Seek Out The Misunderstood Premium Bonds

Klotz on Bonds

Home > News and Perspectives > Seek Out The Misunderstood Premium Bonds

<h3>James A. Klotz</h3>

James A. Klotz

In a market saturated with bonds selling above par, it’s surprising so many investors are unaware that premium bonds provide the best value in today’s municipal bond market.

Too often investors shun bonds trading above par (100.00) because they think they are overpaying for them. Ironically, these misconceptions are actually what drives their value.

Why Premium Bonds

Premium bonds rarely start out that way. They were issued at par when bond rates were higher. So premium bonds pay more interest than bonds issued today and therein lies their fundamental value.

Another advantage is their defensive nature.

Because of the bigger coupon, rising rates will affect them less than par or discount bonds.

Think Yield, Not Price

Much of the confusion regarding premium bonds stems from focusing on “dollar price” rather than “yield.”

Yield is the true measure of what investors earn on their money. Dollar price is actually irrelevant.

If you’re a long-time muni investor, chances are you own bonds that command a premium price today, even though you may have purchased them at par.

If you were to sell these bonds, they would be priced to approximate the current lower interest-rate environment.

Municipal bonds aren’t the only bonds that can trade at a premium.

Treasuries and corporate bonds can also, but only munis reflect this substantial yield advantage.

That’s because the tax-free market is dominated by individual investors, not institutions, many of whom are under the mistaken belief that they’re being penalized when buying bonds selling above 100.00.

Worst Case Yield

It’s important to note that higher coupons on premium bonds make them more likely to be called prior to maturity.

Investors should know when their bonds can be called and the “worst case” yield if they are called.

We’ve explored premium bonds in previous articles (e.g. “Hidden Gems In The Muni Market”), but the formula remains the same – and simple: Make sure the yield-to-call and yield to maturity on the premium bonds are higher than the yield available on a par bond maturing in those years.

Remember, when buying a premium bond, every dollar invested is working at the stated yields, even the premium dollars.

Following this guideline puts you 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 isn’t called, your yield to maturity will be higher than comparable bonds issued at the time of your purchase.

You’re ahead either way.

James A. Klotz is the President of FMSbonds, Inc.
Email the Author

Jul 29, 2019

Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.