There are two definitions to the term premium bond:
- A special bond issued in the UK
- Any bond which is trading above par
If a bond is trading above the par value of 100, it is said to be trading at a premium. This will reduce the yield on the bond (yield and price are inversely correlated). Any premium will tend to zero as the bond approaches maturity as original borrower only repays the par value at maturity. A bond will trade at a premium when the coupon rate is higher than interest rates in other places. Premium bonds in the UK are a unique kind of bond which can be thought of as a lottery bond. Investors can up to £30,000 worth of these bonds (each one costing £1) and every month there is a prize draw with prizes ranging from £25 to £1,000,000. The money invested in these bonds is guaranteed by the UK government so they are essential riskless. The chance of winning is approximately 1/24,000 and the prize winnings tend to average out marginally higher than typically savings rates.
To learn more about this concept and become a master at bonds and fixed income, you should check out our Bond Course - Fixed Income (coming soon!).