3 Things to Consider When Buying Premium Bonds

By: The Financial Lexicon

(July 2012) In this era of ultra-low interest rates, it has become harder to find higher quality bonds trading at discounts to par.  This is to be expected.  After all, as interest rates decline, bond prices rise.  With Treasury and corporate bond yields at or near record lows, prices on many of the highest quality bonds, even newly issued ones, are trading above par.  If the era of ultra-low interest rates is to continue for quite some time, then an abundance of premium bonds (bonds trading over par) will also be commonplace in the bond market as time goes on.  If it hasn’t happened already, you may eventually find yourself gravitating toward premium bonds as an option for your individual bond portfolio.

 

For those investors becoming more interested in purchasing bonds trading at a premium to par, the following information may be of use.

1. Keep in mind that even though you are paying a premium to the bond’s face value in order to acquire it, the coupon on the bond will be higher than the yield-to-maturity.  For example, if you are paying a premium to acquire a bond and the yield-to-maturity is 4%, the coupon on that bond might be 5%.  Therefore, despite yields in the market of around 4%, you will be paid a 5% coupon from the bond.  The additional 1% you are paid over the going rate in the market will, over time, offset the premium you paid on the bond.

2.  Pay attention to call provisions.  A callable bond can be redeemed before maturity.  If you are paying a premium for a bond that can be called at a specific price (100, 102.50, 103.25, etc.), you should pay close attention to the yield-to-call in addition to the yield-to-maturity.

A make whole call is another type of call provision to be aware of.  The make whole call is typically an expensive option for the issuer, as it requires the issuer to make you whole for the future coupon payments that will not be made as a result of the bond being called early.  Although a yield-to-call is not advertised when buying a premium bond with a make whole call, as a general rule of thumb, keep in mind that the higher the premium you are paying, the greater the risk that you will be disappointed should the make whole call be exercised.

Premium bonds that are non-callable are the most straightforward in terms of calculating the yield you can expect from your purchase.  This is because these bonds cannot be called early by the issuer.  Therefore, whether you are buying a bond at 101 or at 150, the yield-to-maturity is the yield you can expect assuming you hold the bond to maturity and there is no default.

3.  Should you decide to purchase a bond trading at a premium to par, you may find IRS Publication 550:  Investment Income and Expenses helpful come tax time.  Specifically, take a look at the section called “Bond Premium Amortization.” This section will help you work through your responsibilities from a tax perspective with regard to the premium you paid for a bond.

Just because it is becoming more difficult to find bonds trading at a discount to par doesn’t mean you can’t find bonds worth buying.  Remember that in the era of ultra-low interest rates, bonds trading at discounts to par might be doing so because the issuer is not healthy or because the coupons are incredibly low.  If you want access to the highest quality issuers and higher coupon payments, premium bonds are something you will have to consider for the foreseeable future.

 

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