Premium Bond

A premium bond is a bond that trades above its face (par) value. For example, a bond with a $1,000 face value might trade for $1,050 — a $50 premium. Premiums typically arise when a bond’s fixed coupon rate is higher than prevailing market interest rates or when the issuer’s strong creditworthiness makes the bond especially attractive.

Note: In the U.K., “Premium Bonds” is also the name of a government-run lottery-style savings product; this article addresses premium-priced bonds in the fixed-income market.

How premium bonds arise

• Fixed-rate bonds pay a set coupon over their life. When market interest rates fall, older bonds with higher coupons become more valuable relative to newly issued lower-coupon bonds.
• Investors seeking higher coupons bid up the prices of those older bonds, pushing them above par (premium).
• Conversely, when market interest rates rise, older lower-coupon bonds lose appeal and may trade below par (discount).

Example: If you hold a $10,000 bond paying a 4% coupon while newly issued 10-year bonds offer 2%, buyers will pay more for your 4% bond in the secondary market, so it can trade at a premium.

Credit ratings and premiums

• A bond’s price is also influenced by the issuer’s creditworthiness. Bonds from issuers with strong credit ratings (e.g., AAA) are perceived as lower risk and can command higher prices.
• Credit-rating agencies assign letter grades to help investors assess default risk. Highly rated bonds tend to attract demand, which can push their market prices above par.

Effective yield on premium bonds

• Although a premium bond pays a higher coupon, the effective return an investor realizes may be lower than the coupon because of the premium paid.
• Yield to maturity (YTM) is the standard measure that accounts for:
• coupon payments,
• the premium paid above par,
• and the return of par at maturity.
• If you pay a premium, part of your return is effectively a return of principal, which reduces the bond’s effective yield compared with its coupon rate.
• Reinvestment assumptions matter: effective yield calculations typically assume coupon payments are reinvested at the bond’s yield; in falling-rate environments that may be unrealistic.

Pros and cons

Pros
– Typically offer higher coupon payments than newly issued bonds when market rates are lower.
– Often issued by well-rated, creditworthy issuers.

Cons
– Higher purchase price partly offsets the higher coupon, reducing effective yield.
– If market rates rise after purchase, the bond’s market price can fall, causing potential capital losses.
– Overpaying for a premium bond can make it unattractive compared with other opportunities when rates change.

Real-world example

Suppose a highly rated company issues a 10-year bond with a $1,000 face value and a 5% coupon. If comparable Treasury yields are lower, investors may pay $1,100 for that bond in the secondary market. The investor receives 5% coupon payments, but because $100 of the purchase price is a premium that will not be repaid beyond par, the bond’s YTM will be lower than 5%.

Key takeaways

• A premium bond trades above face value, usually because its coupon exceeds current market rates or because the issuer has strong credit.
• Higher coupons do not automatically mean higher effective yields; YTM accounts for the premium paid and gives a true measure of return.
• Investors should evaluate why a bond is trading at a premium and compare the bond’s YTM and interest-rate outlook before buying.