When you purchase a bond and you pay a price that is above the bond’s par value the bond has been purchased at a premium. Typically, the par value for bonds is set at $100.00 for each $100.00 of maturity value.
For an example of a bond purchased at a premium, let’s assume that an investor has purchased $100,000 par value of a bond maturing in two years with a coupon interest rate of 4.375%. The bond has a high credit rating of “AA” and is purchased at a time when the two-year interest rates are low, let’s say 1.41%.
To purchase the bonds with a coupon of 4.375%, when the market interest rates are 1.41%, the investor will have to pay a premium above the bond’s $100.00 par value. In the case of our example, the investor pays $105.75 for every $100.00 of par value. This means the investor pays $105,750.00 for the $100,000 of maturity value and the investor’s yield to maturity is 1.41% per year.
For each of the next two years, the investor will be paid $4,375.00 of interest income for a total interest income of $8,750.00.
But this bond was purchased at a premiumprice and the premium paid for this bond was $5,750.00 ($105,750 – $100,000) and the bond will mature and only return $100,000.00 of the original $105,750.00 invested..
At the end of the two years, the investor will have been paid $8,750.00 in interest income, but they will not receive the $5,750.00 premium paid at the bond’s maturity. Therefore, $8,750.00 less the $5,750.00 premium equals $3,000.00 net return over the two-year period to the investor.
This $3,000.00 divided by the original $105,750.00 invested equates to a 1.41% per year yield to maturity.
If the bond was held in a non-taxable account (for example, an RRSP, RRIF, RESP, Tax-Free Savings Account (TFSA)), then the 1.41% is the investor’s annual investment return.
However, if the bond was held in a taxable investment account, then the investor’s after-tax return will be lower and possibly negative. How can this be possible? See the example below.
Example: Let’s assume the bond was held in a taxable account and the bondholder’s income is taxed at a 41% income tax rate. Then the $8,750.00 of bond interest income received would require the investor to pay approximately $3,587.50 in income tax. The investor would pay $3,587.50 in income tax even though the net income they received was only $3,000.00. In this example, the bond investor, by buying the bond at a premium and holding it in a taxable account,lost approximately $587.50, over the two-year period. They made a negative investment return after paying income tax.
|Bond purchased at a premium|
|At maturity, receive par value of||$100,000.00|
|Plus two years of interest income (taxable at 41%)||$8,750.00|
|Amount received over the two years||$108,750.00|
|Less the initial investment||$105,750.00|
|Equals the net investment income over two years||$3,000.00|
|Less income tax on $8750. of interest income||$3,587.50|
|Estimated after-tax investment loss||($587.50)|
Purchasing a bond at a premium should only be done inside a tax preferred investment account, not inside a taxable investment account.