In many countries around the world, premium bonds are any type of bond issues that are selling at a price that is considered to be above the recognized par value. This is the opposite of a discount bond, where the bond is selling at a price that is below par. A premium bond can also refer to a bond issue where the holder does not earn interest or capital gains, but is compensated by allowing the holder to participate in a government sponsored lottery. When this is the case, winners of the lottery receive prizes that are free of any type of tax obligation.
The most common structure of the premium bond is that the issue is trading at a higher price than what is considered the present par value. The higher price often has to do with the amount of interest, or the coupon, that the bond is set to pay. For example, a bond that is selling at a four percent coupon is considered to be selling at par. A similar bond is selling at a seven percent coupon, which means that the purchase price will be higher. This higher purchase price identifies the second bond as being a premium bond issue.
Identifying a lottery bond issue as a premium bond is a common practice in several countries around the world, notably the United Kingdom and other nations that are part of the British Commonwealth. One of the earliest examples of this type of premium bond issue dates back to 1956, when the strategy was introduced as part of the national budget. Today, the process is managed by the National Savings and Investments scheme that is operated by the government of the UK.
With this application, the purchase of the bond issue allows bondholders to participate in a state-run lottery that takes place on a recurring basis, often monthly. Instead of providing the bondholder with periodic interest payments based on a fixed or floating interest rate, any interest accrued on the bond issue is deposited into a prize fund. Most of these lottery schemes provide several different payments, ranging from a series of small prizes to one major prize. All prizes are free from taxation, and do not have to be declared as income, a feature that makes the premium bond lottery very popular. Investors are free to participate in the lottery for as long as they like, with full guarantees from the government that they can cash in the bonds at any time, and receive the full original investment.