One of the most misunderstood facets of fixed income investing
is purchasing a bond priced at a premium.
Most bond investors grimace at the thought of premium issues
and simply avoid it all together. This article will attempt to
explain premium bond pricing and why premium issues often make good
investments sense.
One of the most misunderstood facets of fixed income investing is purchasing a bond priced at a premium. Most bond investors grimace at the thought of premium issues and simply avoid it all together. This article will attempt to explain premium bond pricing and why premium issues often make good investments sense.
It is a common mistake when investors think they will “lose” the premium paid on a bond, (i.e. the difference between the price paid and the par value returned at maturity). Remember that for a given maturity, two bonds of the same rating should offer the same yield to maturity (the total rate of return figuring in price paid on the bond, interest payments over the life of the bond, interest earned on the interest payments and the $1000 principal repayment at maturity) whether priced at a discount or a premium. The premium is not “lost” since the yield to maturity calculation factors this in just as it factors in the capital gain resulting from purchasing a bond at a discount.
Choosing the premium bond will enable the investor to receive higher interest payments: the first and obvious advantage of a premium bond. Greater interest payments provide an investor with more money to either spend or reinvest into stocks of bonds. If interest payments are in reinvested into fixed income securities that the investor is more quickly compounding the interest payments. Larger dollar amounts to invest mean more interest-on-interest.
In today’s environment where fixed income investors fear rising interest rates, higher levels of interest income can enable an investor to more quickly capitalize on higher bond yields. The flexibility of this higher income stream should not be underestimated.
When comparing two bonds of the same maturity, a premium bond is less interest rate sensitive and therefore, more stable. The duration of the premium bond is lower in this case and is the reason why a premium bond will be less interest rate sensitive. The more relevant way to contrast value among bonds is to compare two duration equal bonds but retail investors typically are not sophisticated enough to do this and will simply look at maturity.
Because retail investors generally avoid premium bonds they tend to trade cheaper and offer an investor better value. Even in the Treasury market, the highest quality and most liquid segment of the bond market, premium bonds offer higher yields than par bonds of the same maturity. The yield advantage is admittedly slim, .02 to .04 percentage points, but it is the Treasury market after all and larger discrepancies would be arbitraged away. The municipal market on the other hand offers bigger gaps wand premium issues there can sometimes offer .10 to .20 percentage points of additional yield. Longer-term municipal bonds are typically callable and can offer even greater advantages. Certain issues with call dates that are two to four-years away are considered fringe call candidates, in other words there is considerable uncertainty as to whether the issue will be called or not, and have higher yields to both maturity and call than comparable non-callable bonds. In this case, an investor is being paid to wait (via higher interest payments) and if the bond is called, he/she has earned an above market yield to call, or if the bond goes to maturity, the investor has also reaped an above market yield to maturity. These bonds are often called “cushion” or “kicker” bonds.
Tax benefits are the least known benefit of premium bonds. An investor can write off a bond premium in one of two ways: one, by amortizing the premium over the life of the bond, or two, by taking a capital loss at maturity. The premium can be used to offset capital gains but not interest income. This tax benefit cannot be accounted for in the yield to maturity formula so it reality, an investor can reap a greater after tax return than par or discount bonds.
To help explain bond premiums, let’s compare two million dollar bond portfolios. A January bond portfolio cost $1,000,000 to purchase for which an investor received $915,000 par value in bonds, a yield to maturity of 3.9% and a current yield of 5.11%. Investors may balk at the $85,000 difference between cost and number of bonds (i.e. premium paid). However, the investor is compensated with an income distribution of 5.11%, the current yield. The same portfolio but with par bonds, a $1,000,000 outlay will result in $1,000,000 par value in bonds but the current yield will equal the yield to maturity, 3.9%. On a million dollar portfolio, an investor choosing par bonds will receive $12,000 less ($51,100 – $39,100) per annum in interest income.
With interest rates still near historic lows, most bonds in the secondary market are trading at a premium since they were issued over past years when interest rates were higher. Rather than present an obstacle, premium bonds can offer investors a number of benefits.
