When a bond sells at a premium, its purchase price is higher than its face value. This often occurs when the bond's coupon rate is more than current market interest rates. While a premium-priced bond may attract investors seeking a greater yield, it's not necessarily a good investment for everyone.
You can't evaluate the quality of a bond investment solely by its price compared with its par value. Many other factors come into play, such as expected changes in interest rates and the issuer's creditworthiness. Moreover, it's crucial to consider that bonds selling at a premium often have lower yields to maturity than their coupon rates, which could influence your long-term investment goals.
Key Takeaways
- Premium bonds are priced higher than face value because of higher coupon rates or favorable market conditions.
- They offer advantages such as a higher income stream and potential tax benefits, particularly for municipal bonds.
- Premium bonds can serve as a hedge against economic downturns and for diversifying an investment portfolio
- Premium bonds are sensitive to interest rate changes.
- Investing in premium bonds requires careful analysis to ensure that the benefits outweigh the higher initial cost and that they align with your financial goals.
Differences Between Premium and Discount Bonds
Bonds have a par or face value, generally the amount investors pay the issuer to buy the bond. Bonds pay interest for a set period. Once that time ends, the bond matures, and the issuer returns the face value of the bond to the investor.
Before a bond matures, investors can buy and sell the bond on the open market. The market value of a bond can vary from its face value. When a bond's value exceeds its face value, it sells at a premium. Conversely, the bond sells at a discount when the market value is less than the par value.
For example, a bond with a par value of $1,000 is selling at a premium when it can be bought for more than $1,000. Alternatively, a bond selling for less than $1,000 is discounted. A bond could also be discounted because its coupon rate is lower than the current market interest rates. Like most fixed-income securities, bond values are associated with interest rates. When interest rates increase, a bond's market price will fall and vice versa.
Let's look at an example. Suppose the market interest rate is 3%, and you just purchased a bond that pays a 5% coupon with a face value of $1,000. If interest rates decrease by 1% after your purchase, you can sell the bond for a profit (or a premium). This is because the bond is paying more than the market rate. The spread was 2% (5% - 3%), but it's now increased to 3% (5% - 2%). This is a simplified way of looking at a bond's price since many other factors can be involved, but it does show the general relationship between bonds and interest rates.
Advantages of Paying a Premium Price
At first glance, paying a premium contradicts the usual investment objective of buying low. Nevertheless, investing in premium bonds presents unique advantages, including greater interest income, price stability, and capital preservation.
More Interest Income
The primary lure of premium bonds is their above-market coupon rates. For investors looking for consistent cash flow, these bonds can offer more generous interest payments than bonds sold at par or at a discount. For instance, consider two bonds with a par value of $1,000. The first bond offers a 3% interest rate, while the second offers a 5% interest rate. Naturally, the higher coupon rate bond will command a premium in the marketplace.
For those focused on generating a consistent cash flow from their bond investments, purchasing premium bonds often delivers higher interest payments, providing a more robust income stream. However, there's a trade-off. When the bond matures, you'll receive back the face value, which will be less than the premium price you initially paid. Essentially, you are sacrificing some principal to earn higher interest income over the bond's life.
Better Price Stability
Premium bonds often have more price stability than other bond categories, making them more appealing to risk-averse investors. While interest rates are a significant component of bond prices, they are not the only factor. The time to maturity plays a role, with the bond’s market price converging with its face value as the maturity date nears.
Premium bonds deliver more of their total cash flows through higher coupon payments before the bond reaches maturity. This typically serves to dampen price fluctuations in response to changes in the market interest rates. This gives them an advantage for investors looking to preserve their capital while earning investment income.
Higher Coupon Rates
A bond's coupon rate is the annual interest income an investor will receive, given as a percentage of the bond's face value. Premium bonds typically trade at a premium because of their higher coupon rates. Investors focused on increasing their income generally prefer these bonds.
In essence, a higher coupon rate translates to more income for the bondholder. Therefore, investors who prefer regular interest payments often gravitate towards premium bonds despite their higher upfront costs.
May Be Undervalued
Some investors avoid premium bonds because they feel they are overpaying for the bond and would rather not pay over the face value. Sometimes, however, these premium bonds may be undervalued.
Premium bonds also often offer a more attractive yield to maturity than bonds with similar credit risk and maturity. This suggests that investors opting for premium bonds could achieve better long-term returns, thus potentially offsetting the initial premium cost.
