They provide superb value, but to some investors, premium bonds are a mystery.
Typically, investors get tripped up over price. Why, they ask, would you pay above par?
Such was the lament of an investor recently who was in a dither over new-issue bonds being sold at a premium.
While it “used to be that a surer way of getting a fair price on a municipal bond meant buying a new issue at par value,” the investor said, new issues today being sold at a premium “seem like a free loan to the bond issuer.”
A common misconception about premium bonds
Unfortunately, she’s missing a fundamental aspect of municipal bond investing: Regardless of whether bonds are new issues or are in the secondary market, yield is and always has been the only factor that matters when pricing or evaluating bonds.
When a new issue is priced by the underwriter, the first step is setting the scale of yields for all maturities. Then the coupon rate is established. Finally, the dollar price is calculated as a function of the coupon and yield. This is also true of pricing in the secondary market.
In the secondary market, bond traders bid bonds in yield, not dollar price.
Once again, the dollar price is calculated as a function of the coupon and yield.
There is no reason to believe that you’ll get a better value on a new issue simply because it is priced at 100.00.
The key question you should always ask is, what is the fair yield for a bond in a certain maturity?
Value in premium bonds
In the secondary market, we have always found bonds trading above 100.00 to provide the best value for our clients.
Remember, 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 a par bond would in that year and yields more-to-maturity than a par bond would in that year.
Premium bonds provide more yield because most people don’t understand them and are averse to paying above 100.00. So the simple law of supply and demand dictates that they have to be priced to yield more than bonds trading at 100.00.
Misconceptions about premium bonds are common, and it’s an issue we’ve addressed many times (e.g. “Hidden Gems in the Muni Market”).
An easy rule to keep in mind is, successful bond investors think yield, not dollar price.
