Premium Bond

Definition

A premium bond is a type of bond that is sold at a price higher than its face value or nominal value. This typically happens when the bond’s stated interest rate is higher than the current market rates. The extra cost for the bond is balanced by the bond’s higher-than-market interest payments.

Phonetic

The phonetic pronunciation of “Premium Bond” would be: /ˈpriːmiəm bɒnd/

Key Takeaways

1. Unique Investment Option: Unlike regular bonds, the return on premium bonds is decided through a monthly lottery draw. The interest paid out is not fixed but depends on the prize money that the bondholder wins, making it a unique but uncertain investment.
2. No Capital Loss: The amount you invest in Premium Bonds is safe. The bond can be cashed at any time, with the full nominal value returned. While the return is not guaranteed, risk to the initial investment is low.
3. Tax-Free Winnings: Prizes that bondholders win from the draw are tax-free. This includes any amount won, from smaller prizes to the maximum prize of £1 million. As a result, premium bonds can be an effective way to earn tax-free income.

Importance

A premium bond is significant in business finance due to its unique role in investment strategies. It is a bond that sells for more than its face value or principal. It typically offers a higher yield than the current market rate, which makes it attractive to investors looking for greater income. Premium bonds are, therefore, an effective way for companies to raise capital. Besides, they present a lower risk level compared to many other investments because even if market interest rates rise, the investor can still benefit from the higher coupon rate. As interest rates and bond prices have an inverse relationship, a premium bond can also add an element of capital appreciation to the total return if interest rates were to fall. Thus, understanding premium bonds is essential in bond investment decisions, risk management, and planning for future financing.

Explanation

Premium Bonds serve as a unique kind of investment tool where the interest gained is not paid directly to the bondholder. Instead, the ‘interest’ is pooled into a fund used for random prize drawings offering tax-free rewards. This makes premium bonds particularly attractive for those who enjoy a ‘gamble’ with their investments without risking the loss of the initial capital. The bond holder could earn a large return or might end up gaining no return at all, depending upon the randomness of the prize draw. This variability, combined with the chance of winning a substantial prizes, generates a sense of excitement not typically associated with bond investments. Premium Bonds are used to encourage long-term saving in a fun, appealing manner. Despite the uncertainty of returns, the bondholder’s initial capital is always secure, making them a risk-free investment. This provides a safety net that is attractive to risk-averse or new investors. Premium Bonds are especially prominent in the United Kingdom, managed by National Savings and Investments (NS&I), where millions of people hold them. The opportunity to win large, tax-free prizes provides an alternative to traditional interest-bearing savings or investments, but it’s important to note that they may not be suitable for everyone, particularly those who need steady, reliable returns.

Examples

1. U.S. Treasury Bonds: U.S. Treasury Bonds often sell at a premium due to their low-risk nature and the full backing of the U.S. government. These bonds are appealing to investors for their safety and predictability. Therefore, investors are willing to pay a premium for these bonds, which means they’re paying more than the bond’s face value.2. High-Grade Corporate Bonds: These are premium bonds issued by corporations with strong credit ratings. Investors pay a premium for these bonds because they are less risky compared to bonds issued by companies with lower credit ratings. An example would be a bond issued by a well-established company like Microsoft or Google.3. Municipal Bonds: Municipal bonds can be superior investment options due to their tax advantages, something that can make them premium bonds. They are issued by state and local governments to fund public projects. Many investors are willing to pay a premium for these bonds as the interest earned is often exempt from federal income taxes, and sometimes from state and local taxes too.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Face Value
• Interest Rate Risk
• Bond Yield
• Investment Grade Bond
• Maturity Date

Sources for More Information

• Investopedia
• Money Advice Service
• Fidelity
• Business Insider Markets