Definition
A premium bond is a bond that is sold at a price higher than its face or redemption value. For instance, a bond with a face value (or par value) of $1,000 is categorized as a premium bond if it is sold for $1,050. This additional amount is considered the bond premium.
Examples
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Corporate Bonds: A company issues a bond with a face value of $5,000. At issuance, the bond market is booming, and investors are willing to pay $5,200 for that particular bond due to the higher coupon rate compared to prevailing market interest rates. Here, the bond is sold at a $200 premium.
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Government Bonds: The U.S. Treasury issues a bond with a par value of $1,000. Due to various economic factors, demand for a safer investment increases, and investors are willing to buy the bond for $1,100, making it a premium bond.
Frequently Asked Questions (FAQs)
Q: Why would an investor buy a premium bond?
A: Investors might prefer premium bonds because they typically offer higher coupon rates compared to new issuances or prevailing market rates. This higher income might outweigh the initial premium paid.
Q: How is the premium on a premium bond amortized for tax purposes?
A: The bond premium can be amortized on a straight-line basis over the life of the bond. This means the premium amount is evenly spread out across the bond’s life, reducing the bond’s interest income for tax purposes.
Q: What is the impact of premium bond amortization on taxable income?
A: Amortizing the bond premium reduces the bondholder’s taxable income as it decreases the interest income that needs to be reported.
Q: Can the premium on a premium bond be recovered if held to maturity?
A: No, the premium paid for the bond is not recoverable upon maturity. The bondholder will receive the face value of the bond at maturity, resulting in the initial premium amount being a sunk cost.
Q: Are there specific accounting standards that regulate the amortization of bond premiums?
A: Yes, U.S. GAAP and IFRS both have specific guidelines for accounting for bond premium amortization. Companies must follow these standards in their financial reporting.
Coupon Rate: The annual interest rate paid on a bond, expressed as a percentage of the face value.
Face Value (Par Value): The amount paid to the bondholder at maturity; also the value used to calculate interest payments.
Amortization: The process of gradually writing off the initial cost of an asset.
Discount Bond: A bond that sells for less than its face value.
Online References
- Investopedia - Premium Bond
- U.S. Securities and Exchange Commission - Bonds
Suggested Books for Further Studies
- “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau
- “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi
- “Fixed Income Analysis (CFA Institute Investment Series)” by Barbara S. Petitt
Fundamentals of Premium Bonds: Finance Basics Quiz
### Does a premium bond sell for more or less than its face value?
- [ ] Less
- [x] More
- [ ] Exactly the same
- [ ] It can sell for any value
> **Explanation:** A premium bond sells for more than its face value. For example, a bond with a face value of $1,000 might sell for $1,050.
### Why might investors be willing to pay more than the face value for a bond?
- [x] Because of a higher coupon rate compared to market interest rates
- [ ] Because of a lower coupon rate
- [ ] Because of shorter maturity
- [ ] Due to lower credit rating of the issuer
> **Explanation:** Investors may be willing to pay a premium if the coupon rate on the bond is higher than the prevailing market interest rates, which provides better periodic returns.
### How is the premium on a bond treated for tax purposes?
- [ ] Fully deductible in the year of purchase
- [ ] Cannot be deducted at all
- [x] Amortized on a straight-line basis over the life of the bond
- [ ] Only deductible when the bond is sold
> **Explanation:** The premium on a bond can be amortized on a straight-line basis over the life of the bond, reducing the taxable interest income each year.
### What happens to the premium paid when a bond matures?
- [ ] It is recovered along with the face value
- [ ] It is added to the interest payment
- [ ] It is lost because only the face value is returned
- [x] It is treated as a sunk cost
> **Explanation:** When a bond matures, only the face value is returned. The premium paid originally is not recovered, making it effectively a sunk cost.
### Which feature primarily differentiates a premium bond from a discount bond?
- [x] Selling price relative to face value
- [ ] Type of issuer
- [ ] Maturity date
- [ ] Coupon payment frequency
> **Explanation:** A premium bond sells for more than its face value, whereas a discount bond sells for less than its face value. This difference in selling price relative to face value is the key differentiator.
### Which method is used to amortize the premium on premium bonds for tax purposes?
- [x] Straight-line method
- [ ] Double declining balance method
- [ ] Units of production method
- [ ] Sum of the years' digits method
> **Explanation:** The straight-line method is commonly used to amortize the premium on bonds over the life of the bond for tax purposes.
### What does the face value of a bond represent?
- [x] The amount paid to the bondholder at maturity
- [ ] The original issue price
- [ ] The market price of the bond
- [ ] The interest earned over the bond's life
> **Explanation:** The face value, or par value, of a bond represents the amount that will be paid to the bondholder at maturity.
### What is a bond premium?
- [ ] The interest payment made by the bond issuer
- [ ] The difference between the issue price and face value when sold at a discount
- [x] The amount by which the purchase price exceeds the face value
- [ ] The amount by which interest exceeds the coupon rate
> **Explanation:** A bond premium is the amount by which the purchase price of a bond exceeds its face value.
### Could a bond with a face value of $1,000 be sold as a premium bond at $900?
- [ ] Yes
- [x] No
- [ ] Only if interest rates fall
- [ ] Only if interest rates rise
> **Explanation:** A bond selling for $900 is below its face value of $1,000, making it a discount bond, not a premium bond.
### What happens to the bondholders' interest income if the premium on a bond is amortized?
- [ ] It increases for tax reporting
- [ ] It remains unchanged
- [ ] It is not affected at all
- [x] It decreases as the premium amortization reduces the interest income
> **Explanation:** Amortizing the bond premium reduces the bondholder's reported interest income, thus lowering taxable income.
Thank you for taking an in-depth look at premium bonds and challenging yourself with our quiz. Continue to elevate your understanding of finance!