Premium Bonds are those
bonds which are sold at the price above the par value of the same. Suppose, a bond has a par value of hundred US dollars. Now, if an investor sells this bond in the market at a rate above the US $ 100, say US $ 150, then this bond would be regarded as the
Premium Bond. In such a case the bond would be said to have been sold at a
premium of fifty US dollars.
Now, let us explore the different factors that comes into play for the origination of
premium.
Whenever the existing interest rate originally offered for a bond remains higher than the currently offered interest rate, then only the
premium originates. This
premium bond appears because in such a situation the investors who have already invested in the same with the original rate would not part themselves from the bond. They would hold the bond and would not sell them off until and unless the price offered for the same is higher than the par value.
Now, let us try to explain this mechanism with the help of an example. Let us suppose that the coupon rate of interest was 10% for a particular bond having a maturity period of 15 years. Now, the issuing authority of the bond issues another one of the same type but with an associated interest rate less than that of the previous one, say 8%. In such a case, the investor who possesses this bond would have no incentive in selling the same and hence would hold on to the bond in the hope that the rate of interest rate would go above the par value. They would only part from the bond if and only if the price offered to them is above its face value. This causes the market's price mechanism to come into play. The prospective buyers of the bond in the market offer a higher price for the same. Hence it is evident that the
bond price and the
bond yield has an inverse relation between them.
Following the above law, it can be said that as the price of the bond increases, the yield associated with the same would decrease with passage of time. This process of falling interest rate would continue until and unless the current offered rate of interest is reached, here 9%. Now, if we see at the price of the bond then we would witness that its price has reached a mark which is above the face value of the same. At this juncture the bond would be referred as the
premium bond.
The price sensitivity of the
premium bonds are observed to be less than that of the par and/or the discount ones.