Premium Bond

The MSRB's educational material on premium municipal bonds states that a premium municipal bond is a security purchased at a price in excess of its par value, and with a coupon rate that is higher than the prevailing market interest rate. The material states that such a bond therefore sells for more than 100 percent of par.

How a Premium Is Quoted

Bond prices are quoted against par. FINRA's page on bonds states that bond quotes are typically expressed as a percentage of their par value, with the percentage converted to a point scale. A bond with a face value of one thousand dollars trading at par is said to be trading at 100. A bond quoted at 105 is trading at a premium, at 105 percent of par, or one thousand and fifty dollars. A bond quoted at 95 is trading at a discount, at 95 percent of par, or nine hundred and fifty dollars.

The MSRB's page on how municipal bonds are priced uses the same convention. It states that the price of a municipal bond is expressed as a percentage of the principal or par value of the bond, which is usually one thousand dollars, and that a bond trading at par is said to be trading at 100, or one thousand dollars. It states that a bond quoted at 105 is trading at a premium at 105 percent of par, or one thousand and fifty dollars.

The SEC's bulletin on corporate bonds states that bond prices may be quoted in dollars or as a percentage of face value, and that a bond often trades at a premium or discount to its face value.

Why a Bond Trades at a Premium

The SEC's bulletin on corporate bonds states that a bond can trade at a premium or discount when market interest rates rise or fall relative to the bond's coupon rate. It states that if the coupon rate is higher than market interest rates, the bond will likely trade at a premium.

Investor.gov's glossary entry on selling a bond before maturity describes the effect of rate movements on the sale price. It states that investors who hold a bond to maturity get back the face value, or par value, of the bond, but that investors who sell a bond before it matures may get a far different amount. If interest rates have risen since the bond was purchased, the bondholder may have to sell at a discount, below par. If interest rates have fallen, the bondholder may be able to sell at a premium above par.

FINRA's page on bonds gives a case. If you own a bond that pays a coupon of 8 percent but new issuances are only paying 5 percent, so that interest rates fell, the secondary price of your 8 percent bond will rise because people will be willing to pay a premium for that higher coupon payment.

FINRA states that if you buy or sell a bond after it has been issued, its price is subject to market forces and often fluctuates above or below par. It states that the price of a bond can be above or below its par value for many reasons, including whether the credit rating for the issuer or the bond itself has changed, a change in supply and demand, and a host of other factors, but that the price is often driven by changing interest rates. FINRA's investor education article on defining the value of an investment states that a bond's market value can be above or below par value, based on interest rate levels, the perceived financial health of the issuer, and supply versus demand.

The SEC's investor bulletin on interest rate risk works through the premium case with figures. It uses the case of a Treasury bond that offers a 3 percent coupon rate, where a year later market interest rates fall to 2 percent. The bond still pays a 3 percent coupon rate, which makes it more valuable than new bonds paying a 2 percent coupon rate. The bulletin's table shows a face value of one thousand dollars, a maturity of 10 years that becomes 9 years remaining, a price that moves from one thousand dollars to one thousand and eighty-two dollars, and a yield to maturity that moves from 3 percent to 2 percent.

The bulletin then reverses the case. When market interest rates rise from 3 percent to 4 percent, its table shows the price of the 3 percent bond falling from one thousand dollars to nine hundred and twenty-five dollars and the yield to maturity rising from 3 percent to 4 percent. It states that the yield to maturity will rise as the price falls, and that when market interest rates rise, prices of fixed-rate bonds fall.

Yield on a Premium Bond

The SEC's bulletin on corporate bonds shows how a premium price affects yield. It compares three bonds that share a 10-year maturity, a 4.00 percent coupon rate and a face value of one thousand dollars. Bond A is priced at par. Bond B is priced at 90 percent of face value, or nine hundred dollars. Bond C sells for a premium at one thousand one hundred dollars, or 110 percent of face value. The bulletin states that because of the premium price, the yield to maturity on Bond C, at 2.84 percent, is lower than the coupon rate. It states that investors in Bond C will receive a total of forty dollars per year in coupon payments and the bond's face value of one thousand dollars at maturity.

