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Discount or premium

What Is Discount or Premium?

In finance, a discount or premium refers to the difference between an asset's market price and its intrinsic value or face value. This concept is fundamental in asset valuation and is a key aspect of investment analysis. When an asset trades at a discount, its market price is below its intrinsic or face value, suggesting it may be undervalued. Conversely, when an asset trades at a premium, its market price is above its intrinsic or face value, suggesting it may be overvalued. This phenomenon is particularly relevant in fixed income securities, such as bonds, and in certain investment vehicles like closed-end funds.

History and Origin

The concepts of discount and premium have been inherent in financial markets for centuries, dating back to the earliest forms of debt instruments. The formalization of these concepts in financial theory became more prominent with the development of modern capital markets and the introduction of various financial products. For bonds, the idea of a discount or premium emerged naturally from the relationship between a bond's stated interest rate (coupon rate) and prevailing market interest rates. If a bond's coupon rate was lower than the market rate, it would need to be sold at a discount to offer a comparable yield to investors. Conversely, if its coupon rate was higher, it would command a premium.

A significant historical development related to premiums and discounts involves the U.S. Treasury's auction process. Since its inception, the Treasury has used auctions to sell marketable securities like bills, notes, and bonds. The price at which these securities are sold, and thus whether they are issued at a discount or premium, is determined by market demand and prevailing interest rates at the time of the auction. The U.S. Department of the Treasury publishes auction rates, which reflect the fundamental cost of buying a bond.17, 18 If a previously issued security is "reopened," its price is also determined at auction, and if the price is greater than its face value, the purchaser pays a premium.16

Key Takeaways

  • A discount occurs when an asset's market price is below its face or intrinsic value, while a premium occurs when it is above.
  • This concept is crucial for valuing fixed income securities, particularly bonds, and for analyzing closed-end funds.
  • For bonds, the relationship between the coupon rate and market interest rates primarily determines whether they trade at a discount or premium.
  • Closed-end funds frequently trade at discounts or premiums relative to their net asset value (NAV).
  • Understanding discounts and premiums is essential for assessing potential investment opportunities and risks.

Formula and Calculation

The calculation of a discount or premium is straightforward:

Discount or Premium=Market PriceFace Value (or Intrinsic Value)\text{Discount or Premium} = \text{Market Price} - \text{Face Value (or Intrinsic Value)}
  • If the result is negative, the asset is trading at a discount.
  • If the result is positive, the asset is trading at a premium.
  • If the result is zero, the asset is trading at par value.

For bonds, the face value is typically the par value (e.g., $1,000), which is the amount repaid to the bondholder at maturity. For closed-end funds, the intrinsic value is their net asset value (NAV).

Interpreting the Discount or Premium

Interpreting a discount or premium requires understanding the specific asset class and market conditions. For bonds, a bond trading at a discount implies that its stated coupon rate is lower than current market interest rates for similar bonds. Conversely, a bond trading at a premium indicates its coupon rate is higher than current market rates. Investors might be willing to pay a premium for a bond with a high coupon because it offers greater income. As a bond approaches its maturity date, its price, whether at a discount or premium, will converge towards its par value.15 This "time decay" means a premium bond's price will decline, and a discount bond's price will rise, even if interest rates remain unchanged.14

For closed-end funds, a premium suggests that investor demand for the fund's shares is strong, perhaps due to specialized management or an attractive portfolio. A discount, which is more common, may indicate a lack of investor interest, concerns about management fees, or market inefficiencies.12, 13

Hypothetical Example

Consider a newly issued bond with a face value of $1,000 and a coupon rate of 4% paid annually.

Scenario 1: Trading at a Discount
Suppose prevailing market interest rates rise to 5%. An investor looking to buy a new bond would expect a 5% yield. To make the 4% coupon bond attractive, its market price must fall below its face value. If the bond trades at $950, the discount is:
$950 (Market Price) - $1,000 (Face Value) = -$50 (Discount)

Scenario 2: Trading at a Premium
Now, suppose prevailing market interest rates fall to 3%. The 4% coupon bond is more attractive than newly issued bonds offering 3%. Therefore, investors are willing to pay more than the face value for this bond. If the bond trades at $1,050, the premium is:
$1,050 (Market Price) - $1,000 (Face Value) = $50 (Premium)

In both cases, the market price adjusts to reflect the bond's effective yield relative to current interest rates. The capital gain from a discount bond or capital loss from a premium bond is realized at bond maturity.

