High-priced bonds are investment bonds selling for more than the eventual maturity value. An investor buying a premium bond will pay a higher price than the face value of the bond. Premium bonds available to U.S. investors are priced the way they are due to changes in interest rates.
Bond Rates and Prices
Bonds are issued to pay a fixed rate of interest -- called the coupon rate -- until a bond matures and the face or par amount is paid to the investor holding the bond. When interest rates change, the bond market reacts to the new rates by changing the market prices of bonds. If a bond has a higher coupon rate than the current market rate for similar bonds, the bond price will be above the face value of the bond. An investor who buys at the premium price will earn a yield from the coupon rate in line with current market rates. The quoted yield-to-maturity rate of a bond takes into effect the coupon rate, bond price and time to maturity to give an investor an accurate yield on a bond purchased at the current market price.
Greater Cash Flow
With the same yield-to-maturity, a high-priced premium bond will provide a greater cash flow to an investor on an annual and total basis. Consider two 10-year, $100,000 bonds, both with a yield to maturity of 5 percent. One bond has a coupon rate of 5 percent and is priced at par, or $100,000. The second bond has a coupon rate of 6 percent, which requires a market price of $107,800. The premium-bond investor will earn $6,000 in annual interest for 10 years and the $100,000 face amount at maturity for a net gain of $52,200. The par bond will pay $50,000 in interest over the 10 years and the original investment amount at maturity, $2,200 less than the premium bond.
Many investors do not like to pay premiums for bond investments. It does not seem right to pay $108,000 for a bond and only get $100,000 back at maturity. This bias against premium bonds often results in premium bonds having a slight yield-to-maturity advantage over par or discount bonds. Premium bond buyers get paid a little extra for buying bonds that are not of interest to other investors.
The worst news for bond investors is rising interest rates. Rising rates result in falling bond prices. Premium bonds, with their already-higher coupon rates, do not decline as much in value as do discount bonds when interest rates increase. The premium in a higher-priced bond provides some cushion when bond prices start falling due to rising rates. Bond duration is a measure of bond price volatility and a premium bond will have a shorter duration than a par or discount bonds with the same time to maturity.
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