A premium bond is a bond whose current selling price on the open market is higher than its par (or stated) value. This situation arises when the stated interest rate on the face of the bond is higher than the market interest rate currently in existence. Thus, when investors see the higher interest rate being paid on the bond, they will bid up the price of the bond until the stated interest rate divided by the price paid equals the market rate.
The amount of the premium that investors are willing to pay for a bond is based on the following calculation:
+ Present value of the scheduled redemption amount of the bond
+ Present value of the stated amount of future bond interest payments
- Undiscounted scheduled redemption amount of the bond
= Amount willing to pay for the bond
For example, ABC International sells $1,000 bonds at a stated interest rate of 8%, and at a time when the market interest rate is also 8%. Since the stated and market interest rates are identical, ABC can sell the bonds at the full $1,000 price. Investors are buying the bonds at neither a discount nor a premium.
A year later, market interest rates have fallen to 6%. Since investors can no longer obtain the 8% interest rate on the ABC bonds elsewhere, they bid up the price of the bonds to $1,050. Investors will continue to buy the ABC bonds at a premium until such time as the market interest rate either equals or exceeds the rate on the ABC bonds.
It is also possible that an investor will buy a bond at a premium because its investment policy requires it to only purchase bonds at a credit rating above a certain level. Bonds having higher-quality credit ratings are slightly more expensive, since their risk of default is lower. Consequently, they are somewhat more likely to sell at a premium.
The amount of a bond premium is limited by two factors:
- The amount of time to its scheduled redemption. If there is only a short interval remaining before the issuer buys back the bonds, then the premium will be quite small, since investors will only be paid the face amount of the bond by the issuer.
- Whether the bonds are callable, and the timing and redemption prices of the calls. If a call is imminent, then the price of the bond is likely capped at the price at which the call will be made.
The reverse of a premium bond is one that sells at a discount to its par value.