What are Premium Bonds?
Premium bonds are defined as a financial instrument that trades at a premium i.e. at a price higher than its face value. A bond trades at a premium if its coupon rate is higher than the prevailing rates in the market or if the issuing company has high creditworthiness. For example, Bond X was issued at a face value of $100 and a coupon rate of 5% with a 10-year maturity. The current interest rate in the market is 3%. In this case, Bond X will have high demand and hence it will trade at a premium, say $110. Premium bonds can be traded in the secondary market before they reach maturity. At maturity, they will only yield the face value like any other bond. However, the increased interest rate benefit is somewhat offset by the increase in the price of the bond.
How They Are Different from Other Bonds?
A non-premium bond would yield the face value plus the coupon rate (interest rate) at maturity while a premium bond would yield coupon plus an amount which is normally higher than the face value. This kind of bond should not be confused with another type of premium bond issued under the National Savings and Investment scheme in the UK and works like a lottery.
Premium Bonds Calculation
A bond is valued by calculating the present value of all the future coupon payments and face value, also known as par value. Keep in mind that the face value of a bond is not the purchase price. A bond can be purchased at, above (premium) or below face value (discount).
- BV= Bond Value
- r = Discount rate also called Yield to Maturity (YTM)
- n = Number of periods until maturity
- F = Face value
Example of Premium Bonds Calculation
Let us understand the following example of premium bonds.
Suppose that IBM Corporation issued a bond that has a face value of $1,000, a coupon rate of 6% and a maturity of 5 years. The bond makes annual coupon payments. If the yield to maturity (discount rate) is 4%, the bond’s price is determined as follows:
Calculation of Bond Value will be –
Bond Valuation Formula = 57.7+55.47+53.34+51.28+49.31+821.92
Bond Value =1089.04
The bond price is greater than the face value.
This is the traditional way of calculating the bond value. This can also be calculated in MS-Excel by using the PV (present value function).
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Bond Formula to use:
- Rate = YTM
- Nper = Number of periods
- Pmt = Coupon payment
- Fv = Face value
- Type = this is a logical value. For payment at the beginning of the period, use 1. For payment at the end of the period, Omit or use 0.
The aforementioned example is also calculated in Excel, yielding the same value.
Please refer the given excel template above for detail calculation.
A very important relationship can also be derived from this formula. In the described example coupon rate (r) is greater than YTM. If r<YTM, bond price will be less than face value while if r=YTM, bond price will be equal to its face value. This also suggests an inverse relationship between YTM and bond prices.
Simulating two more combinations of coupon rate and YTM yields the following results:
** This graph looks like a straight line since we have used only two data points but in reality when we consider more data points, it converges to look more like an exponential graph.
Advantages of Premium Bonds
Some of the advantages of premium bonds are as follows:
- The bond market is highly efficient and a high-interest return renders premium bonds less sensitive to changes in rates.
- Investors would have the opportunity to reinvest high coupon payments at higher rates.
- Bonds are less volatile than stocks, hence they are considered as a safer investment option.
Disadvantages of Premium Bonds
Some of the disadvantages of premium bonds are as follows:
On the face of it, premium bonds look pretty straightforward but investors need to conduct a proper evaluation to know if the premium bond is fairly valued since overvalued bonds may result in losses. Following factors are capable of marring the profit-making ability of these bonds:
- Some secondary market investors worry that in the market situation of rising interest rates, bond prices may fall. This type of risk is addressed as Interest rate risk.
- The more the duration of the bond, the more susceptible will be the bond to changes in interest rates. This is also known as duration risk.
- Callable bonds: these are bonds where the issuing company reserves the right to redeem the bond any time before maturity. Higher the coupon, the more the chances of it being called.
- Credit risk: Premium bonds are usually issued by companies and government organizations with impressive credit ratings. However, when the economy staggers, it impacts everything else.
- Event risk: Events like mergers, restructuring, buyouts, etc. may lead to changes in the capital structure of corporations, hence affecting the credibility of the bonds.
- Reinvestment risk– Higher for long term bonds and those carrying larger coupons.
Limitations of Premium Bonds
Moving forward, premium bonds do carry some limitations.
- During economic boom/slowdown, bonds offer stable returns during economic growth as well as a slowdown. But Inflation often fuelled by economic growth increases the overall prices of goods and services so the same stable income isn’t appealing to investors while it looks more attractive during slowdown/deflation since the same income can be used to buy more goods and services.
- Bonds being fixed income instruments receive only the coupon rate of the bond. Interest paid remains constant over the life of the bond.
In a nutshell, premium bonds look like a safe and stable investment option although not very lucrative since the benefits are affected by different risks during the entire duration before maturity. Premium bond investors should strive to diversify their portfolio by rotating sectors to manage risks. A rigorous macroeconomic analysis is also sometimes necessary. Also, they do not offer returns as fast as other investment options like share trading. This is understandable when we believe in the common investor saying- More the risk, more the return.
This has been a guide to what are Premium Bonds and its definition. Here we discuss the formula to calculate Premium Bonds with examples, advantages, and disadvantages. You can learn more about accounting from following articles –