Municipal Bond Forum
Why pay a premium?
Q
My broker is encouraging me to invest in bonds, but I don’t quite understand them. He wants to sell me bonds with a coupon higher than the yield-to-maturity, and he says I have to pay a premium price for the bonds. I know what a coupon is, but what is yield-to- maturity? Why do I have to ever pay a premium price for bonds? Why can’t I invest $100,000 and buy $100,000 worth of bonds? I can invest $100,000 in CDs now and receive $100,000 at the CD’s time of maturity. Is it cheaper to buy CDs than bonds?
A
James A. Klotz responds:
The fact that a bond sells at a price above 100.00 merely reflects that the bond is carrying a higher coupon (interest) rate than bonds being issued currently.
For example: If long-term AAA-insured bonds are being issued today at a rate of 4.75%, an older bond with a coupon rate of 5 1/2% will trade at a premium (above 100). A bond with a 4% coupon of comparable quality will trade at a discount to 100.00. Likewise, a 4% CD is worth more than a 3% CD.
Yes, you can buy bonds at par (100.00). You would invest $100,000.00 and receive $100,000.00 at maturity. You will see a number of bonds priced at 100.00 on our Web site.
Try not to be distracted by dollar prices. The most important factor to consider when investing in bonds is “yield.” Premium bonds often provide a higher rate of return than par or discount bonds. Because premium bonds are more likely to be called prior to maturity, the yield-to-call is an important consideration when making your decision.
For more on premium bonds, see “Finding Value in this Market ” .
Start here.
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The responses provided in this forum are meant to address specific questions posed by investors about their municipal bonds and to provide market insight for our general audience. Please note, your investments, objectives, results and experience may differ significantly. Our answers and any potential strategies discussed should not be construed as a solicitation to buy nor sell any security or investment product. All investing entails risk.
