Premium bond

Definition

A premium bond is a type of bond that is sold at a price higher than its face value, typically because its coupon rate is higher than the prevailing market interest rates. This means that investors are willing to pay more upfront for the bond in order to receive greater interest payments over its life. Understanding premium bonds is crucial when analyzing bond risk and return, as they can affect an investor's total return and yield calculations.

5 Must Know Facts For Your Next Test

1. Premium bonds usually occur in a declining interest rate environment where older bonds with higher coupon rates are more attractive than new issues with lower rates.
2. Investors in premium bonds receive higher periodic interest payments, which can lead to a lower overall yield to maturity compared to the bond's coupon rate.
3. When a premium bond matures, investors will only receive the bond's face value, which means they may incur a capital loss if they paid significantly above that price.
4. Premium bonds are often considered less risky than discount bonds since they provide higher cash flows earlier in their life.
5. The price of premium bonds can fluctuate based on changes in market interest rates; if rates rise, the price of premium bonds may fall as newer bonds become more attractive.

Review Questions

• How does the coupon rate of a premium bond influence an investor's decision-making?
  • The coupon rate of a premium bond plays a significant role in an investor's decision-making because it reflects the bond's attractiveness compared to current market rates. If the coupon rate is higher than prevailing rates, investors are more likely to purchase the bond despite its higher price. This interest can result from a desire for stable and higher income over time, which premium bonds provide through their greater periodic interest payments.
• Discuss how holding a premium bond until maturity affects the overall return for an investor compared to purchasing it at face value.
  • Holding a premium bond until maturity affects an investor's overall return by providing higher coupon payments throughout its life, but it also leads to a capital loss upon maturity since the investor receives only the face value. This means that while investors benefit from larger cash flows during the bond's life, they may end up with a yield to maturity lower than the initial coupon rate due to this capital loss. Therefore, understanding the balance between these factors is crucial for making informed investment decisions.
• Evaluate how market interest rate fluctuations impact the attractiveness of premium bonds over time and their role in an investment portfolio.
  • Market interest rate fluctuations significantly impact the attractiveness of premium bonds by influencing their prices and yields. When interest rates rise, existing premium bonds become less appealing because newer bonds with higher yields are available, leading to potential price declines for premium bonds. Conversely, in a declining interest rate environment, premium bonds remain attractive due to their higher coupon payments. Evaluating these dynamics allows investors to strategically include premium bonds in their portfolios for consistent income while managing overall risk exposure.

Related terms

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures, taking into account both the interest payments and any capital gains or losses.

Coupon Rate: The annual interest rate paid on a bond, expressed as a percentage of its face value.

Discount Bond: A bond that is sold for less than its face value, typically because its coupon rate is lower than the current market interest rates.