Understanding Premium Bonds: Your Guide to High-Yield Bonds Trading Above Face Value
Introduction
A premium bond is a bond trading above its face value, meaning it is sold for more than its original price. This often occurs because the bond offers an interest rate higher than the current market rate. These premium bonds should not be confused with the lottery bond accounts sold in the United Kingdom, also known as premium bonds.
Premium Bonds Explained
When a bond is trading at a premium, it’s priced higher than its face value. For example, a bond issued for $1,000 might sell for $1,050 in the market, indicating a $50 premium. Despite not reaching maturity, the bond can still be traded in the secondary market, allowing investors to buy and sell it before its term ends. If held to maturity, the investor receives the face value of $1,000.
Key Takeaways
- A premium bond is traded above its face value.
- Higher interest rates on a bond can lead to it trading at a premium.
- The creditworthiness of a company and its bond ratings can also elevate bond prices.
- Investors pay more for bonds from reliable issuers.
Bond Premiums and Interest Rates
To understand bond premiums, it’s essential to see how bond prices and interest rates interact. As interest rates drop, bond prices rise. Conversely, increasing interest rates result in falling bond prices.
Most bonds have fixed interest rates, meaning the interest remains stable throughout the bond’s life. Therefore, bonds offer a secure stream of interest payments regardless of how market interest rates move. If an older bond has a higher interest rate than current market rates, it becomes an attractive option.
Example: Comparing Bond Yields
Imagine an investor who bought a $10,000 bond that pays 4% interest and matures in ten years. If the market rate falls and new bonds pay only 2%, the old bond becomes more attractive, leading to it selling at a premium. So, as interest rates drop, bond prices rise because investors rush to buy higher-yielding bonds, increasing their market value.
Bond Premiums and Credit Ratings
A company’s credit rating and subsequently the bond’s rating significantly impact its market price and the interest it offers. A good credit rating indicates high creditworthiness and makes a bond more attractive to investors, often resulting in trades at a premium.
Credit-rating agencies measure the risk levels associated with corporate and government bonds. They typically use letter grades; for instance, Standard & Poor’s rates from AAA (excellent) to C and D. Bonds rated below BB are considered speculative or junk bonds, indicating higher default risks.
Effective Yield on Premium Bonds
While premium bonds typically offer higher coupon rates, investing in them might not always be beneficial due to the premium cost over face value. Effective yield assumes reinvestment of coupon payments at the bond’s interest rate, which may not be feasible if interest rates fall.
The current bond price adjusts to reflect whether market rates are higher or lower than the bond’s coupon rate. Investors should identify whether the premium arises from market interest rates or the issuing company’s credit rating to make an informed decision.
Pros and Cons of Premium Bonds
Pros
- Higher interest rates than the overall market.
- Usually backed by well-rated companies.
Cons
- Higher prices partially offset the added yield.
- Risk of overpaying if bond prices are considered overvalued.
- Potential losses if market rates rise significantly post-purchase.
Real World Example
Imagine Apple Inc. issuing a bond with a $1,000 face value and a 10-year maturity, bearing an interest rate of 5%. Given Apple’s AAA rating, the bond pays more than the 10-year Treasury yield. Consequently, the bond trades at a premium—say, $1,100. Investors get a 5% annual interest on their investment. The premium price reflects the added yield.
Investors pay the premium to benefit from the higher coupon rate on the Apple bond, acknowledging the company’s strong credit rating and stable financial health.
Related Terms: fixed-rate bonds, coupon rate, secondary market, discount bonds.
