Premium bond

Definition

A premium bond is a type of fixed income security that is sold for more than its face or par value, often due to lower interest rates in the market compared to the bond's coupon rate. This means that the bondholder will receive periodic interest payments that are higher than the current market rate, making it an attractive investment. The premium reflects the bond's higher yield, as investors are willing to pay extra for the benefits of greater returns relative to newer issues with lower coupon rates.

5 Must Know Facts For Your Next Test

1. Premium bonds can provide a higher yield to maturity compared to other bonds with similar credit quality and risk levels.
2. The price of a premium bond decreases as interest rates rise in the market, leading to potential capital losses if sold before maturity.
3. Investors might choose premium bonds when they seek higher income from interest payments, especially in a declining interest rate environment.
4. At maturity, premium bonds are redeemed at their par value, resulting in a loss for investors if purchased at a significant premium.
5. Tax implications can arise from premium bonds since the amortization of the premium can affect taxable interest income.

Review Questions

• How does the market interest rate influence the pricing of premium bonds?
  • The pricing of premium bonds is significantly affected by market interest rates. When market rates fall below the bond's coupon rate, investors are willing to pay a premium because they want the higher interest payments that exceed what new bonds offer. This relationship means that as market rates rise, the price of premium bonds generally decreases since their fixed coupon payments become less attractive compared to new issues with higher rates.
• Discuss the potential risks and rewards associated with investing in premium bonds.
  • Investing in premium bonds carries both risks and rewards. The primary reward is the higher periodic interest payments that exceed current market rates, providing a steady income stream. However, risks include capital loss if the investor needs to sell before maturity when market interest rates rise, as this can lower the bond's market price. Additionally, tax implications from amortizing the premium can affect overall returns.
• Evaluate how changes in economic conditions impact investor behavior towards premium bonds.
  • Changes in economic conditions significantly influence investor behavior toward premium bonds. In a low-interest-rate environment, investors are more inclined to purchase premium bonds for their attractive yields compared to new issues. Conversely, if economic conditions shift leading to rising interest rates, investors may turn away from premium bonds due to potential capital losses and seek out discount bonds instead. This dynamic illustrates how investor sentiment and economic indicators shape decisions in fixed income securities.

Related terms

par value: The face value of a bond, which is the amount paid back to the bondholder at maturity.

coupon rate:

The annual interest rate paid on a bond's face value, usually expressed as a percentage.

discount bond:

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