Understanding Premium Bonds Many individual investors prefer to purchase individual bonds at prices around par value (100), or even at a discount to par. With interest rates hovering near historic lows, this presents a challenge for these investors as most individual bonds issued over the prior few decades carry higher than market coupon rates, causing them to trade at high premiums in the secondary market (often at prices of 110 or more). As we will attempt to illustrate in this commentary, the dollar price of a bond should not be the sole determinate in evaluating its attractiveness in any type of buy/hold/sell decision. In fact, higher premiums that are typically associated with higher coupons may in fact provide a degree of protection in a rising interest rate environment, vis-à-vis a par or discount bond. Given today s challenging fixedincome environment, it may be of particular value for investors to explore this issue with the goal of overcoming a psychological barrier which may be unfairly coloring investment decisions. For the sake of simplicity, we will focus on federally tax-exempt municipal bonds. Premium Bond Definition A premium bond, as it is generally defined, is a bond trading at price higher than its par value (typically, a price of 100, or face value of $1,000 per bond). Because bonds are typically issued with a fixed coupon, as the interest rate environment changes over time, the price of that bond will also change to reflect current market rates. For instance, current new issue AAA rated 10-year municipal bond rates are around 2.50% (Source, Bloomberg L.P. 6/10/14). There may be a bond outstanding that was issued 20 years ago and now has 10 years left to run carrying a coupon rate of 5% (due to interest rates being much higher 20 years ago vs. today). If today s 2.5% coupon bond is trading at par (100) to reflect current market rates, then the 5% coupon bond that has 10 years left to maturity must be trading at a price higher than par, in order to bring that bond s prospective return in line with the current 2.5% market rate. In fact, a 5% coupon non-callable bond 10-years long priced at 2.50% yield to maturity would have a price of around $122, a significant premium above par value. This concept leads us to explore other ways to measure a bond s attractiveness in the marketplace, rather than simply looking at price alone. Yield to Worst Yield to worst is a measure of the minimum annualized return an investor can expect to achieve when purchasing a bond at a given price, with a given fixed coupon rate, maturity, and stated call provisions. Of course, this calculation assumes the bond does not default, and the investor holds the bond to call or maturity date. We believe this is a much better way of determining the attractiveness of a buy/hold/sell decision. This calculation takes into consideration both the fixed coupon rate, as well as the price you pay/receive for the bond s purchase/sale. For non-callable bonds, the yield to worst would be the
bond s yield to maturity. For callable bonds priced at a premium, the yield to worst will most often be the yield to call. For callable bonds priced at a discount to par, the yield to worst will typically be the yield to maturity. For callable bonds, it is important to consider both the yield to call and yield to maturity when making a buy/hold/sell decision. Importantly, because many investors do not understand the concept of paying premiums for municipal bonds, bonds priced closer to par tend to be in higher demand. Due to the well known laws of supply and demand, higher demand for par-type bonds can place upward pressure on the bond s price, resulting in lower yield (the yield and price of a fixed-coupon bond move inversely). Therefore, investors may be able to purchase higher premium bonds at a lower price (higher comparative yield) versus a partype bond with similar characteristics, all else being equal. Let s explore this concept by way of a purely hypothetical example. Examine the two bonds and scenarios listed below. This example is for illustrative purposes only, and is not a recommendation to buy, sell, or hold either of these securities. Bond 1: Hillsborough County FL School Board 5% coupon, matures 7/1/19, non-callable, trading at a 1.70% YTM, for a price of about 115.635 for settlement on 7/15/14. Source: Bloomberg, LP.
Bond 2: Tulsa County OK School Dist #1 2% coupon, matures 7/1/19, non-callable, trading at 1.50% YTM for a price of about 102.381 for settlement on 7/15/14. Source: Bloomberg, LP. In an effort to illustrate this concept and for the sake of simplicity, let s assume these two bonds are roughly identical (ignore the qualitative differences such as geographic location, ratings, etc. for this particular exercise) with the exception of a) the coupon, and b) the yield/price in which they are trading. Note that the higher premium Hillsborough bond as shown in this hypothetical example could be purchased at a 1.70% YTM vs. a 1.50% YTM on the OK bond, reflecting the potentially lower demand / higher yield that may be possible as mentioned previously. Now, let s examine the cash flows of these two bonds between now and final maturity, using the YTM s as listed above:
Bond 1: Hillsborough yield and cash flow analysis. Source: Bloomberg, LP. Bond 2: OK yield and cash flow analysis. Source: Bloomberg, LP.
