- A premium bond is a bond that sells for more than its face value.
- A higher interest payment rate may make premium bonds less rate sensitive relative to discount bonds.
Some investors today are concerned that interest rates may rise and hurt bond values. Premium bonds are not immune to rising rates—premium bond prices will likely fall if rates rise—but premium bonds offer higher payments and the opportunity to reinvest at higher rates sooner, as well as the opportunity to help offset interest rate risk.
While institutional investors often favor these bonds, premium bonds have not been as attractive to retail investors. For some individuals, however, the benefits of premium bonds may outweigh the extra effort required to evaluate them.
Why pay a premium?
To appreciate the defensive role premium bonds can play, you need to understand some basic principles of bond pricing. When you buy a bond—whether as a new issue or in the secondary market—it may be priced at par (the bond’s face value), at a discount to face value, or at a premium to face value. "Why might an investor be willing to pay a premium for a bond? It comes down to cash flow," says Elizabeth Hanify, vice president of municipal finance in Fidelity Capital Markets.
The 3 municipal bonds shown in the table below all offer the same yield—assuming the worst-case return of the bond, no defaults, and that the bond is held to maturity. Paying a premium means you have to make a larger initial investment: about $12,000, in this example, compared with $10,000 for the bond selling at face value—known as a par bond. Why would you pay more for the same yield? Because the premium bond has a higher coupon. The coupon measures the cash paid each year as a percentage of the face value of the bond. In this case, the premium bond pays its owner 5% of its face value ($500) every year until maturity, compared with just 2.65% for the par bond ($265). If the maturities, call dates, and yields of 2 bonds from the same issuer are identical but one has a higher coupon, the bond with the larger coupon will have a relatively higher price (and vice versa).
In short, premium bonds offer a fairly straightforward trade-off: You pay more up front in exchange for larger interest payments. The higher cash flow of the premium bond accelerates the return on your investment, which may offer some degree of interest rate risk protection.
The impact on duration
Duration is a critical concept in bond investing: It measures the sensitivity of a bond to changes in interest rates. Its greatest use is that it allows an investor to compare the relative interest rate sensitivities of 2 bonds. Thus, a bond with a 4-year duration has roughly twice the interest rate sensitivity of a bond with a 2-year duration. Duration also gives an investor an estimate for the percentage price change of a bond were interest rates to change.
For example, a 4-year duration bond would fall approximately 4% if rates rise 1% (and would fall approximately 6% if rates rise 1.5%, etc.). All else equal (issuer, maturity, etc.), a premium bond's larger cash flow reduces its duration—in other words, the higher the coupon, the shorter the duration. As you can see in the table above, the premium bond in this case has a duration of 8.20 years, compared with 8.85 years for the par bond and 9.08 years for the discount bond.
Premium bonds' relatively shorter durations mean their values may hold up better than those of par or discount bonds, with all other features being the same, when interest rates rise. In addition, a premium bond’s larger cash flow lets you reinvest more in new bonds, to capture the rate increase.
"In a rising interest rate environment, the higher cash flow received on the premium bond provides an opportunity to reinvest sooner at higher rates," explains Debra Saunders, vice president of municipal finance in Fidelity Capital Markets. "That's one reason premium bonds may be considered defensive when rates climb."
A few caveats
While premium bonds do have the potential to deliver higher cash flow and reduce rate risk, other features may present some trade-offs.
A callable bond's issuer has the right to redeem the bond on specific dates before the stated maturity, at a designated premium—typically $102 to par. A premium bond, by definition, pays a higher coupon than prevailing market rates for that issuer.
The higher the bond's coupon relative to the prevailing rates, the more likely the issuer may call it before maturity, all other things equal. So it is important to note the earliest call date of a premium bond. The bond's yield based on that first call date, rather than its stated maturity, is known as its "yield to worst."
If rates rise or the underlying credit of the bond deteriorates such that the bond is trading at a discount price, then the issuer would likely leave the bond outstanding. At a discount, the bond would have more price volatility than bonds with higher coupons. So callable premium bonds may have a very different risk profile in a higher interest rate environment.
Rates are another important consideration. For bonds of identical maturity and credit quality, premium bonds tend to underperform par and discount bonds when rates fall. (Discount bonds tend to lead the market during periods of falling rates.) As a result, emphasizing premium bonds could hamper returns if interest rates decline.
Although many bond investors are worried about interest rate risk, credit risk is another important consideration. While the historical default rate on municipal bonds and investment-grade bonds is low, understanding a bond's underlying credit can help avoid loss due to downgrade or default. If the US economy falters, corporate and municipal creditworthiness could deteriorate, potentially causing corporate and muni bond values to drop.
The taxation of bond discounts and premiums can be complicated. So be sure to understand the potential tax impact of an investment before you make it. You may want to consult a tax professional.
It is important to consider the diversification of any fixed income portfolio. So whether you build a portfolio of individual bonds or invest in diversified funds or ETFs, you will want to consider securities in a variety of sectors, with different credit ratings and maturities, to help manage both credit risk and interest rate risk.
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