What Are Premium Bonds?

Premium Bonds Explained in Less Than 5 Minutes

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A premium bond is a bond that is selling for more than its par value on the open market. Bonds usually trade for a premium if their interest rate is higher than the market average.

Paying a premium for a bond may not seem like a good financial decision on its face, but there are times when premium bonds can protect against changes in the interest rate. Learn how they work and what they mean for individual investors.

Definition and Examples of Premium Bonds

A premium bond is a bond that trades above its par value. Bonds are issued by a business or a federal, state, or local government to raise capital. “Par value” is the face value of each bond—it is what the bond costs and the amount that the business or institution promises to pay back at the end of the bond term.

A good example of premium bonds is Target Corp’s bonds that mature in 2031. Target issued these bonds in 2001 for $99.37 with a 7.05% coupon rate—that means investors would earn 7.05% interest per year. At certain points in the bond’s history, it traded at around $144, making it a premium bond.

Premium bonds have a different meaning in the United Kingdom. In the U.K., premium bonds are an investment product that enters investors into a monthly prize draw instead of interest payments.

A bond trading at a premium would also impact its current yield. Yield is an important metric to understand, as it tells you the return you could get from the bond relative to the current price of the bond.

How Do Premium Bonds Work?

Bonds trade on a secondary market, so the price of the bond floats either below or above the original par value based on supply and demand. When it’s above par value, the bond trades for a premium. When it’s below par value, the bond trades for a discount

Bonds are priced as a percentage of fair value. For example, a bond with a par value of $1,000 that costs $1,050 will be quoted as “105”. Any quote over 100 is a premium bond. 

Bond prices can be affected by a number of factors. Here are some of the factors that can push the prices up to make it a premium bond or bring them down for the bond to trade at a discount:

  • Changes to interest rates
  • Credit rating of the bond and the creditworthiness of the bond issuer
  • Supply and demand for the bond

Let’s say there’s a corporate bond with a good risk rating that trades for 105 and has a 5% yield. That yield means it currently pays $52.50 to investors every year ($1,050 x .05). If interest rates go down en masse and every equivalent bond suddenly has a yield of only 3%, owners of the 5% bond will sell it at a premium since its yield is higher.

This means that, generally, speaking, the more interest rates go down, the more premium bonds there will be in the market. Look back at the Target example above. When the bonds were issued in 2001, Target had to offer a 7% coupon yield to sell them. Twenty years later interest rates are down. The yield has dipped to below 3% and the bond has traded, at times, for more than a 30% premium.

The financial position of the company also matters. Risky bonds will trade for a discount because there is less demand for them. If a company issues bonds when it is in a shaky financial position, it will have to pay a higher interest rate to compensate investors for that additional risk. If the company then shores up its balance sheet, the same supply and demand effect will occur. Investors will pile into the bond because it trades at a higher yield than similar bonds, then pump the brakes when the bond trades at a premium and its yield is the same as similar bonds.

Premium Bonds Vs. Discount Bonds

A discount bond trades for less than par value. Though this can happen because interest rates have risen since the issuance, the opposite of what happened to Target’s 2001 bond issue, most discount bonds are what is referred to as junk bonds or high-yield bonds.

Junk bonds have higher yields and lower prices than other corporate bonds because there is elevated risk. This is usually because the company is losing money or is in a bad financial position. 

Generally speaking, discount bonds are the opposite of premium bonds. The company issuing the bonds has or is not performing well and the bond price has suffered. That doesn’t mean discount bonds are always a bad investment. A well-diversified portfolio may be able to support the additional risk in exchange for a higher yield.

A premium bond tends to be less sensitive to changes in interest rates than a discount bond because its duration is lower and its coupon rate tends to be higher. This means that if all else is equal, it’s better to buy a premium bond when interest rates are expected to rise than a discount bond.  

What It Means for Individual Investors

A bond’s price in relation to its par value is just one factor for investors to consider. A premium bond may be a better choice ahead of rising interest rates than a discount bond with the same yield. Other factors, such as financial position, industry-specific factors, and tax consequences all need to play a role in your analysis.  

Key Takeaways

  • Premium bonds trade for more than their par value.
  • Bonds are priced as a percent of par value. For example, a bond priced at 105 costs $1,050.
  • Bonds trade for a premium when the issuer improves its financial position or when interest rates decrease. 

Article Sources

  1. Financial Industry Regulatory Authority. “Bonds Detail: Target Corp."

  2. NS&I. “Premium Bonds.”

  3. St. Louis Federal Reserve. "Federal Funds Effective Rate."