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.