How to Get a Bargain By Paying a Premium
Many people object to paying a premium for anything! They feel like they are not getting a “good deal,” or are somehow being taken advantage of by the sale. The opposite is true most of the time in the bond markets. “Premium” bonds are generally good buys. In order to illustrate this fact, I’m going to explain two sets of terms in the bond market… “Par” versus “Premium” bonds, and “Current Yield” versus “Yield to Maturity.”
“Par” Bonds Versus “Premium” Bonds
A “Par Bond” is a bond whose current market price is exactly equal to its maturing value. For instance, a bond with a face value of $1,000 will be redeemed at maturity for $1,000 and it is trading in the market at a price of 100. This means that it is trading at 100% of its face value. We call this 100% price “Par,” and we call this bond a “Par Bond.” A “Premium Bond” refers to a bond that is trading at a price over 100. Let’s say it is at a price of 104 or 106 or even 110. These numbers represent the percentage of the face value that the bond is currently trading for in the market. So in the case of a bond that is trading at, say, 104, we would have to pay $1,040 in order to purchase this $1,000 bond.
“Current Yield” Versus “Yield to Maturity”
“Current yield” (also called “coupon rate” or “cash flow”) is the rate of interest that is printed on the bond certificate. A 6% coupon means you will be paid $60 of interest income a year on a $1,000 bond (face value). Current yield does not reflect your return on investment, since it does not take into consideration the price you paid for the bond, which may be more or less than face value.
“Yield to Maturity” is the TRUE indicator of the return on your investment, since it DOES take into account the price you paid for the bond. Changes in the price will affect the bond’s yield to maturity (or yield to call). An increase in price lowers the yield, while a decrease raises the yield. The return on your investment or the “yield to maturity” (or “yield to call”) is what you can earn on your investment. It is this number that helps you compare bonds in the market, not the coupon rate nor the price.
Yield fluctuates with the interest rate environment. As “the market” interest yield changes, each individual bond adjusts its price so that it has a yield comparable to the market yield for similar types of bonds. When you hear on the news that “rates are going up,” it means the expected return on investment, or your yield to maturity, is going up and the market price of bonds is going down. Similarly when you hear in the news that “rates are going down,” it refers to “yields” are going down or yield to maturity is going down. This is a very important distinction and one that people confuse all the time. “Current Yield” is not the same as “Yield to Maturity” or “Yield to Call.” Current Yield refers to a stream of income; Yield to Maturity (or call) refers to a return on your investment.
Why “Premium” Bonds May Be a Good Bond Investment
O.K., so why do I think that premium bonds are such a good bond investment? Here are a few reasons:
Premium bonds cost more than par. But most premium bonds also provide a higher yield in order to entice investors to overcome their psychological aversion to paying a premium for anything. Since yield is what we can earn on our investment, premium bonds are attractive because they yield more.
A second reason I like premium bonds is that they are higher coupon bonds. We pay a premium price because we get a higher cash flow than with a par bond. A higher cash flow means a greater amount of cash to reinvest and provide the opportunity to earn “interest on interest.” Earning interest on interest can be lucrative over a long period of time! Also, it’s almost always better to get income now rather than later (the old bird in the hand…). This allows investors to use the interest now before the value of the money declines over time through inflation.
A third reason I favor premium bonds is that in a declining interest rate environment, premium bonds provide a higher cash flow than newer issue bonds. In a declining rate environment, premiums move to even higher valuations, presenting the investor with opportunity for capital gains and the potential risk of being “called.” (Note: This call risk may also be an opportunity to improve the bond portfolio’s total return through things like pre-refundings and defeasements and was discussed in another article on managing your bond portfolio.)
A fourth reason is that in a rising interest rate environment, premium bonds hold their value better than par bonds (or discount bonds). Premium bonds’ already existing higher coupons are more comparable to the bonds being issued in a new, higher interest rate environment, and this is what helps them hold their value (as well as the simple mathematics of it!).
So often I hear the objection, “but I lose that premium because I don’t get it back at the end.” No, you have NOT lost that premium. It comes back all along the way in the form of higher interest income.
Par vs. Premium
(both rated Aa3/AA+; actual prices on 3/11/11: for illustrative purposes only)
|Premium Bond||Par Bond|
|Essex County, NJ||Upper Trinity, TX|
|Buy: $100,000 bond @102.936||Buy: $100,000 bond @ 100 (par)|
|Spend $102,936||Spend $100,000|
|6.0% coupon, due in 19 years||4.75% coupon, due in 19 years|
|Cash Flow:||Cash Flow:|
|$100,000 bond||$100,000 bond|
|$6,000 annually||$4,750 annually|
|x19 years to maturity||x19 years to maturity|
|$114,000 lifetime interest||$90,250 lifetime interest|
|-1,029 premimum paid|
|$112,971 net return over life of investment||$90,250 net return over life of investment|
One last note. Say a high coupon bond is bought at a price of 110 and has a 10-year maturity. 7 years pass, and now it is a 3-year bond. It still has a very large premium, all things being equal, because of its high coupon and short maturity. But on its maturity date in three years it must have a price of par (100), because that is the face value of the bond. As the bond moves from three years to maturity, down to its redemption date, that premium is going to erode, slowly, toward par. It must(!) because the bond has to be redeemed at par, the face value. Instead, consider selling the bond at that 3-year point, retaining the remaining amount of premium, and move back out to a longer-term, new premium bond. In this way, you will recapture some or all of the premium (thereby actually raising your yield for your holding period), and have gained the advantages of the higher stream of income all along the way.
Bottom line: Put ice cubes in your veins and make an objective, emotionless choice and buy the bond with the higher yield and don’t be afraid to pay a big premium, assuming the other bond features are attractive and appropriate for you.
(A discount bond is a bond for which you pay less than face value – a price below 100. The difference between the discounted price paid and the maturing value of the bond represents a part of the bond’s yield to maturity, and one will not receive that yield until the bond matures. This type of bond is even less attractive for me than a par bond: there is less opportunity to earn interest on interest; the capital gain at maturity is taxable on municipal bonds, and, because of inflation, a flow of capital today is worth more than a flow of capital later.)