Practical Applications

The concept of a discount or premium is applied across various financial instruments and strategies:

  • Bonds: Bond pricing is a primary area where discounts and premiums are observed. Bonds are often issued at a discount (zero-coupon bonds) or trade on the secondary market at a discount or premium due to changes in market interest rates, credit ratings, or supply and demand. The amortization of bond premiums and discounts is a crucial accounting practice, adjusting the carrying value of the bond over its life.11
  • Closed-End Funds (CEFs): CEFs frequently trade at significant discounts or premiums to their net asset value (NAV). This divergence can be a source of potential arbitrage opportunities for investors who believe the discount or premium will narrow over time. Academic research has explored the "closed-end fund puzzle," which refers to the persistent discounts observed in many CEFs, and how these deviations from efficient market theory can be exploited.9, 10 The SEC has also implemented "swing pricing" rules for open-end funds to mitigate the dilution effects of large purchases or redemptions, which effectively adjusts the net asset value per share to account for trading costs, influencing the perceived premium or discount for transacting investors.8
  • Options and Derivatives: Options contracts, which derive their value from an underlying asset, can trade at a premium or discount relative to their intrinsic value, primarily due to factors like time decay and volatility.
  • Currencies: In foreign exchange markets, a currency can trade at a forward premium or discount relative to another currency, reflecting interest rate differentials and expected future exchange rates.
  • Initial Public Offerings (IPOs): New stock offerings can be priced at a premium or discount relative to their perceived fundamental value, often influenced by market sentiment and investment banking strategies.

Limitations and Criticisms

While discounts and premiums provide valuable insights, they are subject to certain limitations and criticisms:

  • Market Efficiency: The persistence of discounts and premiums, particularly in closed-end funds, often challenges the notion of efficient markets. If markets were perfectly efficient, such discrepancies would quickly be arbitraged away. However, various factors, including liquidity constraints, information asymmetry, and investor sentiment, can prevent prices from always aligning with intrinsic values.7
  • Subjectivity of Intrinsic Value: Determining the "true" intrinsic value of an asset can be subjective, especially for complex instruments or those with uncertain future cash flows. Different valuation models may produce different intrinsic values, leading to varied interpretations of whether an asset is at a discount or premium.
  • Behavioral Biases: Investor behavior can play a significant role in creating and sustaining discounts or premiums. Herding, overreaction, or irrational exuberance can lead to assets trading away from their fundamental values for extended periods. The "closed-end fund puzzle," for instance, has been partly attributed to the influence of "noise traders" and investor sentiment.6
  • Liquidity and Transaction Costs: Exploiting discounts or premiums through arbitrage strategies can be hindered by liquidity issues and transaction costs. For example, a small discount on a thinly traded bond might not be worth pursuing due to the high cost of executing trades.

Discount or Premium vs. Par Value

The terms "discount," "premium," and "par value" are interconnected concepts, particularly in the context of fixed income securities.

FeatureDiscountPremiumPar Value
Market Price vs.Market price is less than face valueMarket price is greater than face valueMarket price equals face value
Face Value
Coupon Rate vs.Coupon rate is less than market interest rateCoupon rate is greater than market interest rateCoupon rate equals market interest rate
Market Interest Rate
Yield to MaturityHigher than coupon rateLower than coupon rateEqual to coupon rate
Investor's Gain/LossCapital gain at maturity (if held)Capital loss at maturity (if held)No capital gain or loss from price convergence

When a bond is issued or trades at its par value, its market price is exactly equal to its face value, and its coupon rate is aligned with the prevailing market interest rates. A bond trading at a discount or a premium simply signifies this misalignment. The concept of par value serves as the baseline against which discounts and premiums are measured.

FAQs

What causes a bond to trade at a discount or premium?

A bond trades at a discount when its coupon rate is lower than prevailing market interest rates, making it less attractive to new investors at its face value. Conversely, it trades at a premium when its coupon rate is higher than prevailing market interest rates, making it more attractive. Other factors like changes in the issuer's creditworthiness or general supply and demand in the bond market can also influence whether a bond trades at a discount or premium.

Why do closed-end funds often trade at a discount?

Closed-end funds often trade at a discount to their net asset value (NAV) for several reasons, including potential concerns about management fees, lack of liquidity compared to open-end funds, or a general lack of investor awareness or demand for the specific fund. Market inefficiencies and investor sentiment can also contribute to these persistent discounts.4, 5

Does a discount or premium affect a bond's coupon payments?

No, the discount or premium at which a bond trades does not affect its coupon payments. Coupon payments are fixed at the time of the bond's issuance and are based on the bond's face value and stated coupon rate. The discount or premium only affects the bond's purchase price and, consequently, the investor's overall yield to maturity.

Is it always better to buy an asset at a discount?

While buying an asset at a discount might suggest it is undervalued and offers potential for capital appreciation, it's not always inherently "better." A discount could reflect legitimate concerns about the asset's quality, future prospects, or market illiquidity. Thorough due diligence is essential to understand the reasons behind a discount before making an investment decision.

How does the SEC regulate pricing for investment companies?

The U.S. Securities and Exchange Commission (SEC) has regulations in place, such as Rule 22c-1 under the Investment Company Act of 1940, that govern the pricing of redeemable securities by investment companies, including mutual funds. This rule generally requires that such securities be sold, redeemed, or repurchased at a price based on the current net asset value (NAV) next computed after the receipt of an order.3 In 2016, the SEC adopted amendments permitting open-end funds (excluding money market funds and exchange-traded funds) to use "swing pricing," which adjusts the NAV per share to pass on trading costs to purchasing or redeeming shareholders, thereby protecting existing shareholders from dilution.1, 2