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, Buckingham (79 clicks)
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Summary

  • The higher annual interest payments received for premium bonds offset the amortization of the premium paid for them.
  • Higher coupon premium bonds are less sensitive to the negative effect of rising interest rates.
  • Purchasing premium bonds allows investors to avoid onerous tax implications created by buying discount bonds.

A common error made by many bond investors is to avoid purchasing premium bonds - bonds that trade above their face value (or par, typically 100). A bond will trade at a premium when the coupon (stated) yield is above the current market rate for a similar bond of the same remaining term to maturity.

Many investors avoid premium bonds because they don't want to buy a product that they believe comes with a guaranteed loss built into the price. You pay above par, yet receive only par at maturity. This is a major mistake. In fact, the higher annual interest payments received for premium bonds offset the amortization of the premium paid. So when building individual bond portfolios, we at Buckingham - where I am director of research - don't try to avoid premium bonds. We generally prefer them because they offer a number of excellent advantages over discount or par bonds.

The first advantage is related to supply and demand. Because many individuals avoid premium bonds, their supply is greater. Another reason for the greater supply of premium bonds is that most trust companies have strict buying parameters that limit what they can purchase, with prices generally ranging between $98 and $102. The limit is because, in many trust documents, trustees are required to balance the interests of the income beneficiary (often a spouse) and the remaindermen (often children from another marriage). When buying bonds, this means trustees cannot buy bonds either at a great discount or a large premium. Also, many retail brokers put their clients in the same types of par-priced bonds. These two categories of buyers help create strong market demand for lower coupon bonds. Strong demand for a limited product means prices are higher and yields lower. Lower demand for premium bonds results in higher yields for bonds of the same maturity. It also provides a larger pool of bonds from which to buy.

A second advantage to buying premium bonds is that their higher coupon makes them less sensitive to the negative effect of rising interest rates on price. The higher coupon shortens the bond's duration, which is a measure of the price sensitivity of a fixed-income investment to a change in interest rates. That makes premium bonds less susceptible to increasing interest rates. If interest rates do rise, the higher coupon payment on the bond provides the investor with more current cash to reinvest at the now-higher market rates. Thus, premium bonds can offer higher risk-adjusted returns. To demonstrate, consider two New York City municipal bonds that our trading desk recently considered for a client.

Maturity

Yield

Coupon

Price

Duration

Bond 1

Aug. 1, 2023

2.80 %

3%

101.632

8.07

Bond 2

Aug. 1, 2023

2.80 %

5%

117.974

7.58

A 1 percent rise in interest rates would cause the price of Bond 1 to fall about 8.1 percent. The same rise in rates would cause the price of Bond 2 to fall 7.6 percent. So, while many investors would avoid Bond 2 because they don't want to pay almost 18 percent more than the value at which the bond will mature, we prefer Bond 2 because the yield is the same as Bond 1 and it will fall less in price if rates rise - a major concern of today's investors.

Premium bonds can also provide some tax advantages. For taxable bonds (not municipals), the IRS allows a one-time election to amortize (write down over time) the premium paid over the remaining life of the bond. The ability to deduct the amortized premium improves the bond's after-tax return. With municipal bonds, many states - for example, my home state of Missouri - will allow investors to amortize premiums on out-of-state bonds. This additional capacity to improve after-tax returns is something many CPAs, let alone individual investors, are unaware of.

A final advantage to purchasing premium bonds is the ability to avoid onerous tax implications created by buying discount bonds. The term de minimis refers to circumstances under which an investor must pay capital gains taxes for any bond bought at a discount to face value, original issue discount excluded, in excess of a quarter-point per year to maturity. This can significantly reduce the bond's after-tax yield. The same concern exists for low coupon bonds that aren't subject to this tax at time of purchase. If the owner wants to sell the bond and rates are higher at the time of sale, the market will treat the bond as de minimis, and the client's bid price will be significantly lower than for the same bond with a higher coupon not in de minimis territory. Many investors are unaware of this situation, but we take strong measures to avoid it.

Greater supply, lower susceptibility to rising interest rates and significant tax advantages are all reasons we generally recommend higher coupon bonds for our clients, and those are reasons why you should prefer them as well.

Source: Why We Love Premium Bonds And You Should Too