Does a lower price always represent the best value?

Consider booking a flight. A cheaper fare may initially look more attractive, but once baggage fees, seat selection and other costs are considered, a higher-priced ticket may offer more for the money.

The same distinction between price and value can apply when investing in municipal bonds. Investors instinctively shy away from premium bonds – bonds priced above their face value – particularly knowing that they typically receive only the face value when the bonds mature or are called.

But a closer look reveals a different story, that focusing on price alone can obscure what investors can receive in return: Higher coupons and greater tax-exempt cash flow.

Why pay more?

The interest on bonds is fixed when they are issued, but prevailing interest rates change. When the interest rate on bonds is higher than rates available on comparable newly issued bonds, the bonds may trade above face value because of the greater income they provide.

In other words, the higher price reflects the value of receiving above-market interest payments.

This is where price and value can become easy to confuse.

Consider an investor comparing bonds priced at, say, $100 with bonds priced at $110. The investor may naturally gravitate toward the lower-priced bonds. But the price doesn’t tell the whole story. The premium bonds’ higher interest rate may generate substantially more tax-free income each year and provide a greater yield-to-maturity.

Income generated

Suppose we analyze some bonds with a 5.00% coupon and others with a 3.50% coupon. For every $100,000 in face value, the 5.00% bonds pay $5,000 in annual tax-exempt interest, compared with $3,500 from the 3.50% bonds. That additional cash flow is an important part of determining value. Over time, the higher interest rate payments will offset the premium paid for the bonds, even though the investor generally receives only the face value when the bonds mature.

Because investors pay more than face value for premium bonds, yield calculations account for the higher purchase price and the bonds’ repayment at par if held to maturity. That’s why investors should compare yield, call features and other characteristics rather than coupon or price alone.

Still, premium bonds can offer an attractive combination of yield and greater tax-exempt cash flow. And depending on market conditions, the difference in yield between premium bonds and comparable bonds priced near par may be substantial.

Today’s elevated issuance gives investors a broad selection of municipal bonds to compare across different prices, coupons and yields, and they can identify those that best fit their goals.

What we look for

Premium bonds are often misunderstood. It’s why we discuss them periodically (e.g. “Hidden Gems in the Muni Market”).

In our experience, bonds trading above 100.00 often provide the best value for our clients. Every dollar invested, including the premium dollars, is working at the worst-case yield or higher.

We look for premium bonds that yield more-to-the-call than par bonds would in that year and yields more-to-maturity than par bonds would in that year.

Just remember: Bonds priced above par aren’t necessarily “expensive,” just as bonds priced below par aren’t necessarily a bargain.

Price is one number. Value depends on what an investor receives in return.