Lottery bonds are a type of government bond in which some randomly selected bonds within the issue are redeemed at a higher value than the face value of the bond. Lottery bonds have been issued by public authorities in Belgium, France, Ireland, Pakistan, Sweden, New Zealand, the UK and other nations.
Outwardly, lottery bonds resemble ordinary fixed rate bonds; they have a fixed, though usually long, tenor and either pay no interest or regular coupons. The individual bonds within each issue are numbered, like ordinary bonds, but the serial numbers serve a different function from ordinary bonds. For a lottery bond the serial number is an added incentive for the purchaser to buy the bond.
Although the details vary by bond and by issuer, the principle remains the same. A drawing takes place according to a schedule to decide which serial numbers are to be redeemed. The individual bonds within the issue thus identified by the drawing are then bought back by the issuer, so that the total value of an issue will decrease as time passes and more bonds are redeemed. A small number of bonds are redeemed for an amount greater than their face value. Hence the holder of that particular bond will have won the ‘lottery’. Lottery bonds are similar to prize-linked savings accounts.
If the government of Belgium issues a 10 year lottery bond to finance re-gilding the Atomium, the issue may consist of 10,000 individual bonds with a face value of EUR 1,000. The coupon rate is reasonable to attract investors, but not high. However, the issuer has committed to redeem 5,000 of the 10,000 bonds issued before the bond’s maturity date and has further committed to redeem 120 of these at a redemption value of EUR 1,250.
This means that any purchaser of a single bond for EUR 1,000 will receive annual interest a little above the bank rate, but will also have a 1.2% chance of winning an additional 25% of his original investment.
So the issuer borrows 10,000 * 1,000 EUR which is 10 Million Euros. It will repay 120 of those bonds at 1,250 EUR which is equal to 150,000 EUR and a further 9,880 at 1,000 EUR (9,880,000 EUR) making a total of 10,030,000 Euros, or 100.3% of the original borrowing. The issuer will also pay interest on any unredeemed bonds.
Lottery bonds are usually issued in a period where investor zeal is low and the government may see an issue failing to sell. By knowing ahead of time when the coupons will be paid and how many bonds will be redeemed at the original value and at the lottery value, the issuer can value the bond accurately and know ahead of time the cost of the borrowing.
The purchaser, however, is subject to the element of chance, as it is not known in advance which actual bonds will be redeemed at either value, nor when. This element of chance appeals to a section of society who will take a lower guaranteed return in the hope of a windfall.
UK Premium Bonds
The government of the UK offers a variation on the standard Lottery Bond. Through the NS&I (National Savings and Investment), the public can purchase Premium Bonds worth £1 each, with a minimum spend of £100 (or £50 if you invest by standing order). The maximum number of Bonds (as of the 2014 tax year) that an individual can hold is £30,000.
The bonds themselves attract no interest, are perpetual and are redeemable at par (face value) at any time. The attraction for an investor is that, each month, a draw takes place and, should an investor hold one of the bond numbers chosen, then the bond-holder will be awarded a prize of variable value. Prizes (which vary between £25 to £1 million) can be reinvested - if you do not exceed the £30,000 cap - or can be paid out.
As of March 2014 "NS&I Premium Bonds give you the chance every month to win £1 million. Instead of paying interest, we hold monthly prize draws with a £1 million jackpot and over a million other cash prizes." All prizes are tax free and, with approximately 47 billion bonds issued, the chances of any one bond winning a prize for that month are approximately 26000 to 1. However, it is important to recognise that, if a bond wins a prize, that bond is not redeemed but remains 'in the pool' for all forthcoming draws (at least until you decide to redeem it.).
The prize fund is paid for out of the equivalent interest payable on the entire bond pool for that month. As of March 2014 the interest rate is 1.30%. The average bond holder could hence reasonably expect to achieve this level of return should he hold his bonds for long enough.
Although riskier than a typical European bond, the UK Premium Bond offers the chance of enjoying a significantly larger windfall, though you can also never win a prize!