Can premium bonds help reduce rate risk?

Premium bonds cost more but may offer higher cash flow and less rate risk.

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Some investors today would rather hold cash than buy bonds because they’re concerned that interest rates may rise and depress bond values. Premium bonds are not immune to rising rates—premium bond prices will likely fall if rates rise—but they may offer a way to capture the higher yields offered by fixed income securities, with some degree of protection against interest-rate risk.

While institutional investors often favor these bonds, they 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 flows,” says Elizabeth Hanify, vice president of municipal finance in Fidelity Capital Markets.

The three 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 two 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 flows of the premium bond accelerate the return on your investment.


Examples of bond pricing for a $10,000 bond purchase (Bonds with the same maturity and call features)*
Type of bond Maturity
date
Coupon
(%)
Yield to
"worst"
(%)
Tax
equivalent
yield (%)
Price ($) Price paid
(initial investment) ($)
Annual
interest ($)
Effective
duration
Discount JUNE 2026 2.000 2.650 4.387 94.28 9,428.00 200.00 9.03
Par JUNE 2026
2.650 2.650 4.387 100.00 10,000.00 265.00 8.80
Premium JUNE 2026
5.000 2.650 4.387 120.67 12,067.26 500.00 8.15
*Illustrative calculation assumes settlement in May 2016 and a maturity date of June 2026.
Yield to worst measures the yield an investor will receive based on the earliest call or maturity date.
Tax-equivalent yield calculates the yield a taxable bond would need to pay to equal the after-tax yield from a tax-free municipal bond. This example uses a generic tax rate of 39.6%. Interest is paid semi-annually.
Effective duration estimates the approximate change in price for a bond if interest rates change 100 basis points.

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 two bonds. Thus a bond with a four-year duration has roughly twice the interest rate sensitivity of a bond with a two-year duration. It also gives an investor an estimate for the percentage price change of a bond were interest rates to rise 1% (or any multiple thereof). For example, a four-year duration bond would fall approximately 4% if rates rise 1% (and would fall approximately 6% if rates rise 1.5%, etc.). A premium bond’s larger cash flows (generated by its larger coupon) accelerate the time it takes to repay the initial investment; in other words, the higher the coupon, the shorter the duration, all else equal (issuer, maturity, calls, yield). As you can see in the table above, the premium bond in this case has a duration of 8.15 years, compared with 8.80 years for the par bond and 9.03 years for the discount bond.

Playing defense

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. Premium bonds' larger cash flows let 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 at higher rates,” explains Debra Saunders, vice president of municipal finance in Fidelity Capital Markets. “That’s one reason why premium bonds may be considered defensive when rates climb.”

A few caveats

Be careful with callable premium bonds. A callable bond’s issuer has the right to redeem the bond on specific dates prior to the stated maturity. A premium bond, by definition, pays a higher coupon than prevailing market rates for that issuer. When considering callable premium bonds, take note of the first call date. The issuer may redeem the bond on or after the call date (at a designated premium, typically ranging from $102 to par) if the bond is still trading at a premium (higher than the redemption value) after the call date. After the bond’s call date, the bond will typically not trade at a price higher than the price at which the issuer can call the security.

Bottom line, the buyer of a callable bond should realize the issuer may call the bond prior to maturity; the higher the bond’s coupon, the more likely the issuer will call it prior to maturity, all other things equal. 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 so the bond is trading at a discount price, the issuer would likely leave the bond outstanding. At a discount, the bond would have more price volatility than bonds with higher coupons (but are the same in all other ways). So callable premium bonds may have a very different risk profile in a higher interest rate environment.

Another important consideration: Premium bonds tend to underperform par and discount bonds (with identical features away from coupon) 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. That scenario may seem unlikely, with inflation showing signs of perking up and the Federal Reserve considering a hike in its target short-term interest rate later this year; however, it is an important risk to keep in mind.

Furthermore, although many fixed income investors are focused narrowly on interest rate risk, credit risk is another important consideration. While the historical default rate on municipal bonds is low, understanding a bond’s underlying credit can help avoid loss due to downgrade or default. If the U.S. economy falters, corporate and municipal credit-worthiness 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.

When managing your investments, stay cognizant of all risks. Fidelity’s representatives and fixed income specialists have access to the full spectrum of available fixed income investment products and stand ready to help you build a portfolio of individual bonds that meets your investment and risk profile whether through individuals bonds, a bond fund, or both. New issue municipal bonds provide an excellent opportunity to purchase bonds at the original offering price without any markup or additional fees and often with priority allocation to individual investors. It is important to consider the diversification of any fixed income portfolio. So whether you build a portfolio of individual bonds, or invest in a diversified fund or ETF, 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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The information provided above is general in nature and should not be considered legal or tax advice. Consult with an attorney or tax professional regarding a specific legal or tax situation.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
Diversification does not ensure a profit or guarantee against a loss. Interest income earned from tax-exempt municipal securities generally is exempt from federal income tax, and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. In addition, you may be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates. “Market discount” arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price by more than a statutory amount. Before making any investment, you should review the official statement for the relevant offering for additional tax and other considerations.
The municipal market can be adversely affected by tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax adviser regarding your specific situation.
Investing in municipal bonds for the purpose of generating tax-exempt income is generally more beneficial the higher an investor’s tax bracket.
Tax-advantaged accounts such as IRAs and 401(k)s are generally not appropriate for holding tax-exempt municipal securities.
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