Premium Bond

A premium bond is a bond trading above its face value or in other words; it costs more than the face amount on the bond. A bond might trade at a premium because its interest rate is higher than current rates in the market.

A bond that’s trading at a premium means that its price is trading at a premium or higher than the face value of the bond. For example, a bond that was issued at a face value of $1,000 might trade at $1,050 or a $50 premium. Even though the bond has yet to reach maturity, it can trade in the secondary market.

In other words, investors can buy and sell a 10-year bond before the bond matures in ten years. If the bond is held until ma-turity, the investor receives the face value amount or $1,000 as in our example above.

A premium bond is also a specific type of bond issued in the United Kingdom. In the United Kingdom, a premium bond is referred to as a lottery bond issued by the British government’s National Savings and Investment Scheme.

For investors to understand how a bond premium works, we must first explore how bond prices and interest rates relate to each other. As interest rates fall, bond prices rise while conversely, rising interest rates lead to falling bond prices. Most bonds are fixed-rate instruments meaning that the interest paid will never change over the life of the bond. No matter where interest rates move or by how much they move, bondholders receive the interest rate—coupon rate—of the bond. As a result, bonds offer the security of stable interest payments.

Fixed-rate bonds are attractive when the market interest rate is falling because this existing bond is paying a higher rate than investors can get for a newly issued, lower rate bond.

For example, say an investor bought a $10,000 4% bond that matures in ten years.

Over the next couple of years, the market interest rates fall so that new $10,000, 10-year bonds only pay a 2% coupon rate. The investor holding the security paying 4% has a more attractive—premium—product.

As a result, should the investor want to sell the 4% bond, it would sell at a premium higher than its $10,000 face value in the secondary market.

So, when interest rates fall, bond prices rise as investors rush to buy older higher-yielding bonds and as a result, those bonds can sell at a premium.

Conversely, as interest rates rise, new bonds coming on the market are issued at the new, higher rates pushing those bond yields up.

Also, as rates rise, investors demand a higher yield from the bonds they consider buying. If they expect rates to continue to rise in the future they don’t want a fixed-rate bond at current yields. As a result, the secondary market price of older, low-er-yielding bonds fall. So, those bonds sell at a discount.

The company’s credit rating and ultimately the bond’s credit rating also impacts the price of a bond and its offered coupon rate. A credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation.

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