Legal Definitions - bond premium

A bond premium occurs when the market price an investor pays for a bond is greater than its face value (also known as par value). The face value is the amount the bond issuer promises to pay back to the bondholder when the bond matures. Bonds typically trade at a premium when their stated interest rate (coupon rate) is higher than the prevailing interest rates for similar bonds in the market, making them more attractive to investors.

• Example 1 (Corporate Bond): Imagine a large technology company issued a bond with a face value of $1,000 and an annual interest rate of 5%. A year later, general market interest rates for similar corporate bonds have fallen to 3%. Because this existing bond offers a more attractive 5% interest payment, new investors are willing to pay more than $1,000 for it. If an investor buys this bond for $1,050, the $50 difference ($1,050 - $1,000) represents the bond premium. This premium reflects the higher value investors place on the bond's superior interest payments compared to what new bonds offer.

• Example 2 (Municipal Bond): A city issued a municipal bond with a face value of $5,000 and a tax-exempt annual interest rate of 4%. Due to a sudden increase in demand for tax-exempt investments and a general decline in interest rates for comparable government securities, this bond becomes highly desirable. An investor purchases this bond for $5,200. The $200 difference ($5,200 - $5,000) is the bond premium, indicating its increased market value above its maturity payout because of its attractive tax-exempt income stream and favorable interest rate.

• Example 3 (Government Bond): The U.S. Treasury issued a 10-year bond with a face value of $10,000 and a 2.5% annual coupon rate. Six months later, the Federal Reserve cut interest rates significantly, causing newly issued 10-year Treasury bonds to offer only 1.5%. The older 2.5% bond is now much more appealing because it pays a higher interest rate. An institutional investor buys this bond for $10,300 on the secondary market. The $300 difference ($10,300 - $10,000) is the bond premium, demonstrating its higher value due to its superior interest payments compared to current market offerings.