Why pay more for your muni bonds?

Premium bonds may help protect you from risks.

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Key takeaways

  • Premium bonds may be less sensitive to changes in interest rates and may provide protection for investors' portfolios.
  • Premium bonds sell for more than their face value.
  • Most municipal bonds are issued at a premium.

Savvy investors keep close eyes on how much they pay for stocks and bonds as well as on the fees they pay for investment management services. So why would some of the savviest investors on earth, those who run giant pension funds, foundations and endowments, regularly pay above-market prices for what are known as premium bonds?

What those institutional investors understand is that premium bonds pay more interest sooner than non-premium bonds do. That matters because it can help protect the investors who hold the bonds from changes in interest rates in the future. They think of premium bonds as offering a cushion against the risks posed by interest rate changes. That same protection against surprises from future interest rate moves that makes premium bonds appealing to institutional investors is also available to individual investors.

To understand how premium bonds can offer protection against future rate moves, let's imagine 3 bonds, each with a $10,000 face value. Assuming the issuers don't default, all 3 would pay the same yield if they are held to maturity. One of the bonds sells for its face value, one sells at a discount, and the third, a "premium" bond, sells for $2,000 above face value. The premium bond pays its owner $500 or 5% of its face value every year until it matures, while the face value bond pays $265 or 2.65% of face value and the discount bond pays $200 or 2% of face value.

Those larger interest payments appeal to smart investors because they may offer some degree of protection from the risks posed by changes in interest rates. Interest rate risk is one of those things that keeps experienced bond investors up at night. Put simply, interest rate risk is the possibility that rates might rise in the future while all their cash remains tied up in bonds that pay less and they are unable to take advantage of the new higher rates.

Like many things in investing, the risk that rising interest rates pose to bonds can be measured and managed and premium bonds are one of the tools that can be used to manage that risk. To measure the amount of risk that changing rates pose to various bonds, investors look at a metric known as duration. Duration measures the sensitivity of a bond's price to changes in interest rates and lets an investor compare how sensitive various bonds would be to changes in interest rates. For example, a bond whose duration is 4 years is roughly twice as sensitive to rate changes as a bond with a 2-year duration. Duration also gives an investor an estimate for how much the price of a bond might change if interest rates rose or fell.

For example, a bond with a duration of 4 years would fall approximately 4% if rates were to rise 1%. The faster flow of interest payments to the bondholder that premium bonds offer reduces their duration and the possibility that they will lose value if rates increase in the future. In essence premium bonds offer a different composition of total return (interest income, appreciation) than discount bonds, as well as a lower effective duration, all else being equal.

Bear in mind

While premium bonds have the potential to deliver higher cash flow and reduce rate risk, investors should be aware of some of their unique characteristics.

Callability

The issuer of a callable bond has the right to redeem the bond before it matures and the higher interest rate that the bond pays relative to prevailing rates, the more likely the issuer may be to call it. Because premium bonds pay higher-than-average interest, premium bondholders should be aware of the earliest date their bonds could be called. The bond's yield based on that first call date, rather than its stated maturity, is called its "yield to worst."

Rate risk

When interest rates fall, premium bonds tend to underperform other muni bonds of identical maturity and credit quality so a large allocation to premium bonds could hurt returns if interest rates decline.

Credit risk

While the historical default rates on municipal bonds and investment-grade bonds are low, it's wise to understand a bond issuer's creditworthiness to help avoid a loss if the issuer is downgraded or defaults. In an economic slowdown, the creditworthiness of municipalities and corporations could deteriorate, potentially raising default risk and lowering bond prices.

Taxes

Taxes on bond investments can be complicated so be sure you understand the potential tax consequences of any investment before you make it. You may want to consult a tax professional.

Diversification

It's important to maintain a diverse mix of investments in any fixed income portfolio. A properly diversified portfolio includes securities from a variety of sectors, with different credit ratings and maturities, to help manage both credit risk and interest rate risk.

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