As the Federal Reserve considers whether to continue its policy of hiking interest rates to slow inflation, this may a good time to know more about premium municipal bonds.
Premium bonds are bonds whose purchase prices are higher than the amount that the issuer promises to repay when the bond matures. Premium bonds may be attractive to investors because they pay more interest (and pay it sooner) than non-premium bonds do.
These benefits of premium bonds have long been understood by sophisticated institutional investors but individual investors can also gain exposure to them in separately managed accounts.
Historically, when rates have risen, the prices of premium bonds have been less sensitive than those of non-premium bonds. When interest rates have fallen, premium bonds have tended to underperform other muni bonds of identical maturity and credit quality.
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.
How a premium bond compares to other bonds with the same face value1
|Discount bond||Face value bond||Premium bond|
|Annual interest paid||$200||$265||$500|
|Tax-equivalent yield (%)3||4.21%||4.21%||4.21%|
2. Effective duration estimates the approximate change in price for a bond if interest rates change 100 basis points.
3. Tax-adjusted equivalent calculation uses a generic tax rate of 37% and provides a comparison of yield to taxable securities.
Discount is a bond traded for less than face value, par is a bond that trades at face value, and premium is a bond that trades at a price higher than face value.
Like many things in investing, the risk that changing 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.
The issuer of a callable bond has the right to redeem the bond before it matures and the higher the 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."
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 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.
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.