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Main Dictionary P

Premium Bond

A premium bond is a debt security traded for a higher price than its nominal value. The bond can be sold at a premium or, in other words, for a more expensive price when it’s in a high demand on the market due to its profitable interest rate.

Lottery bonds

Also, premium bonds are the special securities introduced in the middle of the 20th century in the United Kingdom – lottery bonds. Though they are considered to be premium bonds as well, there is a difference between them. Each lottery bond is a premium one, but not every premium bond is a lottery one. These terms aren’t replaceable.

Basically, lottery bonds are similar to lottery tickets. Every month traders having these bonds get the chance to win an occasional cash prize. Winnings aren’t liable to tax. However, interest rates of these securities often are lower than usual or aren’t offered at all. The duration of the lottery bonds usually is shorter (the debt is paid within a year or close).

Lottery bonds have been created as a tool of drawing government investments and encouraging people to make savings. But in this article, we concentrate on the premium bonds as the securities traded above their nominal price.

Trading Premium Bonds

Premium bonds and market interest rates. Bonds are considered to be a safe instrument of investing because of their stability. Most of them have a fixed coupon rate. For instance, if you have a 5-year bond nominated for $500 and by the end of the year you earn $20 from this security, then the coupon rate of this bond is 4%. And each year you’ll get the same amount of money for holding this bond till the maturity date. Let’s imagine that the current market interest rates go down to 2% for the bond with the same characteristics. In that case you don’t lose your earnings from the security regardless of the market situation. However, there is the opposite side of this stability. If the current interest rates rise to 6%, your income from the bond will be lower than the same on the market.

As you can see, the opportunities to sell bonds at a premium occur when their interest rates surpass the current market rates. Generally, there is a rule that bond values grow when interest rates go down. Consequently, when the interest rates jump up, bond prices start to decline. So, bond prices and interest rates are inversely related. 

Premium bonds and credit ratings. Bond prices can be pushed by the credit ratings of an emitent or a security itself. The credit ratings refer to the trustworthiness of the issuer. These qualities are assessed by the credit-rating agencies and, basically, show investors the possibility of the debt being paid back to them. Based on this assessment they give each bond a specified rating. For example, one of these international agencies – Moody’s – rates bonds from “Aaa” to “C”, where “Aaa” refers to a high level of creditworthiness and low riskiness conversely, the “C” is related to the bond with an extremely low rating of trustworthiness. Moody’s considers the bonds under the “Baa” rating as speculative because of a high risk of default. These bonds are called “junk bonds”. The symbols for assessment can vary in different agencies.

The credit rating of the bond is mostly related to the credit rating of the borrower. So, if the latter is reliable, investors will buy this security, thereby increasing its credit rating.

Let’s consider the following example:

You buy a few 5-year US treasury bonds for $500 per bond with a 5% interest rate. Then interest rates on the market go down to 3%. This situation becomes advantageous for the holders of these bonds. You can sell the securities for a higher price. Let it be $530 per bond. In other words, you sell the bond at a premium of $30. Note that if you hold these bonds till the maturity date, you’ll receive only the face value of the securities, or $500 per bond. In case the current interest rates rise to 7% conversely, the price of these bonds will go down, or they will be traded at a discount.

Pros and cons of buying Premium Bonds

Though it might be advantageous for a bondholder to sell some securities at a premium, there is a question as to whether there are any buyers for that price. Let’s take attention to the reasons for buying bonds at a premium and discuss why and when it might be profitable.

First of all, you should check the current market interest rates and credit ratings of the bond and the emitent. Then you should analyze the current market situation. Try to predict if possible, whether interest rates are going to fall or go up soon. If you decide to buy a premium bond, estimate the risks and bonuses. You have to understand that if you’re going to hold the security till its maturity, you’ll get only the face value of the bond. Thus, your overpayment must be covered by the coupon income. If the current market rates go up, the premium bond won’t be cost-effective anymore. Moreover, in this case you’ll lose the money that you paid over the face value of the bond.

Let’s take another example:

Current market rates are 4%. You decide to buy a 3-year 7% bond for $630 or at a $30 premium. Let’s imagine that the market conditions are unstable, but you overpay for this bond at a risk. Then the market rates increase to 8%. If the market rates stay at this level, you’ll lose $30 of overpayment for the premium bond. Moreover, your coupon rate will be lower than it is on the market.

Even though bonds are one of the safest instruments of investing, you always take some risks buying them at a premium. Take action carefully.

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