Many investors find it difficult to pay a price greater than par for a bond. We often find this hesitation is purely psychological and causes some investors to miss an advantageous structure in a low interest rate environment. This market commentary is written to explain why premium municipal bonds often offer value in today’s market — helping to justify paying above par for a bond.
Premium bonds carry a coupon rate that is higher than current market yields. This causes the price of the bond to trade above the par value ($100) to bring the overall return in line with current rates. The higher coupon of premium bonds creates a number of benefits for the investor.
Reinvestment at higher rates
If rates rise, the higher coupon payment (i.e. cash flow) of premium bonds can be reinvested at the high rates. Take for example two $1,000,000 par amount portfolios. One is invested in premium bonds carrying 5% coupons, the other in par/discount bonds with 3% coupons. The first portfolio generates cash flow of $50,000 per year compared to the second at $30,000 per year. An additional $20,000 in cash flow from the premium bond portfolio is now available to take advantage of rising rates. $50,000 compounded at a 4% yield for 10 years amounts to $74,012 — whereas $30,000 amounts to only $44,407.
Higher coupon bonds are inherently less volatile than lower coupon bonds. Duration is a measure of the sensitivity of the price of a bond to changes in interest rates. The higher the duration, the more volatile a bond’s price changes as rates fluctuate. There are a number of factors affecting the duration calculation. One is a bond’s coupon rate. Because a relatively higher coupon returns cash flow to the bondholder sooner, it is a favorable input in the calculation and lowers the duration (volatility) of the bond.
Dearth of demand
There is a large contingent of the retail investor base that entirely avoids premium bonds. This reduces demand and makes them less expensive for others to buy at relatively higher yields. If you have read this far, hopefully you are no longer part of that crowd.
A defensive opportunity — with one caveat
The benefits of premium municipal bonds described above provide investors with both an opportunity and a defense mechanism in a rising rate environment. One caveat, however, should be noted about premium bonds — often these types of securities carry a short-term call date. Because of the high coupon, the likelihood of a call is often relatively high. Investors must take into account this possibility in the context of the overall portfolio structure — and should be properly compensated in yield return priced to that date.
Please contact us if you have any questions on portfolio strategies for a rising rate environment or would like a portfolio review.
Bernardi Securities, Inc.
October 2, 2014