Outwardly, lottery bonds resemble ordinary fixed rate bonds, they have a fixed, though usually long, tenor and pay 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 the incentive for the purchaser to buy the bond.
Although the details vary by bond and by issuer the principal 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.
However there is a further complication; occasional bonds will receive a bonus. 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’.
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 back 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.
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 offers a variation on the standard Lottery Bond. Through the NS&I (National Savings and Investment), the public can purchase bonds worth £1 each, with a minimum spend of £100 (or £50 if paying by monthly standing order). The maximum (as of the 2007 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 valuable.
As of July 2007, there were two £1 million prizes awarded each month, plus over 1 million smaller prizes ranging in value from £50 up to £500,000. All prizes are tax free and, with approximately 23 billion bonds issued, the chances of any one bond winning a prize for that month are approximately 24000 to 1. However, it is important to recongise that, on winning a prize, the bond is not redeemed but remains 'in the pool' for all forthcoming draws.
The prize fund is paid for out of the equivalent interest payable on the entire bond pool for that month. As of July 2007 this is 3.80%. A bond holder with a sufficiently large pool of premium bonds could hence reasonably expect to achieve this type 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.