Key Takeaways
- Trades above face value due to higher coupon rates.
- Pays fixed coupons exceeding current market interest rates.
- Yield to maturity is lower than the coupon rate.
- Premium amortizes over the bond's lifetime until maturity.
What is Premium Bond?
A premium bond is a fixed-income security that trades above its face value because its coupon rate exceeds current market interest rates. This higher price reflects the bond’s attractive fixed payments compared to prevailing yields, though the bondholder receives only the original face value at maturity.
Premium bonds commonly appear in markets when older issues with higher coupons remain valuable after rates decline, offering investors steady income above newer bonds.
Key Characteristics
Premium bonds have distinct features that impact pricing and returns:
- Above-par price: Trades higher than face value due to coupon rates surpassing market rates.
- Fixed coupon payments: The bond pays consistent interest, which remains unchanged despite price fluctuations.
- Yield to maturity (YTM): Lower than the coupon rate, reflecting the premium paid upfront.
- Amortization of premium: The extra amount paid is gradually recovered over the bond’s life through coupon payments.
- Callable feature: Some premium bonds are callable bonds, meaning issuers can redeem early at par, impacting potential returns.
How It Works
Premium bonds arise when an investor buys a bond at a price above its face value, often because the bond’s coupon exceeds current market yields. The investor enjoys higher interest payments but must accept that the bond will redeem at par value at maturity, effectively amortizing the premium paid.
For example, purchasing a bond with a $1,000 face value and a 6% coupon at $1,050 means you receive $60 annually but only $1,000 at maturity. The difference between coupons received and yield reflects the gradual return of the $50 premium. Understanding duration helps assess interest rate sensitivity for premium bonds compared to par bonds.
Examples and Use Cases
Premium bonds suit investors seeking stable income and lower interest rate risk:
- Corporate bonds: Companies like BND may include premium bonds in their portfolios to provide consistent cash flow.
- Municipal bonds: Tax-exempt premium bonds appeal to income-focused investors looking to reinvest coupons efficiently.
- Income strategies: Retirees often prefer premium bonds from high-credit issuers to secure predictable interest over time.
Important Considerations
While premium bonds offer higher income, their total return depends on holding the bond to maturity to recoup the premium paid. Callable premium bonds may be redeemed early, potentially limiting income and requiring reinvestment at lower rates. Evaluating the par yield curve helps anticipate pricing and interest rate trends.
Investors should also consider tax implications of amortized premiums and monitor market conditions to ensure their bond holdings align with income needs and risk tolerance.
Final Words
Premium bonds offer higher coupon payments but come at a cost above face value, which is gradually recovered through amortization. To decide if a premium bond suits your portfolio, compare its yield to maturity with current market rates and consider call risk before investing.
Frequently Asked Questions
A premium bond is a bond that trades above its face value because its fixed coupon rate is higher than current market interest rates. Investors pay more upfront for these bonds to receive higher-than-market interest payments until maturity.
Premium bonds usually appear in the secondary market when older bonds with higher coupons remain attractive after market rates fall. The extra price paid upfront is gradually recovered through higher coupon payments compared to the bond’s yield to maturity.
They trade at a premium because their fixed coupon payments exceed prevailing market rates, making them more valuable to investors who want steady, above-market income. The premium reflects the present value of these higher coupons.
At maturity, the bondholder receives only the bond’s face value, not the premium paid. The premium is effectively amortized over the bond’s life through the higher coupon payments, so investors recoup the premium indirectly.
The YTM on a premium bond is lower than its coupon rate because it accounts for the higher purchase price, the coupon payments, and the repayment of par value at maturity. It reflects the actual return if the bond is held to maturity.
If a premium bond is callable, it may be redeemed early at par when interest rates fall further. This can limit the bond’s price appreciation and affects its valuation, as investors anticipate the possibility of early redemption.
Premium bonds issued by highly rated companies are generally considered lower risk because they offer steady above-market income and have lower default risk. However, they can be sensitive to interest rate changes and call risk.
Premium bonds may outperform par bonds during rising rate environments because their higher coupons provide faster cash flow that can be reinvested at higher rates, cushioning price declines compared to bonds with lower coupons.
