Introduction of Premium Bonds
A premium bond is a bond that is valued higher than its face value (i.e.) at a premium. A bond might be valued and traded at a premium because of the returns it gives to its investors (i.e.) the interest rate offered by the bond will be higher than the market rate and other bonds.
Bonds are fixed-income securities, and it pays the fixed interest to the bondholders till the maturity period. Market rate movements will not change the interest rate of the bond. As the interest rate doesn’t change with respect to market conditions, the bond changes’ value with respect to interest rate movements.
Premium bond usually trades more than its face value, and it is purchased by the investors considering the benefits from it like higher interest rate, the credit rating of the company issuing the bond, the creditworthiness of the company, etc.
Features of Premium Bonds
- Premium bonds trade more than their face value.
- Premium Bond holders receive higher interest compared to the market rates.
- Its trade at a high value considering the credit rating of the issuing company and the financial strength of the company.
How Does Premium Bonds Work?
Bonds are stable income securities, and it offers fixed interest income. The market movements don’t affect the bonds’ interest, but it changes the market’s bond value trading. Bonds can be traded either in premium, face value, or discount.
The companies issue the bonds at face value, and the bond price moves up and down based on the market interest rate movements. When the bond’s interest rate is lower than the market interest rate, then the bond loses its value, and the price will decrease in the market. It trades at a discount as the new bonds issued at present offers more interest. It is vice versa if the interest offered by the bond is more than the market interest rate; in that case, investors get better returns from the bond than the new bonds offered. Accordingly, the price of the bond increases in the market and trades premium.
Bonds can trade at a premium price, even based on the status of issuing companies. If a bond is issued by a well-established, financially stable company with a good credit rating will have high demand in the market as the investors feel the investment is more secured and the risk of default is less.
Example of Premium Bonds
X Corp issues bonds of $1,000/ bond with a 5% interest rate which matures in 10 years.
Mr A bought 10 bonds of X Corp at the price of $10,000. After2 years the interest rate in the market falls, and now the new bonds are offering only 2% interest. Considering the situation, X Corp pays more to its investors than the market interest rate. So, in the secondary market, X Corp bonds start trading in premium as there will be more demand to buy this high return bond from the market. The bond’s face value is $1,000, whereas it trades at a value of $1,050.
In the above-mentioned scenario, if the interest rate in the market increases after 2 years and offers 7% interest, then the new bonds pay more interest, so investors may not prefer the X Corp bonds as it offers low interest and it will start trading in the secondary market at a discount. The bond’s face value is $1,000, whereas it trades at a value of $950.
How to Buy Premium Bonds?
Premium bonds are traded in the secondary market; an investor who expects more return than the market rate and wants to buy from a high credit rating issuer can go for these bonds considering the returns and security of investment.
How to Sell Premium Bonds?
As mentioned above, premium bonds can be sold in the secondary market. When investors want to liquidate their investment, they can sell the same in the market and can take their money from the investment.
Some of the advantages are given below:
- It offers a higher interest rate than the market rate, and the bondholders receive better returns than the average market returns.
- Companies issue it with good credit ratings.
- Well-established and well-managed companies issue it with good creditworthiness.
- It is less volatile than stocks, and it is a safe investment option.
Some of the disadvantages are given below:
- Premium bonds trade at a higher price than face value; the higher price partly offsets the premium bond’s the higher interest rate. So, the net gain is reduced.
- Paying too much premium is risky to bondholders as the bond value changes based on the market interest rate movements.
- There is a risk of overvaluation of the bond price.
- The longer the period of the bond, it is riskier for investors as the interest rate is fixed and will not change according to market changes.
Bonds are fixed-income securities, and it trades at the premium price considering the returns, creditworthiness of the issuing company, etc. When the demand for the bond increases in the market, it pushes the price of the bond to high levels. Bond price can be volatile in the market; it may not always be at a premium ordiscount as market movements determine it. When the returns are better than the market rate, then the price moves up, and when the returns are lower than the market rate, then the price of the bond reduces as investors lose interest in the investment.
This is a guide to Premium Bonds. Here we also discuss the introduction and how does premium bonds work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –