bond. In addition, credit quality can help to mitigate default risk. The better a bond issuer’s credit is, the less likely the issuer is to skip out on repayment of the bond. Understanding these things can help with understanding how premium and discount bonds work.

What Are Premium Bonds?

When a new bond is issued, it’s sold on the primary market. Existing bonds, on the other hand, are sold on the secondary market. A premium bond is a bond that trades on the secondary market above its original par value.

Bonds trade at a premium when the coupon rate or interest rate offered is higher than what’s being offered for new bonds. A simple way to tell whether a bond is trading at a premium is to check its price. If what you have to pay to purchase a bond is above its face value then it’s a premium bond.

During periods when interest rates are falling, whether because of the market or the Federal Reserve, the volume of premium bonds on the secondary market can increase. That’s because of the relationship between interest rates and bond prices. When rates decrease, bond prices go up and vice versa. Investors may be attracted to older bonds that are generating higher yields in a declining interest rate environment versus new-issue bonds. As demand for these older bonds rises, more of them can trade at a premium.

The gap between a bond’s original par value and its premium value can shift as the bond gets closer to its maturity date. Generally, the closer a bond is to maturity the lower the premium tends to be. It can eventually diminish to zero as the bond’s price once again becomes equivalent to its par value.

Pros and Cons of Premium Bonds

Here are the most important pros and cons of investing in premium bonds that you should be aware of.

Tax-free: Any winnings from Premium Bonds are completely tax-free, making them an attractive option for those looking to maximize their returns without worrying about tax implications. This feature can be particularly beneficial for higher-rate taxpayers.
Government backing: Premium Bonds are backed by the UK government, providing a high level of security for your investment. This means that your initial investment is safe, even if the financial markets fluctuate.
No guaranteed returns: Unlike traditional savings accounts Premium Bonds do not offer guaranteed interest, which can be a disadvantage in times of inflation.
Inflation Risk: With no interest payments, the real value of your investment may decrease over time due to inflation. This risk is important to consider, especially for long-term savings goals.

Premium bonds offer a unique savings opportunity with the potential for tax-free winnings and government-backed security. However, the lack of guaranteed returns and the impact of inflation are significant factors to consider.

What Are Discount Bonds?

Computer screen with bond information on it.

The key difference between premium and discount bonds comes down to trading price. When bonds are traded on the secondary market for less than their original par value, they’re labeled as discount bonds. This means the coupon rate for the bond has fallen below wherever market rates are currently. Discount bonds can be attractive to investors who want to purchase bonds at a lower price. The discount price can help to offset lower yields associated with the bond. The deeper the discount, the higher the potential for gains from these bonds. And investors still benefit from regular interest payments.

There are, however, some unique risks associated with discount bonds. For instance, a bond that’s been deeply discounted could carry a higher credit risk. If the issuer is struggling financially, it’s possible that a steep discount could hint at the possibility of default. A discount bond’s default risk also increases with longer maturities.

Pros and Cons of Discount Bonds

Understanding the pros and cons of discount bonds can help you make informed decisions about whether they fit into your investment strategy. Here are the pros and cons of discount bonds you should know.

Potential for capital gains: Discount bonds are purchased at a price lower than their face value, which means there is an opportunity for capital gains when the bond matures. If held to maturity, the investor receives the full face value, resulting in a profit. This potential for capital appreciation can be particularly appealing in a low-interest-rate environment.
Steady income stream: Like other bonds, discount bonds provide regular interest payments, known as coupon payments. These payments offer a predictable income stream, which can be beneficial for investors seeking stability. The combination of interest income and potential capital gains makes discount bonds an attractive option for income-focused investors.
Interest rate risk: One of the primary risks associated with discount bonds is interest rate risk. If interest rates rise, the value of existing bonds typically falls, which can lead to losses if the bond is sold before maturity. Investors need to be mindful of interest rate trends and their potential impact on bond prices.
Credit risk: Discount bonds may carry higher credit risk, especially if they are issued by entities with lower credit ratings. This risk reflects the possibility that the issuer may default on interest payments or fail to repay the principal. Investors should assess the creditworthiness of the issuer before purchasing discount bonds.

