It is becoming increasingly clear to bond investors that despite the financial media’s silence on the subject, yields on long-term bonds have been steadily declining since the Fed began pushing up short-term interest rates in June 2004.

However, tax-free bonds still provide outstanding value when compared with other fixed-income investments. Although Treasury bond yields have declined to levels not seen since the 1960s, municipal yields have not fallen as precipitously. High quality tax-free bonds still return close to 4.00% in 10 years and more than 4.50% on longer-term maturities.

The yield advantage over taxable bonds is dramatic. Investors in the 35% tax bracket would have to purchase taxable bonds yielding 6.15% and 6.92%, respectively, to match the after-tax yield of municipals, which compare very favorably to 10- and 30-year Treasuries yielding 4.77% and 4.90%.

With this yield advantage in mind, how does a muni investor find the best values in the market today?

Contrary to the instincts of most individual investors, the best values will invariably be found in premium bonds.

What is a premium bond?

Premium bonds usually don’t start as such. It is likely that they were originally issued at par (100.00.) Since they were issued when interest rates were higher, they pay more interest than bonds being issued today.

If you have been investing in bonds over the last five to 10 years, you have bonds in your portfolio that command a premium price today, even though you may have purchased them at par or at a discount. If you were to sell these bonds, they would be priced to approximate the current interest rate environment. Obviously, an older 5.50% bond will sell at a higher price than a 4.50% bond issued today at 100.00.

Greater yield to maturity

Premium bonds invariably provide a greater yield to maturity than par or discount bonds of the same quality. Their higher coupon rates also generate greater cash flow for reinvestment. This makes them more defensive if interest rates rise. Although all bond prices decline in value if interest rates rise, the dip in premium bonds will be less severe.

U.S. Treasury and corporate bonds can also trade at a premium, but it is only in the municipal bond market that premium bonds yield substantially more to maturity than par or discount bonds. This is because the tax-free market is dominated by individual investors, rather than institutions. Individual investors often avoid bonds selling above 100.00, thinking that paying a premium represents some sort of penalty.

They fear that the premium dollars paid are “lost,” as opposed to recognizing that these additional dollars are all working at the stated yields. Premium bonds also produce more reinvestable income.

Think yield

Individuals can be distracted by the dollar price of a bond, rather than focusing on yield. This causes them to avoid premium bonds, which reduces demand for bonds with larger coupons and higher dollar prices. As with any other product or commodity, this softer demand lowers prices and subsequently causes the yield to maturity on these bonds to be as much as 50 basis points higher than the yield on new issue par bonds. Conversely, because most individuals prefer par bonds, the demand for those securities often causes them to become overpriced.

This yield advantage does not exist with Treasury bonds because institutional investors buy yield, which is the only relevant factor when analyzing a bond investment. The dollar price is irrelevant. It is merely a product of the coupon rate and yield.

Be careful: The higher coupons on premium bonds make them more susceptible to being called prior to maturity. It is important to know when your bonds can be called. Your purchase price must reflect the “worst case” yield on your bonds, assuming they will be called (although they may not be.)

Rule of thumb

Finding the hidden value in premium bonds is easy if you use this simple rule of thumb: Make sure the yield-to-call is higher than the yield available on a par bond maturing in the same year.

For example, in today’s new-issue market, a bond due in 2016 would yield approximately 3.75% to 4.00%. So if you are buying a premium bond that is callable in 2016, the yield-to-call should be 4.25% to 4.50%. The yield-to-maturity should also be higher than the yield available on new issues maturing in that same year. In other words, the right premium bond will have a yield-to-maturity greater than the 4.50% available on bonds selling at 100.00 today.

If you follow this guideline, you are in a win-win situation: If your bond is called, you receive a higher return than if you bought a bond maturing in that year. If the bond is not called, your yield to maturity will be higher than comparable bonds issued at the time of your purchase. You come out ahead either way.

Purchasing a premium bond with a yield advantage to the call as well as to maturity will always provide the best value available.

Remember, if you are buying shares of stock, think “dollars.” When investing in tax-free bonds, think “yield.”

James A. Klotz is the President of FMSbonds, Inc. Email the Author10/13/2006