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By Nicholas Gliagias and Rom Badilla, CFA

Many bond investors do not like the idea of purchasing a premium bond, or a bond that is priced at more than its principal amount. They would rather buy a bond at a discount or at par value because it looks like the "better deal." Contrary to popular opinion, premium bonds can actually be advantageous to the investor.

Although paying a premium for a bond at the time of the purchase may seem unattractive, that outflow of cash that was spent is recouped through higher coupon payments over time. Premium bonds are attractive for their high coupon rates that are greater than current market yields. In other words, the higher initial cost can be offset by the higher cash payments received throughout the life of the bond.

Let's examine how a premium bond can be more beneficial than a discount bond. In this example, we have two 10-year bonds, each with a face value of $1,000. One bond is priced at a discount while the other is priced at a premium.

Coupon RateBond PriceAnnual Cash Flow10-year Cash FlowNet Cash FlowYield to Maturity
Premium Bond:5%$1,100$50$500$4003.78%
Discount Bond:2%$900$20$200$3003.18%

As we see in this example, although at first it may seem that we are getting a better deal with the discount bond due to its lower price, there is another important factor to consider. The discount bond's coupon payments are lower than the premium bond's payments, and as a result, we are better off with the premium bond in this case. The premium bond's net cash flow of $400 is derived from the 10-year cash flow, or $500, minus the premium paid on the bond which is $1100-$1000, or $100. In contrast, the discount bond's net cash flow was only $300. This was derived from the 10-year cash flow of $200 plus the amount we are saving through the discount which is $1000-$900, or $100. In this case, the higher cash flows earned over the life of the bond justify paying a premium for this bond. If the bond is held to maturity, there is additional cash flow of $100, or $400-$300, with the premium bond.

In addition, these higher coupon payments make premium bonds more defensive against changes in interest rates. Higher coupons or cash flows from premium bonds may shield the investor against rising interest rates or inflation, making the bond's price less volatile. The higher coupon provides a cushion against price declines because the bond price has further to fall before it becomes a discount bond. Therefore, premium bonds with higher coupons should be less price sensitive to changes in interest rates than discount bonds with lower coupons. Also, if interest rates rise, these higher cash flows may be reinvested at the higher prevailing rates to your advantage.

Another possible advantage of premium bonds is that their yield to maturities can be higher than the yield to maturities of discount bonds of similar maturity and credit quality. In this example, the premium bond's yield to maturity was 3.78%, while the discount bond's yield to maturity was 3.18%. Therefore, in this specific case, the premium bond is the better choice. It is always wise to consider the bond that is giving you the highest yield to maturity. The yield to maturity is a very important number as it shows your overall rate of return, taking into account the fixed coupon payments given over time and the price of the bond which can be variable.

Besides these main factors that affect yield to maturities, the yield to maturities for premium bonds may be higher than comparable discount bonds because many investors may be unwilling to own bonds that are priced very high. Not only that, but the fact that premium bonds will decline in price over time may also turn off investors to buying premium bonds.

The bond investor should realize that a bond bought at a premium will most likely not stay at that price during the length of its maturity. It is important to remember that the price of a bond tends to converge to its par value over time. In other words, although you may purchase bonds at a higher price than its par value, by the end of its maturity, the price of the premium bond will most likely have decreased and returned to its par value. The size of the premium will decline as the bond approaches maturity, or its price will decline over time toward its par value. Similarly, the size of the discount on a bond will decline as the bond approaches maturity, hence increasing the discount bond's price over time toward par.

Of course, there may be some disadvantages to premium bonds. One risk of callable premium bonds is that the higher coupons make them more susceptible to being called prior to maturity. Bonds may be called by the issuer when interest rates fall so that they may be reinvested at the lower rate. Since the value you earn from premium bonds is dependent on the receipt of higher coupon payments, if the bonds are called early then you won't be receiving those payments any longer. Therefore, the investor may receive a price for the bond that is less than their original cost.

That is why it is important to remember that every bond is different and an astute investor should always check to see if there is an early call date. If this is the case, then the yield to call and yield to worst are important measures to use. The yield to call of a bond tells you what your rate of return is on your bond if it is called before its maturity. Similarly, the yield to worst of a bond is the lowest possible rate of return on your bond should it be called early or before its maturity date. For example, if your premium bond is called before its maturity date, then you lose some of the premium you paid and get a lower return as your interest payments are truncated. In this case, your yield to call is lower than your yield to maturity and so you are at a disadvantage.

In summary, investors should take note of the main benefits of purchasing premium bonds. Although premium bonds seem expensive, they may offer higher yield to maturities than discount bonds, and ultimately an investor wants to see a higher yield. This cost for the higher yield is reflected in the premium dollar price that is paid for the bond. Also, premium bonds have higher coupon cash flows than discount bonds which makes it an attractive investment. Another advantage of premium bonds is that the higher coupon payments result in a lower price sensitivity to changes in interest rates compared to discount bonds. Finally, these higher cash flows can be reinvested at higher rates if prevailing interest rates start to rise. Therefore, depending on the circumstance, these benefits may make premium bonds a worthwhile investment.

Source: Buying Premium Bonds: Good Or Bad Idea?