Would you lend more than you are paid back? Probably not. But investors do this often.
If a bond returns $1,000 to their bond investors, why would investors purchase the bond for more than $1,000.
Doesn’t that mean that the investor is guaranteed to lose money. Not exactly.
So, why exactly do a company’s bonds trade above the face value?
This happens when the coupon rate, the amount of interest that the bond pays investors exceeds the market rate for that debt.
In this case, if the bond returns 6% per year in coupon payments, or $60, and the market rate is only 5% for bonds of similar risk, then investors would be willing to earn a return at or above 5%.
So, supply and demand will lead the bond to be priced at the current market rate of 5%.
How do we determine the price of the bond based on the 5% rate of return that investors want? Discounting.
This becomes a simple discounting problem where we look at the projected cash flows and discount them back at a rate of 5% to determine what we would pay today.
Doing so tells us that an investor seeking a 5% rate of return would pay ~$1,043 to own a bond that pays out $60, $60, $60, $60, $1060 ($1,000 + $60) in cash flows over the years.
In other words, investing $1,043 today and collecting the stream of cash flows would result in a 5% desired return.
These bonds that sell for higher than their face value are referred to as premium bonds.