By understanding the potential for capital gains, steady income, and associated risks, you can better determine if discount bonds align with your financial goals and risk tolerance.

Tax Implications of Premium and Discount Bonds

When buying premium or discount bonds, it’s important to understand how taxes can affect your overall returns — because the IRS treats bond premiums and discounts differently than simply buying at face value.

If you purchase a premium bond (at a price above its par value), the extra amount you pay is called the bond premium. For taxable bonds, you generally have the option to amortize this premium over the life of the bond, which reduces the taxable interest income you report each year. This can lower your annual tax bill, but it also means you won’t claim a capital loss tax deduction when the bond matures.

On the other hand, if you buy a discount bond (below par value), the IRS may treat the discount as interest income, not a capital gain, when the bond matures or you sell it. For certain types of discount bonds — like Treasury bills or original-issue discount (OID) bonds — you’re required to accrue this income annually, even if you don’t actually receive the cash until maturity.

It’s also worth noting the difference between taxable and tax-exempt bonds. Most corporate bonds are taxable, meaning you’ll pay federal (and sometimes state and local) taxes on the interest income. Municipal bonds, however, are often exempt from federal taxes and may also be exempt from state and local taxes if you live in the issuing state. This tax advantage makes municipal bonds especially appealing for investors in higher tax brackets, even if their yields are slightly lower than comparable taxable bonds.

Before buying premium or discount bonds, particularly if you’re weighing taxable vs. tax-exempt options, it can be helpful to consult a financial or tax advisor to understand the after-tax returns and make the most of your investment strategy.

Premium vs. Discount Bonds: Which Is Better?

Premium and discount bonds can both be used to diversify a portfolio. Whether it makes sense to choose one over the other can depend on your investment goals and risk tolerance. With premium bonds, you’re getting the benefit of potentially earning a higher interest rate than the overall market. These bonds tend to have lower default risk as they’re often issued by government entities or established companies that strong credit ratings.

You can, however, run the risk of paying too much for a premium bond if market interest rates rise. This can result in a premium bond being overvalued. With discount bonds, you have to keep in mind that buying a bond below par value could also increase risk but in a different way. This is why it’s important to consider both the coupon rate of a discount bond and the credit quality of the issuer.

Also, keep in mind that your potential for returns from premium bonds can change if they become callable. This means that the issuer can choose to allow the bond to be redeemed before the maturity date. Premium bonds may become callable if interest rates rise because it may not make sense financially for the issuer to continue paying investors above-market rates.

How to Invest in Premium and Discount Bonds

Bonds can help to balance out a portfolio that also includes stocks, real estate and other investments. When comparing bonds, whether premium or discount, consider things like:

Maturity
Yield
Coupon rate
Bond ratings

When deciding whether to invest in bonds, it’s also important to look at the bigger picture to determine whether it’s a good fit for your investment strategy. Keeping the interest rate environment in focus can also help you to gauge which way bond prices are likely to move, at least in the near term.

When you’re ready to start investing in bonds, you can do so through an online brokerage account. You can also use a brokerage account to trade stocks, mutual funds, exchange-traded funds (ETFs) and other securities. When comparing brokerage options, weigh the range of investments offered as well as the fees you’ll pay to trade.

Bottom Line

The biggest difference between premium and discount bonds centers on their trading price, relative to their par value. Premium bonds trade above par value while discount bonds trade below it. Discount bonds can be riskier but the lower the price, the higher the potential for gains. Premium bonds can deliver higher returns with less risk, but they can be problematic if they become callable.

Tips for Investing

Consider talking to a financial advisor about how to develop an investing strategy around premium and discount bonds. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Inflation can wreak havoc on bonds. Use this free inflation calculator to determine the buying power of a U.S. dollar over time.
Investing in bond funds or bond ETFs can help to dial down some of the risks associated with individual bonds. When you own a bond fund or ETF, you own a collection of bonds in one place. This helps to spread out risk since you’re gaining exposure to different types of bonds at varying maturities. If you want to go as low-cost as possible, consider bond ETFs that follow an indexing strategy as these tend to have the lowest turnover.