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Need help comprehending Premium/Discount in Bonds

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  • Need help comprehending Premium/Discount in Bonds

    I'm struggling to grasp this concept. Specifically the idea of Amortization of Premium and Accumulation of Discount.

    The big question is, "WHY?"

    As I understand bonds, the yield is how much you're earning on the bond. If yield doesn't equal the rate we have a premium or discount.

    So if the price is $1200 for a $1000 Par Value bond, I need to amortize it down over the life of the bond.

    I'm still confused as to what is happening here. I paid $1200. Now, the bond will give me regular payments (say semiannually) until the end of the period when I redeem $1000.

    What is happening after each payment? Why do we need to concern ourselves with premium and discount?

    Sorry if my question seems poorly worded, I'm just very confused on this concept.

  • #2
    I believe I've grasped it.

    When a bond is purchased at a lower price, you will receive a greater return for your investment. Or, stated more properly, your yield will be greater.

    If, for example, I purchase a bond for $920 and the yield is 5%, the interest amounts to $46. But what if the coupon is $40? Well, you are not receiving $46. At least not immediately.

    For me it's still hard to explain, but it seems that you are recognizing that, because you have purchased the bond for $80 less than what it is worth, you can recognize $6 of added benefit (interest) to holding the coupon.

    This $6 can be added into a Sinking Fund so that it can accumulate until the last term of the bond.

    The important thing to understand is that you will always receive your specific bond payment.

    Eventually you will redeem the bond for $1000 based on the time value of money. This is where the writing up or down aspects come in.