Premium bonds may be great deals, but don't get fooled by the name

A bond that is called a premium bond is not necessarily either a high yield bond or a high quality bond.

“I only want the best, Doug,” a client told me as he came into the conference room of my investment company. “So buy me premium bonds!”

Perhaps due to poor nomenclature, some people think that the “premium” in the term “premium bonds” means that these particular financial securities are better than other types of bonds. In fact, it might sound as though “premium” is the opposite of “junk” (as in the term “junk bond.”) But unlike chocolate or coffee, where you would want the premium brand, a bond which is called “premium” does not mean that it is any better or worse than any other bond. It simply means that the bond is priced today higher than it was when it was first issued.

The secret of understanding a bond price

Most bonds are issued at $1000 each. That means that if you buy a bond from a company, you are really lending them $1000 for a fixed period of time. In return for lending them the money, they agree to pay you a fixed rate of interest for a certain amount of time and then they will pay back the money. (If you buy inflation protected bonds or floating rate bonds, the amount they pay will vary; but that’s a discussion for a different article.) Here’s an example of a regular bond: XYZ Corporation 5% bond maturing 12/15/2020. If you saw that description, you would know that you could lend $1000 to XYZ Corporation and they would pay you 5% per year ($50) and then they would pay you back your $1000 in December of 2020 (just in time to buy holiday gifts!). As long as XYZ Corporation does not default on the bond, you will get both the yearly interest payments (usually paid twice a year: $25 x 2) and the $1000 at maturity.

How does the bond become a premium bond?

Let’s say most bonds from companies like XYZ Corporation are only paying 3%. If you see that someone owns the 5% bond and you offered to buy the bond from him, do you think he would sell it to you for $1000? Certainly not. He might say to you, “I will sell you my 5% bond, which pays $50 per year, but I want more than $1000, since I know that you can only get 3% ($30 per year) bonds these days.” If you agree and pay him, say, $1060 for the bond, that bond will now be called a “premium bond.” If it is trading for more than $1000 per bond, it gets the term premium bond. If it trades below $1000 per bond, though, it’s called a discount bond.

Is it better to buy individual bonds or mutual funds that invest in bonds?

There are many pros and cons to either buying bonds directly or buying them in the form of a mutual fund (and you can buy either an open end mutual fund or a closed end mutual fund). However, now you know that just because a bond is called a premium bond, this does not necessarily have any reflection on how good the underlying company is. Rather, it’s just a term for describing whether the bond is trading above par (“par” is $1000 for almost all bonds).

 Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.