Role of Bonds in a Portfolio
Bonds can help stabilize an investment portfolio, helping reduce risk, generate income, and further diversify your assets. Whether you’re an individual investor or managing a retirement fund, including bonds can provide a counterweight to more volatile assets.
Capital Preservation
A common reason to invest in bonds is to preserve capital. While all investments come with risk, it’s generally lower when buying a bond. Bond prices are usually less volatile, and the fixed income from interest payments is a predictable cash flow. Like a version of the story of the turtle and the hare, bonds keep their pace slow and steady even as stocks occasionally get eaten by bears, with the losing about half its value between 2000 and 2002 and then again in 2007-2009, with a full third gone in the first month of the pandemic.
Income Generation
Bonds produce regular cash flows as interest payments. This consistent income is often a primary objective for many investors, especially those nearing, or in retirement. Unlike dividends from stocks, which can be cut or suspended depending on a company’s financial situation, interest payments from bonds are contractually required and are generally unaffected by market conditions. Bonds thus make up an effective component for those looking for a steady income stream from their investment portfolios.
Diversification
Putting all your eggs in one basket can be risky, which is why diversification is a fundamental part of prudent investing. Bonds offer a unique advantage in a diversified portfolio because they often have a low or negative correlation with stocks.
This means that when stock markets are volatile, the stable income and lower volatility of bonds can act as a counterbalance, helping to preserve your overall portfolio. Moreover, you can even diversify with bonds of different types—government, municipal, and corporate—each with its own risk and return profile, offering further diversification opportunities.
Hedge Against Economic Downturns
Bonds can help shield your overall portfolio when the markets face economic storms. While stocks can drop by as much as 50% or more during a bear market, bonds could rise as central banks choose to lower interest rates to encourage spending.
Additional Benefits to Purchasing Premium Bonds Issued by Municipalities
Investors can diversify their portfolios by acquiring bonds from various issuers, such as governments, banks, and corporations. However, municipal bonds floated by local governments offer distinct benefits.
Chief among these is their favorable tax status. Unlike most other bonds, income generated from municipal bonds is generally exempt from federal, state, and even local taxes—though it’s always advisable to consult the relevant laws to verify any individual bond’s tax-exempt status. Premium municipal bonds amplify this advantage. Not only do you often earn a higher coupon rate, but you may also not have to pay income taxes on those interest payments.
Are There Drawbacks to Investing in Premium Bonds?
Yes, there are some reasons to avoid premium bonds. One is that they are more expensive, so you'll need more cash to invest in them. Also, though many offer higher yields to maturity, some offer lower yields to maturity than market-rate bonds, so you need to consider each investment carefully.
What Impacts Bond Prices?
Market interest rates play a significant role in influencing bond prices. When they rise, the value of existing bonds generally falls, as newer bonds offer higher yields. Other factors include the time to maturity, the issuer's credit risk, changes in government policies, and the rate of inflation, which erodes the purchasing power of a bond’s fixed interest payments and lowers its value when inflation climbs.
How are Bond Premiums Treated for Tax Purposes?
The tax implications for bonds can vary significantly depending on the type of bond and where you live. Treasury bonds, for example, are subject to federal taxes but are generally exempt from state and local taxes. Municipal bonds are often exempt from federal income taxes and sometimes from state and local taxes, while corporate bonds are taxable at the federal and state levels. If you sell a bond at a higher price than you paid, you could be subject to capital gains tax on the profit. Lastly, for premium bonds, you may be able to amortize the premium, which means gradually writing off the extra cost over the bond’s life.
Is It Better to Invest in Premium or Discount Bonds?
Premium anddiscount bondscan have different roles in your portfolio, so neither is right for every investor. Discount bonds may be a better choice if you're hoping to produce capital gains in the long term when you receive the return of principal at maturity. Premium bonds generally offer higher coupon rates, which could provide a more stable income stream. However, you typically pay more upfront, which might result in a lower yield to maturity than the coupon rate. Still, they are often less sensitive to interest rate fluctuations, offering some price stability, while discount bonds can be more volatile. In sum, the better investment depends on your priorities: income, capital gains, or stability.
The Bottom Line
Bonds selling at a premium cost more than their face value. They typically provide higher coupon rates, attracting investors seeking higher income streams. Premium bonds may also offer price stability and unique tax benefits, particularly in the case of municipal bonds. However, it's essential to weigh these advantages against the initial cost and consider interest rates, market volatility, and personal financial goals when making investment decisions.