FINRA states the same direction in general terms. A bond trading at a premium, which means above par, offers a return lower than the coupon, which is the stated interest rate, while a bond trading at a discount, which means below par, provides a return above that rate.

FINRA's investor insights article on bond yield and return states that price and yield are inversely related: as the price of a bond goes up, its yield goes down, and vice versa. The article defines current yield as the bond's coupon yield divided by its current market price. It works through a bond with a face value of one thousand dollars, bought at par, that pays forty-five dollars a year, which has a coupon yield of 4.5 percent. It states that if that bond trades at 103, which is above par, the current yield will fall to 4.37 percent.

FINRA defines yield to maturity as the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Mathematically, it is the discount rate at which the sum of all future cash flows, from coupons and principal repayment, equals the price of the bond. The SEC's bulletin describes yield to maturity as the annual return on the bond if held to maturity, taking into account when you bought the bond and what you paid for it.

A Premium Bond at Maturity

Investor.gov states that investors who hold a bond to maturity get back the face value, or par value, of the bond. The SEC's bulletin on interest rate risk states that if you intend to hold a bond to maturity, the bond's price may change, but you will be paid the stated interest rate, as well as the face value of the bond, upon maturity. The bulletin on corporate bonds states that if you hold the bond until maturity, you will receive its face value upon maturity, subject to default risk.

Because the price of a premium bond is above par, the face value returned at maturity is lower than the price paid for it. The MSRB states that premium bonds have higher coupon payments and as a result can generate greater cash flow, and that part of the coupon payment on a premium bond is actually the return of principal. The material compares two municipal bonds that mature in 10 years and are not subject to prior redemption. Bond ABC has a 3.00 percent coupon and a price of 100.00, and bond DEF has a 5.00 percent coupon and a price of 117.13. The MSRB states that bond DEF's coupon payments over the life of the bond are two thousand dollars more than bond ABC's, and that this is partially offset by the one thousand seven hundred and thirteen dollar premium paid at the time of purchase.

Premium Bonds and Call Provisions

Call risk is one of the risks the MSRB lists for premium bonds. The SEC's bulletin on corporate bonds states that the terms of some bonds give the company the right to buy back the bond before the maturity date, that this is known as calling the bond, and that it represents call risk to bondholders. It gives the case of a bond with a maturity of 10 years whose terms allow the company to call the bond any time after the first five years. It states that if the company calls the bond, it will pay back the principal and possibly an additional premium depending on when the call occurs. The word premium in that sentence refers to an additional amount paid when a company calls a bond, which is a separate use of the word from a bond trading at a premium.

The bulletin states that one reason the company may call the bond is if market interest rates have fallen relative to the coupon rate on the bond. It states that investors should check the terms of the bond for any call provisions or other terms allowing for prepayment.

FINRA's page on bonds describes call risk as the risk that a bond may be redeemed by an issuer when interest rates are falling. It describes reinvestment risk as the risk that no available investments will be able to provide a similar return to a bond that has been called or mandatorily refunded.

The MSRB's material on premium bonds describes call risk. It states that call risk is the risk that the issuer will use a redemption feature to redeem the bond prior to its final maturity, and that if a premium municipal bond is called, the proceeds may have to be reinvested at lower interest rates.

FINRA describes the yield measures that apply when a bond can be called. Yield to call is figured the same way as yield to maturity, except that instead of using the time until the bond matures, the calculation uses a call date and the bond's call price. FINRA states that the calculation takes into account the impact on a bond's yield if it is called before maturity, and that it should be performed using the first date on which the issuer could call the bond. Yield to worst is whichever of a bond's yield to maturity and yield to call is lower. FINRA states that if you want to know the most conservative potential return a bond can give you, and you should know it for every callable security, you perform this comparison.

Exchange Act Rule 10b-10(a)(4) covers a debt security subject to redemption before maturity. It requires a statement to the effect that the debt security may be redeemed in whole or in part before maturity, that such a redemption could affect the yield represented, and that additional information is available upon request.

