What is Premium Bond?

1493 reads · Last updated: December 5, 2024

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.

Definition

A premium bond is a bond that is trading above its face value. This typically occurs when the bond's interest rate is higher than the current market rates, leading investors to pay more than the face value to receive higher interest income.

Origin

The concept of premium bonds emerged with the development of the bond market. As the bond market matured in the late 19th and early 20th centuries, investors began to focus on the relationship between bond interest rates and market rates, leading to the concepts of premium and discount trading.

Categories and Features

Premium bonds can be categorized based on their issuer, maturity, and interest rate type. Government bonds, corporate bonds, and municipal bonds can all trade at a premium. The main feature of premium bonds is that their coupon rate is higher than the market rate, making them more attractive in the market, but also requiring investors to pay a higher price at purchase.

Case Studies

A typical example is U.S. Treasury bonds trading in a low-interest-rate environment. Suppose a Treasury bond has a coupon rate of 5% while the market rate is 3%; investors might be willing to pay above face value to receive higher interest income. Another example is a corporate bond trading at a premium after its credit rating is upgraded, boosting market confidence.

Common Issues

Common issues investors face when purchasing premium bonds include whether it is worth paying the premium. This depends on the bond's yield to maturity and changes in market rates. Another misconception is that premium bonds are always better than par bonds, but it is essential to consider both returns and risks comprehensively.

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Interest Rate Swap

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