When a bond is first issued, it is a standard bond and not a premium or discount bond. In other words, the price to be paid for a new bond (its original price) is always fixed and is called the face value. A bond becomes “premium” or “discount” when it starts trading on the market. The new bonds are sold on the “primary market” and the existing bonds are sold on the “secondary market”.
What is a premium bond?
A bond that is traded above its face value in the secondary market is a premium bond. It is negotiated when it offers a coupon rate (interest) higher than the current prevailing interest rates offered for the new bonds. This is because investors want a higher return and will pay for it. In a sense, they are paying it forward to get the higher coupon payment.
What is discount bond?
A bond that is currently negotiable for a value lower than its nominal value in the secondary market is a discount bond, which is negotiated with a discount when it offers a coupon rate lower than the prevailing interest rates. Since investors want a higher return, they will pay less for a bond with a lower coupon rate than prevailing. So they are buying it at a discount to make up for the lower coupon.
What makes them different?
If a bond traded on the market is currently valued at a price higher than its original price (its face value), it is called a premium bond. Conversely, if a bond traded on the market is currently valued at a price lower than its original price (its face value), it is called a discount bond.
Therefore, a premium bond has a coupon rate higher than the prevailing interest rate for that particular maturity and credit quality. Conversely, a discounted bond has a coupon rate lower than the prevailing interest rate for that particular maturity and credit quality.
An example: suppose an investor owns an older bond, originally 10 years old when he bought it five years ago. This bond has a 5% coupon rate and the investor wants to sell it now. At the time of the sale, its bonds will compete on the market with new bonds with a duration of 5 years, since five years have elapsed since their expiry.
Let’s assume that those new bonds, comparable to those of the investor in terms of credit quality, have a coupon rate of 3%. The other investors will “raise” the price of the bond until its yield at maturity is in line with the interest rate of the competing market of 3%.
Due to this bidding process, the bond will be exchanged for a premium at its face value. The buyer will pay more to purchase the bond and that premium the buyer pays will reduce the yield upon maturity of the bond, so it is in line with what is currently being offered. (On the contrary, a discount on bonds would improve rather than reduce its yield on maturity.)