Interest Rate Sensitivity

FINRA's page on bonds states that every bond carries interest rate risk, and that interest rate risk is the risk that changes in interest rates, in the United States or other world markets, may reduce or increase the market value of a bond you hold.

The SEC's bulletin on interest rate risk describes how coupon rate and maturity affect that risk. It states that if two bonds offer different coupon rates while all of their other characteristics, such as maturity and credit quality, are the same, the bond with the lower coupon rate generally will experience a greater decrease in value as market interest rates rise, and that bonds offering lower coupon rates generally will have higher interest rate risk than similar bonds that offer higher coupon rates. It states that bonds with longer maturities generally have higher interest rate risk than similar bonds with shorter maturities.

The MSRB states the point for premium bonds. Since premium municipal bonds have higher coupon rates and larger cash flows, the price sensitivity to movements in interest rates is lower, according to the MSRB. It also states that although premium municipal bonds have less price sensitivity to a change in interest rates than par bonds, overall interest rate risk should be considered when investing in any type of fixed income instrument.

FINRA's article on interest rate changes and duration states that some bonds are more sensitive to interest rate changes than others, that this sensitivity is known as a bond's duration, and that generally the higher the duration, the more sensitive the bond investment is to changes in interest rates.

Benefits and Risks the MSRB Describes

The MSRB's material on premium municipal bonds lists potential benefits and potential risks. For benefits, it lists increased cash flow: premium municipal bonds have higher coupon rates than comparable securities selling at par or at a discount, and while they are priced above par, the additional cash inflow received from the higher coupon may offset the initial higher cost. It lists reduced volatility, for the reason given above. It lists what it calls tax protection: premium bonds may provide investors with protection from any associated market discount costs.

For risks, it lists interest rate risk, which it states as the value of a bond changing due to a change in the overall market interest rate, as with all fixed income securities. It lists secondary market risk, the risk that an investor will not be able to trade a bond in the secondary market, and states that premium municipal bonds may be harder to trade depending on the interest rate environment at the time of sale. It lists reinvestment risk: during a period of falling interest rates, the income stream of a premium municipal bond may have to be reinvested at a lower interest rate, and the risk affects all coupon bearing fixed income securities but is greater for premium bonds relative to par or discount bonds. It lists call risk, described above.

Federal Tax Rules on Bond Premium

The MSRB states that the Internal Revenue Service requires amortization of the municipal bond premium, although the municipal bond's interest is not federally taxable, and that there are tax implications that should be considered and discussed with a tax advisor or investment adviser.

Section 171 of the Internal Revenue Code governs amortizable bond premium. Under section 171(a)(1), in the case of a bond other than a bond the interest on which is excludable from gross income, the amount of the amortizable bond premium for the taxable year is allowed as a deduction. Under section 171(a)(2), in the case of any bond the interest on which is excludable from gross income, no deduction is allowed for the amortizable bond premium for the taxable year. Section 171(a)(3) provides a cross reference: for adjustment to basis on account of amortizable bond premium, see section 1016(a)(5).

Under section 171(c)(1), in the case of bonds the interest on which is not excludible from gross income, section 171 applies only if the taxpayer has so elected. Treasury regulation section 1.171-1(c)(2) states that a holder may elect to amortize bond premium on a taxable bond.

Section 171(b)(1) governs how the amount of bond premium is determined. Under subparagraph (A), the amount is determined with reference to the amount of the basis of the bond, for determining loss on sale or exchange. Under subparagraph (B)(i), for a bond described in subsection (a)(1), it is determined with reference to the amount payable on maturity or, if it results in a smaller amortizable bond premium attributable to the period before the call date, with reference to the amount payable on the earlier call date. Under subparagraph (B)(ii), for a bond described in subsection (a)(2), it is determined with reference to the amount payable on maturity or on an earlier call date.

Treasury regulation section 1.171-1(d)(1) states when a bond is acquired at a premium. A holder acquires a bond at a premium if the holder's basis in the bond immediately after its acquisition by the holder exceeds the sum of all amounts payable on the bond after the acquisition date. The regulation states that this excess is bond premium, which is amortizable under section 1.171-2. Regulation section 1.171-1(a)(1) states that, in general, a holder amortizes bond premium by offsetting the interest allocable to an accrual period with the premium allocable to that period.

