Premium bonds

Definition

Premium bonds are bonds that are sold at a price higher than their face value, meaning investors pay more upfront than they will receive back at maturity. This usually happens when the bond's coupon rate, or interest rate, is higher than current market rates, making it attractive to investors seeking higher returns. Premium bonds can provide steady income through regular interest payments, but they also come with the risk that their market value may decrease if interest rates rise.

5 Must Know Facts For Your Next Test

1. Premium bonds are typically issued when interest rates have fallen since the bond was issued, making them more valuable compared to newer bonds with lower coupon rates.
2. Investors who buy premium bonds benefit from higher coupon payments, but they will face capital loss if they sell before maturity at a lower market price.
3. The premium paid on a premium bond is amortized over its life, affecting the bondholder's taxable income as they report interest received minus amortized premium.
4. When held to maturity, premium bonds will always return their face value, so the initial premium represents a potential loss of capital if sold before maturity.
5. The market price of premium bonds fluctuates with changes in interest rates; as rates rise, their prices typically fall.

Review Questions

• How does the coupon rate of a premium bond affect its market price compared to other bonds?
  • The coupon rate of a premium bond is typically higher than current market interest rates. This makes the bond more appealing to investors, thus driving its price above face value. When investors seek income through regular interest payments, they may be willing to pay a premium for these bonds because the higher coupon payments offer better returns than newly issued bonds with lower rates.
• Discuss how the amortization of premium affects the taxation of income from premium bonds for investors.
  • When investors purchase premium bonds, they must amortize the premium over the life of the bond. This means that each year, a portion of the premium paid reduces the taxable income reported from interest received. This results in lower reported taxable income for investors, which can impact their overall tax liability and net return on investment from these bonds.
• Evaluate the risks and benefits associated with investing in premium bonds in a fluctuating interest rate environment.
  • Investing in premium bonds can provide benefits such as higher coupon payments compared to other bonds, making them attractive in low-interest-rate environments. However, the risk arises when interest rates rise after purchase; this can lead to a decline in market price for these bonds. If an investor needs to sell before maturity, they may incur capital losses. Therefore, understanding the balance between immediate income and potential future losses is crucial for investors considering premium bonds in changing economic conditions.

Related terms

coupon rate: The interest rate that a bond issuer pays to bondholders, typically expressed as a percentage of the bond's face value.

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

yield to maturity: The total return anticipated on a bond if it is held until it matures, taking into account all coupon payments and the difference between the purchase price and face value.