Many individual investors shy away from bonds that trade at a premium to par value because they don’t see the point in paying, say $11,000 for a bond that returns $10,000 at maturity. Here Fidelity offers a primer on premium bonds, why investors need not fear premium bonds, and how premium bonds can be used to reduce interest rate risk in a fixed-income portfolio. You can read the full post here.
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.
Jeremy Jones, CFA
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