Premium Bonds in FINRA's Examination Outline

FINRA's Securities Industry Essentials examination content outline carries a 2025 copyright. Under Section 2, Understanding Products and Their Risks, the debt instruments topic lists coupon value, par value, yield, callable and convertible features, and the relationship between price and interest rate among the items to know. Under Section 3, Understanding Trading, Customer Accounts and Prohibited Activities, the investment returns topic lists concepts of measurement, with the examples yield, yield to maturity, yield to call, total return and basis points. Candidates should check the current outline before the examination.

Common Misunderstandings

One misunderstanding is that a premium bond returns more than par at maturity. Investor.gov states that investors who hold a bond to maturity get back the face value, or par value, of the bond, and the SEC's bulletin on corporate bonds states that Bond C's investors receive the bond's face value of one thousand dollars at maturity.

A second misunderstanding is that a premium bond earns its coupon rate as its yield. The SEC's bulletin states that because of the premium price, the yield to maturity on Bond C, at 2.84 percent, is lower than the coupon rate, and FINRA states that a bond trading at a premium offers a return lower than the coupon.

A third misunderstanding is that a bond's price is fixed when the bond is issued. FINRA states that if you buy or sell a bond after it has been issued, its price is subject to market forces and often fluctuates above or below par, and Investor.gov states that if interest rates have fallen, a bondholder who sells before maturity may be able to sell at a premium above par.

A fourth misunderstanding is that every coupon payment on a premium bond is income. The MSRB states that part of the coupon payment on a premium bond is actually the return of principal.

A fifth misunderstanding is that a premium bond price and its yield move together. FINRA states that price and yield are inversely related, as the price of a bond goes up, its yield goes down.

A sixth misunderstanding is that all bonds react to interest rates to the same degree. The SEC's bulletin on interest rate risk states that the bond with the lower coupon rate generally will experience a greater decrease in value as market interest rates rise, and that bonds with longer maturities generally have higher interest rate risk than similar bonds with shorter maturities. The MSRB states that premium municipal bonds have less price sensitivity to a change in interest rates than par bonds.

A seventh misunderstanding is that a call has no effect on a premium bond. The MSRB states that if a premium municipal bond is called, the proceeds may have to be reinvested at lower interest rates, and Exchange Act Rule 10b-10(a)(4) provides for a statement that a redemption before maturity could affect the yield represented.

An eighth misunderstanding is that the word premium has one meaning in bond disclosures. The SEC's bulletin uses premium for a bond selling above face value and for an additional amount a company may pay when it calls a bond.

A ninth misunderstanding is that a premium on a tax-exempt bond is deductible. Section 171(a)(2) of the Internal Revenue Code provides that in the case of any bond the interest on which is excludable from gross income, no deduction is allowed for the amortizable bond premium for the taxable year.

Key Points

A premium bond is a bond priced above its par value. FINRA states that a premium, in relation to bonds, is the amount by which a bond's market value exceeds its issuing price, which is par value.

The SEC states that if the coupon rate is higher than market interest rates, the bond will likely trade at a premium. Investor.gov states that if interest rates have fallen, a bondholder selling before maturity may be able to sell at a premium above par.

The yield to maturity on a premium bond is lower than its coupon rate. In the SEC's example, Bond C sells at one thousand one hundred dollars with a 4.00 percent coupon rate and has a yield to maturity of 2.84 percent.

At maturity, the holder of a bond is paid the face value. The MSRB states that part of the coupon payment on a premium bond is the return of principal.

FINRA describes yield to call and yield to worst as calculations that involve a bond's call date, and Exchange Act Rule 10b-10(a)(4) requires a confirmation statement that a redemption before maturity could affect the yield represented.

Section 171 of the Internal Revenue Code allows a deduction for amortizable bond premium on a bond other than one whose interest is excludable from gross income, and allows no deduction for such premium on a bond whose interest is excludable from gross income.