What Is a Premium Bond?
Let me explain what a premium bond is directly to you: it's a bond that trades above its face value, meaning it costs more than the amount printed on the bond itself. This happens because its interest rate is higher than what's currently available in the market. Note that this is different from the lottery-style premium bonds sold in the United Kingdom, which are a separate type of investment.
Premium Bonds Explained
When a bond trades at a premium, its price is higher than the face value. For instance, if a bond with a $1,000 face value trades at $1,050, that's a $50 premium. You can buy and sell these bonds in the secondary market before they mature. If you hold it until maturity, you'll get the face value back, like $1,000 in this case. In the UK, premium bonds are lottery bonds from the government's savings scheme, but that's not what we're focusing on here.
Bond Premiums and Interest Rates
You need to understand how bond prices and interest rates connect. As interest rates drop, bond prices go up, and when rates rise, prices fall. Most bonds have fixed rates, so their interest payments stay the same no matter what happens in the market. This stability makes them appealing when rates are falling, as existing bonds pay more than new ones. For example, if you have a $10,000 bond at 4% and rates drop to 2%, your bond becomes premium because others want that higher yield, pushing its secondary market price above $10,000. On the flip side, rising rates make older bonds less attractive, so they sell at a discount.
Bond Premiums and Credit Ratings
The credit rating of the company and the bond itself also affects the price. A strong credit rating means investors trust the issuer, so they're willing to pay more, driving the bond to a premium. Well-managed companies with top ratings, like AAA from Standard & Poor's, often see their bonds trade above face value. Credit agencies rate bonds from AAA down to junk status, and higher ratings reduce perceived risk, making premiums more common.
Effective Yield on Premium Bonds
A premium bond often has a coupon rate above market rates, but the extra cost can lower your effective yield. This yield assumes you reinvest coupons at the bond's rate, which might not happen if rates fall. The market prices bonds efficiently based on current rates and credit, so you should check why it's at a premium—rates or rating? If the premium is too high, it might not be worth it, especially if rates rise and you overpay.
Pros and Cons of Premium Bonds
- Premium bonds typically pay higher interest than the market average.
- They're often from companies with strong credit ratings.
- The high price can offset the benefits of the coupon rate.
- You risk overpaying if market rates increase sharply.
Real World Example
Consider Apple issuing a $1,000 face value bond with 10 years to maturity and a 5% interest rate, rated AAA. If this rate beats the 10-year Treasury yield, the bond trades at a premium, say $1,100 in the secondary market. Investors pay extra for that 5% yield, which is the premium they're willing to cover for the added return.
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