Box 1 in both examples points to the bond s price, which determines the yield to worst (in this case, yield to maturity) as noted by box 2. Box 3 shows how much the total cash outlay would be to purchase 25,000 face value of each bond. Note the premium priced Hillsborough bond will cost $28,957.36 vs. $25,614.69 for the lower priced Tulsa bond, or $3,342.67 more. Given that both bonds will return $25,000 upon maturity (assuming no default), how could the higher priced Hillsborough bond potentially be a better deal? Reviewing the information highlighted by box 4 helps to illustrate just that. As listed, both bonds will return $25,000 in principal upon maturity, again assuming no default. However, note the much higher coupon payments received over time by the Hillsborough bond. Doing a simple calculation of the total income received in Box 4 minus the total amount paid for each bond in Box 3 provides $2,292.64 for the Hillsborough and $1,885.31 for the Tulsa, or a difference of $407.33 over the life of the holding. Quite simply, the higher premium bond in this example has the potential to deliver a higher return to the investor, as is not readily apparent by simply looking at the price or initial cash outlay. An important point to note: As is normal convention in bond arithmetic, the yield to maturity/yield to worst calculation assumes all coupon payments are reinvested at the same rate over the life of the bond. A lower reinvestment rate may lower the return, while a higher reinvestment may raise the return. This is often referred to as interest on interest. For this example, as you can see in the 3 rd line of box 4 titled Reinv @, we have set both reinvestments to 0%. This would be as if the coupon payments earned would simply go to cash earning a 0% return. This penalizes the premium Hillsborough bond somewhat given that interest on interest for this bond would theoretically be higher than the Tulsa bond. However, this helps to keep the illustration simple and is a more conservative measure of the comparison. Understanding Amortization It is a common misperception that the loss associated with buying a bond at a premium and having it mature or be called at a lower price is an unequivocal negative. Investors are conditioned to buy low, sell high. It would appear in this case you are buying high, and selling low. However, what is often forgotten is the fact that the investor is earning a higher than market coupon rate from the time of purchase to either call or maturity date (as illustrated above). This higher than market coupon rate, assuming the investor purchased at a higher yield to worst versus a comparable par bond, may more than makes up for the loss associated with a premium purchase. With a tax-exempt municipal bond purchased at a premium to par, the difference between purchase price and par (or call price, if the bond is callable) is amortized each year, or reduced by a specified amount (based on IRS rules) such that upon call or maturity date, the amortized price equals maturity or call value, resulting in no gain or loss. If the bond is sold prior to call or maturity, there may be a reportable gain or loss depending upon how the sale price compares to the then current amortized value.
It should be noted that this may not be the case with bonds other than tax exempt municipal bonds. As is typically the case, amortization of a federally taxable bond held in a taxable account may be a direct write-off to income for the year. It is important for us to state that this and any discussion of amortization or other tax related issues is for general informational purposes only, and should not be taken or misconstrued as tax advice. Please consult your tax professional for all matters related to the taxation of your investments. Premium Bonds in a Rising Interest Rate Environment The term duration is a measure of a bond s price sensitivity (the value of principal) to changes in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. Put simply, if a bond s duration is 4 years, that bond s price will change by approximately 4% for every 1% move up or down in interest rates. Because premium bonds deliver higher cash flows to the investor (in terms of the higher coupon received), a higher percentage of the returns come over a shorter period of time as compared to a lower coupon bond. This results in the premium bond having a lower duration when compared to the lower premium, par, or discount bond (all else being equal). This lower duration potentially results in a bond holding that drops less in price as interest rates rise. Given the current interest rate environment, bond holdings which may drop less in price as interest rates rise may be of particular interest to fixed-income investors, especially if they may also be purchased at a potentially lower price / higher yield vs. par-type bonds. Another possible advantage to owning higher premium bonds comes from a tax quirk with respect to how tax exempt municipal bonds trading at a discount to par value may be taxed. As stated previously, individual tax free municipal bonds purchased at a premium to par value are not taxed at the federal level if held to maturity or call. However, certain tax free municipals purchased at a discount to par value could have part of the difference between purchase price and par value taxed at ordinary income rates. In the case where part of this return is taxed, an investor would have to receive a commensurately higher yield in order to equate the after tax yield on the discount bond with that of a completely tax free premium bond. As interest rates rise and bond prices drop, this tax on discount bonds can become greater and greater, causing that bond s price to drop faster than that of a comparable premium bond. Due to this technical factor with respect to taxes and bond pricing, it may be beneficial in terms of portfolio pricing and returns to focus more on premium bonds with a lesser chance of trading at large discounts to par value. Of course, if bonds are held to final maturity or call date, this issue becomes less relevant. In our view, it is likely more of an issue with regard to short term performance and valuation metrics, or if an investor is forced to liquidate a bond prior to maturity date. Risks Associated With Premium Bonds Because premium bonds most often carry a higher than market coupon/interest rate, they may be more likely to get called. This higher degree of call risk can be detrimental to an investor from the perspective of having to reinvest the called bond s proceeds at potentially lower
interest rates. This is why yield to worst as outlined above is an important concept, as an investor can compare the expected returns to a given call date versus that of par priced bonds. In the rare case of a default, the recovery rate, or the amount of money you receive back from the defaulted entity, is typically constant across a specific class of bond holders. This recovery rate is uniform irrespective of what you paid for the bond. So if the recovery rate for a defaulted bond is 80 cents on the dollar, the investor who paid par (100) for the bond may have a higher overall return (or less negative return, depending) than the investor who paid a higher premium. As stated previously, higher premium bonds may trade cheaper in terms of higher yields due to the somewhat lower retail demand. Buying cheap may also mean selling cheap. While many investors purchase individual bonds with the idea of holding them to final maturity or call date, it is possible circumstances arise which may force an early sale of a bond holding. Higher premium bonds may sell for a lower price than a comparable par-type bond, using the same supply/demand logic as previously mentioned. Additionally, and as with all bonds, there are additional risks which should be considered. These include default (credit) risk, interest rate risk, and market risk. In today s complex fixed-income markets, we strongly believe individual investors may benefit from working with a skilled fixedincome manager. Conclusion Premium bonds may be misunderstood by some individual bond investors. Often times, this may result in lower demand for these securities vis-à-vis bonds trading closer to par value with similar characteristics. This may provide investors with the potential opportunity to find higher returns in terms of yield to worst / yield to maturity. There are other possible benefits as well, with regard to the possibility of lower price volatility in a rising rate environment. As with all securities, certain risks are present and should be explored and understood before making any buy/sell/hold decisions. As always, if you have further questions, comments, or inquiries regarding premium bonds, or any other fixed-income related matters, please speak with a member of our team who can assist you.