Premium Bonds - CFO vs. CFF sauce, higher, affect, secret, interest

whew1110

"For premium bonds, the cash coupon is higher than interest expense. Consequently, CFO is understated and CFF is overstated." (secret sauce)

How does cash coupon affect CFF being overstated?

JGovender

Let's say you sell a premium bond with a par value of $1000 for a price of $1100. The initial $1100 goes to CFF (CFF = $1100). At maturity, the principal repayment will be a cash outflow of $1000. CFF = $1100 - $1000 = $100 (overstated by $100)

All of the interest payments are CFO outflows.
Coupon payments = coupon rate * par value.
Interest expense = market rate of interest * BV of bond at beginning of period

Coupon rate > market rate of interest, so coupon payments > interest expense

Also, the BV of the bond at the beginning of each period is decreasing each period (it is approaching its par value) so interest expense will be less and less each period.

Hope that helps