Understanding premium bonds by sheer definition is easy since they are simply bonds that are worth more than its par value. But if you are not well-versed on the different economic terminologies, buying a bond could be a risky business, unless you fully understand the factors that affect the price movements of the bonds.
So when a friend got all too excited with how much his bond sold at a higher price as compared to how much he bough it, I am too was excited. He earned a considerable amount of money within a couple of weeks. His income from premium bonds was even more than what I earn working in the office for one month. And needless to say that my friend inspired me thus it started my search for understanding what premium bonds are and how can I earn from it.
The Rise and Fall of Premium Bonds
I found out that interest rates greatly affect the rise and fall of the prices of premium bonds. Let’s say if the current interest rate in the market is 3% then I bought the bond a week ago at 5% interest rate, its current value is higher than how much I bought it a week ago. In short, I earned since my bonds became premium bonds. However, if the current interest rate is 7% while I bought the bonds at 5%, then the market price of my bond will be decrease or I loss money.
To use monetary value in my explanation, the bonds that I bought at $100 USD gave me earnings more than I bought it since (as what economists call it) it was sold at a premium. But if the $100 USD bonds were sold at a lesser price, say $75 USD, and then it was sold at a discount. So, just like most fixed-income securities, if the interest rates go up, then the market value of the bond will go down while decreasing interest rate means that the price of the bond will go up.
- Bonds selling at premium = earning money
- Bonds selling at a discount = losing money
This is basically the first determinant on how I could fully take advantage of my premium bonds. However, predicting when the interest rates will go up and down is another tricky matter. Let’s say is you predicted that the interest rates will go up in a couple of months, then it will be safer to buy bonds with a shorter maturity. So, knowing the factors that affect the movements of interest rates is for your advantage.
Factors that Affect Interest Rates and Premium Bonds
- Inflation. This is basically the rise in the general level of prices of commodities — goods and services— within a certain period of time. It affects the buying power of money like when the prices of commodities go up, and then my money can purchase fewer goods. Let’s say if my $5 USD can buy me 2 cans of milk last month and because of inflation the prices of milk go up to $3 USD per can. It follows that I need to contend my self with one can of milk since my $5 USD is not enough for two cans.
- Federal Reserve. Has the hand in the short-term interest rate and has the control over the federal funds rate. If the fed funds rates are increased, then it is when the Feds supply short-term securities in the market which in effect restricts or limits the money in circulation.
- Supply and Demand. Since the Feds monetary policy affects and determines how much supply of money is circulated in the economy while inflation affects the demand of money. But aside from this the price of premium bonds are also affected by other factors like the fiscal policy, competitive currencies and economic growth.
Predicting when the interest rate will rise or fall gave me a better understanding on how I could earn from my premium bonds.