Loading the player...

What is a 'Premium Bond'

A premium bond is a bond trading above its par value; a bond trades at a premium when it offers a coupon rate higher than prevailing interest rates. This is because investors want a higher yield and will pay more for it. The additional bond premium eventually brings down the effective yield to the market prevailing rate.

BREAKING DOWN 'Premium Bond'

A premium bond is a specific type of bond issued in nations such as the United Kingdom and Canada. In the United Kingdom, premium bonds are referred to as a lottery bond issued by the British government's National Savings and Investment scheme. In Canada, the Canada Premium Bond, first introduced in 1998, offers a higher interest rate at the time of issue than a comparable Canada Savings Bond.

For example, if a bond has a 7% coupon at a time when the prevailing interest rate is 5%, investors "bid up" the price of the bond until its yield to maturity is in line with the market interest rate of 5%. As a result of this bidding-up process, the bond trades at a premium to its par value. A bond premium reduces the yield to maturity of the bond, while a bond discount enhances its yield. The size of the premium declines as the bond approaches maturity. The premium dwindles to zero at maturity since bond issues are generally redeemed at par.

Effective Interest Rate on a Premium Bond

A premium bond has a coupon rate higher than the prevailing market interest rate, but with the added premium over the bond's par value, the effective interest rate on a premium bond is actually equal to the lower, prevailing market interest rate. While a premium bond still makes coupon payments at the stated higher coupon rate, both a premium bond's seller and buyer do not actually pay interest expense and receive interest income, respectively, in the amount of the coupon payments.

The effective interest expense or interest income is calculated as the market trading price of the premium bond multiplied by the prevailing market interest rate. The amount of coupon payments over the effective interest expense or interest income is actually the premium of the bond, which is amortized over the term of the bond to reduce the value of the bond to its par value at maturity for bond repayment.

Bond Premium Amortization

Bond premium amortization for each coupon payment period illustrates how the actual cash coupon payment effectively pays interest expense and returns a portion of the bond premium for the bond seller or earns interest income and receives a portion of the bond premium for the bond buyer. The returning or receiving portions of the bond premium reduce the account balance of the premium on the bond payable for the bond seller or the account balance of the premium on the bond investment for the bond buyer. By the maturity date, the total bond premium is fully amortized and the bond principal is repaid.

  1. Bond Discount

    Bond discount is the amount by which the market price of a bond ...
  2. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  3. Bond Valuation

    Bond valuation is a technique for determining the theoretical ...
  4. Bond Yield

    Bond yield is the amount of return an investor will realize on ...
  5. Current Yield

    Current yield is the annual income (interest or dividends) divided ...
  6. Coupon Rate

    Coupon rate is the yield paid by a fixed income security, which ...
Related Articles
  1. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  2. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  3. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  4. Investing

    Premium Bonds: Problems And Opportunities

    Learn all about premium bonds and how you can make them work for you.
  5. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  6. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  7. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  8. Financial Advisor

    Present Value Of Different Bond Types Using Excel

    To determine the value of a bond today - for a fixed principal (par value) to be repaid in the future - we can use an Excel spreadsheet.
  9. Investing

    Six biggest bond risks

    Bonds can be a great tool to generate income, but investors need to be aware of some of the pitfalls and risks of holding corporate and/or government securities.
  1. When is a bond's coupon rate and yield to maturity the same?

    Find out when a bond's yield to maturity is equal to its coupon rate, and learn about the components of bonds and how they ... Read Answer >>
Hot Definitions
  1. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  2. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  3. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  6. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
Trading Center