Question on purchasing a bond:
Assume:
   The bond is S&P AAA rated
   The interest rate is fair, and at the market
   There is a 10 year maturity with no call date

To buy an older bond today, on the secondary market, the premiums are
very high.

Should the buyer be concerned, if the purchase price is at par, at a
discount, or at a premium?  Assume, in each instance, the interest to
maturity is the same.

Hello and thank you for your question.

At the heart of the question is the tax treatment of Original Issue
Discount (OID) and Amortizable Bond Premium (ABP).  In your case,
since you would be paying par for a new bond or a premium for an old
bond, you do not have to be concerned about owing anything extra to
the IRS during the period you hold the bond (which would be the case
if you bought the bond at a discount).  Instead, you want to be able
to deduct the premium ratably over the period you hold the bond, since
otherwise the interest payments you receive, being a
greater-than-current yield, will cause you to may more income tax than
would be the case with a new bond bought at par.

OID a simple definition
"A long-term debt instrument generally has Original Issue Discount
(OID) when it is issued for a price less than its stated redemption
price at maturity (principal amount). The OID is the difference
between the stated redemption price at maturity and the issue price.
OID is considered to be a form of interest."
All About Original Issue Discount (OID)
http://www.wsc.com/online_serv/oid_calc/allabout.html

Amortizable Bond Premium
"The amount you paid over the face value of the bond. You reduce your
taxable bond interest by your bond premium amortization amount each
year until the bond matures."
Glossary
http://moneycentral.msn.com/taxes/glossary/glossary.asp?TermID=21

So here is your answer in full:
"Amortizable bond premiums. If you paid a premium to buy a bond (that
is, you paid more than the bond's face value, most likely because the
bond's stated interest rate is higher than the current interest rate
at the time you bought it), you can make the election to deduct a
portion of the premium each year while you hold the bond.

"If you make this election, you must make it for every bond you own
and for every bond you purchase in the future, until you revoke the
election. You'll probably need the assistance of your accountant or
financial advisor in determining the amount of amortization to deduct.
If the bond was acquired after 1987, you can deduct this amount from
the rest of your interest income on Line 1 of Schedule B. Take a
subtotal of your interest income, subtract the amortizable bond
premium (label it "ABP") and report the remaining interest on Line 2."
Accrued Interest and Bond Premiums
http://taxguide.completetax.com/text/Q06_2340.asp


Search terms used:
bond oid premium par
"amortizable bond premium"

If you find any of this unclear, please request a clarification of my
answer.  I would appreciate it if you would hold off on rating my
answer until I have an opportunity to respond.

Sincerely,
richard-ga

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Request for Answer Clarification by clicker5-ga on 08 Nov 2002 20:10 PST

Over the last several years, I have purchased many bonds.  And,I
understand most of what was stated on this question.

However, over the prior years, I have purchased the bonds at par, or
at a discount, never at a premium.  I never wanted a call on the
bonds, and I did not understand the premium on the bonds.
  
Now with interest rates going so low, I find tremendous increases in
the prices of bonds.

My concern is:  
When buying bonds at par, or buying at a premium, is the interest
earned, the same in either case?  Is there any interest lost because
of the premium?
(Please put all tax considerations aside)

clicker5-ga

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Request for Answer Clarification by clicker5-ga on 09 Nov 2002 00:06 PST

I am fairly new with the working of Google Answers.  
However, should richard-ga answer the following request for answer
clarification, before being rated, and before being paid?

Over the last several years, I have purchased many bonds.  
And – I fully understand most of what was stated in reply this
question.
 
However, over the prior years, I have purchased the bonds at par, or
at a discount, never at a premium.  I never wanted a call on the
bonds, and I did not understand the premium on the bonds.
   
Now with interest rates going so low, I find tremendous increases in
the prices of bonds.
 
My concern is:   
When buying bonds at par, or buying at a premium, is the interest
earned, the same in either case?  Is there any interest lost because
of the premium?
(Please put all tax considerations aside) 
 
clicker5-ga

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Clarification of Answer by richard-ga on 09 Nov 2002 05:49 PST

Hello again:

When buying bonds at a premium, compared to buying bonds at par, the
*interest* earned is not the same, but the *total return* is the same,
and I believe it is the *total return* that you care about.

Suppose you were buying an 8% $1,000 bond with 3 years remaining in
its term.  For the next 3 years you will get *interest* of $80 per
year, totalling $240.  If similar bonds being issued today at par are
paying, say, 4%, then a person buying a par bond will only get
*interest* of $40 per year, totalling $120.  So when you buy that 8%
bond you have to pay a premium price, approximately $1,100, which is
the $1,000 face amount plus $100 which is the present value of the
extra $120 of interest that you will receive over the next 3 years.

So although you will receive more *interest* from the bond that you
paid a premium for, the premium that you paid when you bought it makes
the two purchases overall equal in terms of total return.

So the market forces that set the prices for bonds whose coupon is
different from current interest rates take care of the differences,
and the choice for you is a choice between equal values.

Sincerely,
richard-ga

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Clarification of Answer by richard-ga on 09 Nov 2002 05:53 PST

You also had a question about Google Answers billing.

Upon my answering your question, Google Answers charges your credit
card the $25 price that you set in addition to the 50 cent listing
fee, and I get three-fourths of the $25 for answering your question.

There's no extra charge for Clarification--it's part of the service.

-R

I have been educated on paying premium for bonds.
Thank you for the clear answers.
I put a strong 5 stars for your answers.
Thanks again.
Clicker5-ga

Richardga 's response is correct.
In addition you should  seek expert advice from a bond specialist.

For instance if you purchase an old seasoned bond with a high coupon
and well- above par price AND you intend to sell the instrument at
some point before its maturity date , you should check as to the
liquidity of this bond issue.I.e your ability to sell it. This type of
information can be obtained from fixed-interest specialists in
brokerage houses.Do not leave home without it !

Another aspect not to be forgotten are the costs associated with the
purchase (and sale if sold before maturity)of the bonds.A new issue
(usually at or near par) should be free of commissions as the bankers
or brokers who handle the issue are directly remunerated by the issuer
.

The amount will play an important part in costs.

I'm surprised the considerations are so complex. My guess is the
difference in profit to you will be less than $10 on a $10,000
purchace, so don't spend a lot of time or money trying to optimize,
unless you will have big money to invest in the future.  Neil

Any specific bond will pay out the same AMOUNT of interest no matter
whether you pay par or premium.  For example, a $1,000 bond with a 5%
coupon will pay $50 a year whether you pay $1,000 or $1,100 or even if
you win it as a door prize and don't pay anything.

But this amount represents different rates of return on your
investment.  If you buy the example bond at par, you get 5% a year,
but if you pay $1,100 for it, you only get 4.545% a year, because 50
is a smaller part of 1,100 than it is of 1,000.

The "yield to maturity" measure is supposed to adjust for all this. 
So if you have two bonds with the same term and the same yield to
maturity and you hold them to maturity, you will get the same results
in the end regardless of the discount, premium, or coupon rate.

(This is ignoring tax considerations, as you requested.)