A premium bond is a bond that is trading above its face value, meaning investors are willing to pay more for it than its stated par value. This situation typically occurs when the bond's coupon rate is higher than the prevailing market interest rates, making it attractive to investors who seek better returns compared to newer issues with lower rates.
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Premium bonds are generally issued during periods of low interest rates, making their higher coupon rates appealing.
Investors in premium bonds may face capital loss if they hold the bond to maturity because they will only receive the face value at maturity, which is less than what they paid.
The price of a premium bond will decrease as market interest rates rise, as newer bonds with higher rates become available.
Premium bonds provide regular income through higher coupon payments compared to similar bonds issued at par or discount.
The presence of a call feature in premium bonds can affect their valuation, as issuers may redeem them early if interest rates decline further.
Review Questions
How does the relationship between market interest rates and the coupon rate determine whether a bond is sold at a premium?
A bond sells at a premium when its coupon rate exceeds prevailing market interest rates. Investors are willing to pay more than its face value because they can earn higher interest payments compared to newly issued bonds that offer lower rates. This relationship reflects the demand for the bond in the context of market conditions.
Discuss how changes in market interest rates affect the price of premium bonds and the implications for investors.
As market interest rates rise, the prices of premium bonds tend to fall. This decline happens because new bonds are issued with higher coupon rates, making existing premium bonds less attractive. For investors holding premium bonds, this price drop can lead to capital losses if they decide to sell before maturity. Conversely, if an investor holds until maturity, they will only receive the face value, resulting in a loss compared to their purchase price.
Evaluate the advantages and disadvantages of investing in premium bonds relative to other types of bonds.
Investing in premium bonds has advantages such as receiving higher periodic coupon payments compared to discount or par bonds, which can provide consistent income. However, disadvantages include potential capital loss if held to maturity and sensitivity to interest rate fluctuations. Evaluating these factors requires an understanding of personal investment goals, risk tolerance, and market conditions to make informed decisions about including premium bonds in an investment portfolio.
A discount bond is a bond that is trading below its face value, often because its coupon rate is lower than current market interest rates.
yield to maturity (YTM): Yield to maturity is the total return anticipated on a bond if it is held until it matures, considering all interest payments and the difference between the purchase price and the face value.