A bond is a type of investment in which the investor lends money to an entity, such as a corporation or government body, for a certain period of time at a fixed interest rate. Governments and companies use bonds to finance projects, such as new schools and business expansion. The entity that issues the bond states the interest rate and the maturity date when the loaned funds will be repaid.
A premium bond is a bond that is trading above its par, or face, value. Investors want a higher yield, and will pay more for it, so a bond will offer a coupon rate that is higher than prevailing interest rates.
For example, if a bond has an 8 percent coupon at a time when the prevailing interest rate is 6 percent, investors bid up the price of the bond until its yield to maturity is the same as the market interest rate. The bidding up process forces the bond to trade at a premium to its par value.
The yield to maturity of the bond will be reduced by a bond premium, and the yield is enhanced by a bond discount. As the bond approaches maturity, the size of the premium will decrease. At maturity, the premium will dwindle to zero, as bond issues are usually redeemed at par.
In the United Kingdom, a premium bond is something altogether different. There, it is a savings account from National Savings and Investment in which you can deposit between 100 and 30,000 pounds. Instead of earning interest on the invested money, a premium bond enters you into a monthly lottery, with the chance of winning between 25 pounds and 1 million pounds, tax-free. However much you invest brings an equivalent number of bonds, thus increasing your chances of winning the lottery.
With a premium bond, the investment capital itself is not gambled in the prize draw, only the interest that is earned on the investment. Investment of money in a premium bond ensures that the investment itself is safe, though this is no longer a point of attraction, as the UK guarantees every regulated savings account up to 85,000 pounds per person, per institution.
There is no minimum length of time that one must hold the bonds. They can be cashed in at any time, though new bonds have a one-month waiting period. Any prize money acquired through the UK's premium bonds program is tax-free. Winnings can also be automatically re-invested to buy more bonds and increase chances of winning, similar to the concept of compound interest in a normal savings account.
Odds of winning are of course slim. The chance of winning the million pound prize is over 44 billion to 1. The invested capital is also safe in a premium bond, but it is not immune to inflation. With no interest earned to offset a possible loss of value, you will end up with less than the initial investment. While not a viable savings account or investment option, UK premium bonds are a good way to forego earning interest in favoring of gambling that interest on the possibility of winning more money.