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What are premium bonds?

Understanding Premium Bonds

A premium bond can be defined in two distinct contexts: the savings bond issued by the UK Government, and the standard investment bond, which is traded at a price higher than its face value. Our focus will primarily be on the latter, but a brief explanation of the former will also be provided for enhanced clarity and understanding.

Standard Investment Premium Bond

In the global finance market universe, a premium bond is a specific type of bond that is traded at a price above its face or par value. The face value is the original value of the bond or the amount the issuer promises to repay the bondholder at the maturity date. However, fluctuations in the market, especially changes in interest rates, can lead to bonds being sold at prices different from their face values. This creates the categories of premium, par, and discount bonds.

Why a Bond Trades at a Premium

The question often arises as to the reasons behind a bond trading at a premium, i.e., why would an investor purchase a bond for an amount higher than its face value? The answer lies in the bond’s afforded interest rate or coupon rate.

The annual interest that the bond issuer pays to the bondholder, typically expressed as a percentage of the bond’s face value, is known as the coupon rate. When a bond’s coupon rate is higher than prevailing market interest rates, the bond becomes more attractive to potential investors as it means higher returns. As a result, the demand for the bond rises, pushing its price up, and it begins to trade at a premium.

Case Study: Premium Bond

Consider a bond with a face value of $1,000 and a 6% annual coupon rate. This bond would provide an annual interest income of $60 ($1,000*6%). Now suppose that market interest rates decline to 4% after this bond is issued. A 4% rate would only render $40 of annual interest income on a newly issued $1,000 bond, making our original bond with a 6% coupon rate more desirable.

As investors flock to purchase this higher-yielding bond, its price on the secondary market will rise. If it goes up to $1,200 due to high demand, it’s said to be trading at a premium because its price is now higher than its face value.

Benefits and Drawbacks of Premium Bonds

Investing in premium bonds comes with its own unique benefits and drawbacks. As a bondholder, the primary benefit of a premium bond is that it typically pays a higher rate of interest compared to other bonds available in the market. This higher income stream can be extremely advantageous, especially for income-seeking investors.

Conversely, a significant drawback is the higher price paid upfront for the bond, which will only be redeemed at face value at maturity, translating into a capital loss if the bond is held till maturity. To hold a premium bond beneficially, investors must weigh the additional interest income against the potential capital loss.

UK Government’s Premium Bond

The National Savings and Investments (NS&I) agency of the UK government offers a lottery savings scheme product that is another common use of the term “premium bond.” These bonds are ‘premium’ in the sense that instead of regular interest payments, bondholders are given the opportunity to win a range of cash prizes each month.

Premium Bonds and their Features

UK Premium Bonds do not accrue interest like standard bonds. Instead, the interest that would be paid is pooled into a prize fund. Each bond (priced at £1) holds an equal chance of winning, and the winnings are tax-free. The prizes range from £25 to a £1 million jackpot. The idea is that the thrill of possibly winning a large tax-free sum substitutes the regular interest received from traditional banking or savings products.

Premium bonds are unique, and some find the lottery-style payout mechanism appealing. However, not winning any prizes means you’re losing spending power, as inflation erodes the value of the money you’ve put in. For some, the chance of winning prizes may be worth it, but for others, a regular, predictable return might be preferred.

End Note

Ultimately, whether a premium bond in the context of an investment product trading above par and offering a higher coupon rate or a UK government lottery savings scheme is beneficial depends largely on the investor’s understanding of the product, the financial environment, risk tolerance, and financial objectives.