Premium on Bonds Payable - Free Accounting Definitions & Terms

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Premium on Bonds Payable

Difference between par value of a bond and its higher issuing price is known as a premium on bond payable and arises when the contract (coupon) rate is higher than the bond’s market rate.

The market rate of interest (effective interest rate) is the % of interest borrowers are willing to pay and lenders are willing to earn for a certain bond taking in to account its risk level. When the bond contract rate equals the market effective interest rate, the bond trades at par value or 100%. When the contract rate does not equal effective interest rate, the bond trades above or below par value; the summary is shown in the table below.

Bond Premiums & Discounts - Contract Rate versus Market Rates

Contract Rate is:

Bond Trades

i) Above market rate

At a premium (>100% of face value)

ii) Equal to market rate

At par value (=100% of face value)

iii) Below market rate

At a discount (<100% of face value)

This graph shows the effects of market rate being greater than the contract rate, less than the contract rate or equal to the contract rate. If the contract rate is greater than the market rate, then the bond is issued at a premium (>100% of face value). If the contract rate is equal to market rate, then the bond is issued at par value (=100% of face value). And lastly if the contract rate is below market rate, then the bond is issued at a discount (<100% of face value).