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<h3>James A. Klotz</h3>

James A. Klotz

Where is the value in today’s municipal bond market?

As long-term par bonds dip under 4.00% and Treasury yields hover near all-time lows, it’s a question we hear often.

The answer is easy: Premium bonds.

Yes, bonds trading above 100.00 (par) – known as premium bonds – offer the best returns in today’s market.

Though it may seem counterintuitive to many investors, they often don’t realize that in fact, there are premium bonds in their own portfolios. Over the past few years, if they’ve purchased bonds at par or at a discount, they were issued when interest rates were higher than today. If they were to sell these bonds, they would command a premium price, reflecting that interest rate difference. Obviously, an older 4.00% or 5.00% bond would sell at a higher price than a 3.50% or 3.75% bond issued today at 100.00.

Value can simply be a function of supply and demand

When contemplating a muni bond purchase, many individual investors avoid premium bonds, which results in less demand for bonds with bigger coupons. As with any other product or commodity, this softer demand lowers prices, causing the yield to be considerably higher than that of new issue par bonds.

Investors cowed by premium bonds fear that paying more than 100.00 represents some sort of penalty. In fact, the additional dollars, including the premium dollars, are working at the stated yields. And when buying bonds, yield is always the foremost consideration in determining value.

It works the other way, too: Because most people are more comfortable with par bonds, this greater demand often results in them being overpriced.

Of course, the larger coupons on premium bonds make them more likely to be called prior to maturity, so it’s important to know when your bonds can be called. The purchase confirmation from your broker should always reflect the “worst case” yield in the event they are called.

An easy test

Here’s an easy way to determine value: Make sure the yield-to-call is higher than the yield available on a par bond maturing in that same year.

For example, in today’s new-issue market, an “A” rated bond due in 10 years would yield about 2.25%. So when buying a premium bond that is callable in 2025, look for the yield-to-call to be 3.00% or higher. The yield-to-maturity will also be measurably higher than the yield on new issues maturing in that same year.

Bottom line: You win either way. If your premium bond is called, you receive a higher return than if you bought a bond maturing in that year. If it’s not called, your yield-to-maturity will be higher than the comparable par bonds issued at the time of your purchase. Plus, the higher coupon rate generates greater cash flow for reinvestment.

Don’t be distracted by the dollar price of a bond, take advantage of it.

James A. Klotz is the President of FMSbonds, Inc.
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Jan 20, 2015

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.