Premium bond

Premium bond

The value of premium bonds as a special kind of savings that combines the appeal of possible financial rewards with the safety of invested funds cannot be overstated. Their allure is the possibility of winning tax-free cash prizes in a monthly prize draw. Premium bonds provide people with a secure and enjoyable way to save money since they promote regular saving habits and have the potential to produce large financial rewards. Premium bonds are a wise investment for many people because of their security, possible returns, and tax benefits. 

What is a premium bond? 

A premium bond is a debt security that is traded in the secondary market over its par value or face value. A bond’s higher interest rate than the market’s current rates might make it trade at a premium. Investors are drawn to older bonds in the same category with higher interest rates, while new bonds offer lower interest rates. They consequently begin trading at a premium. Investors that purchase these bonds do so at a greater cost than their less expensive counterparts in the expectation that they would ultimately profit more, particularly if interest rates increase. 

Understanding premium bond 

Premium bonds contribute to better bond market returns. As bonds are effectively a loan to the issuer, they are often safer than shares. As a result, they have lower risk and typically set returns. Some bonds feature variable coupon rates that fluctuate over time.  

By taking advantage of the fluctuating coupon rates, investors attempt to increase their returns in the bond market. Investors are drawn to older, higher-yielding bonds in the same category when newer bonds offer lower interest rates. Older bonds, therefore, start to trade at a premium on the secondary market. Investors purchase premium bonds at a greater cost than their less expensive counterparts, expecting to profit more, particularly if interest rates ultimately rise. 

As regards limitations, the interest rate on a bond can be impacted by factors including credit rating, market circumstances, and the financial conditions of the bond issue. Long-term interest rate declines will have an impact on the bond’s price. The maturity’s sensitivity to changes increases with length. As a result, premium bonds may occasionally appear expensive if their returns fall short of the amount paid.  

Formula for premium bond 

When bonds’ interest rates fluctuate, or if they are selling at a premium, investors frequently inquire about the bonds’ new issue price. The bond value may also be referred to as the issue price or bond price. You must find the sum of the bond’s present value and the interest’s present value to get the bond’s value or issue price.  

The formula is, 

BV = sum t = 1 to n (Coupon * F)/(1 + r) + F/((1 + r) ^ n) 

Where, 

BV = bond value 

BV = present value of the bond + present value of the interest 

Present value of bond = F/ (1 + r) ^ n 

Present value of the interest 

 = Σt = 1 ^ n Coupon*F/(1+r)^ t 

Where, 

F = bond’s face value 

r =  discount rate or yield to maturity (YTM) 

n = number of periods till maturity 

Coupon = bond interest rate 

Benefits of premium bond 

The following are the benefits of premium bonds: 

• The main draw of premium bonds is the chance to win tax-free cash awards in the monthly prize draw. These rewards range in value from modest amounts to big sums, offering the chance of a sizable windfall. 
• Investors may always redeem their initial investment since the main value of premium bonds is protected. As the invested money is not at risk of being lost, this brings peace of mind. 
• Premium bonds are available in a range of denominations, enabling a variety of investors able to acquire them. Additionally, they provide the option to change the investment amount as necessary. 
• Since premium bonds don’t have a set maturity date, investors can keep them indefinitely. No fees are associated with withdrawals, making them a flexible choice for conserving money. 
• Premium bond winnings are tax-free, in contrast to conventional interest-bearing investments. Since they are not required to pay income tax on their earnings, this can lead to larger net returns for investors. 

Examples of premium bond 

The following example will help to understand premium bonds. Dylan chooses to purchase US$10,000 worth of premium bonds. His bonds are entered into the monthly prize drawings over a year. Dylan is pleasantly delighted to learn that he has won a cash reward of US$1,000 in one specific month, even though he may not receive a prize in some months.  

Since the winnings are tax-free, Dylan is given the whole sum. He keeps holding the premium bonds so that he may continue to enjoy the security of his investment while still having the chance to win further rewards. 

Frequently Asked Questions