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Why is there such a difference between retail investors’ preference for lower coupon bonds and institutional investors’ preference for higher coupons, as observed in the accompanying quotation from the MSRB’s study?
Bonds with lower coupons will trade with lower dollar prices — in many cases at prices at or near $100 (i.e., the par value that will be paid at maturity). By contrast, bonds with higher coupons also have higher prices, requiring buyers to pay a premium in excess of par value. Many retail investors prefer to purchase par bonds because they like knowing that, when their bonds mature, they will receive the full amount of their initial investment and will not have inadvertently spent more than they earned.
Institutional investors, on the other hand, like the lower price volatility of premium bonds, especially when those bonds can be redeemed by the issuer prior to maturity. And they favor bonds that are less likely to suffer negative tax treatment should their price fall significantly below par. To better understand these considerations, it helps to review how par and premium bonds work.
“Retail investors tend to purchase municipal bonds with lower coupons than institutional investors,” reported the Municipal Securities Rulemaking Board. “Customers buying 100 bonds or less were significantly more likely to buy bonds with a coupon rate of 3.0% to 3.5%, while customers purchasing $1 million or more were more likely to buy bonds with a 5% coupon.”
Premium vs. par bonds – what’s the difference?
Consider two hypothetical 5-year bonds, both purchased at a 1% yield. One is a par bond with a 1% coupon, and the other is a premium bond with a 3% coupon. We invest $1 million in each bond and assume a 1% reinvestment rate. The comparison demonstrates that if two bonds have the same maturity and the same yield, their total return will be the same as long as all cash flows are reinvested at the original yield.
Why purchase premium bonds?
Most bonds are premium bonds
As a result of the decline in interest rates during the last decade, and the preference of institutional investors for premium bonds, only a small segment of the municipal market consists of bonds priced at par or less. At the end of January 2020 only 10.3% of the bonds in the Standard & Poor’s Municipal Bonds Index had coupon rates of less than 4% but more than 0%. Furthermore, 69.2% of the bonds had coupon rates of 5% or more.
Given that 30-year general obligation bonds rated triple-A were then yielding 1.80%, and all shorter maturities were yielding less (according to the scale by Refinitiv), the municipal market is clearly dominated by premium bonds.
Premium bonds are less volatile
The longer it takes for an investor to receive the cash flows due on a fixed income investment, the more the value of that security will change in response to changing interest rates. Higher coupons deliver more of the return sooner. One measure of the price volatility of a bond is its modified duration. The par bond in our example would have a modified duration of 4.87 years, while the duration of the premium bond would be 4.67 years.
Optional redemption provisions, found in most municipal bond deals, can greatly reduce the price volatility of bonds. It is most common for municipal bonds to be redeemable at par at the option of the issuer starting 10 years after the bond was issued. A premium bond that can be redeemed early at a price of par will be priced to the redemption date rather than to maturity.
For example, a bond with a 3% coupon, yielding 2.00%, due in 20 years would have a price of $116.417 and a duration of 15.44 years. If that same bond were priced to a call date in 10 years, its price would be $109.023, and its duration would be just 8.69 years. Pricing to the call date limits the upside potential of the bond if interest rates fall, but it also means less of a drop in price if rates rise.
A bond that is priced to a call date today would be priced to maturity in the future if interest rates rise to the point where they exceed the coupon rate. For this reason, bond valuation takes into consideration the potential that a callable bond may someday be priced to maturity, which is known as “extension risk.” A bond with a low coupon naturally has a greater likelihood that its coupon rate will be below future interest rates, and hence it has greater extension risk.
We saw that a 3.00% bond due in 20 years, but priced to yield 2.00% to a 10-year call date, would have a price of $109.023 and a duration of 8.69 years. A 5.00% bond likewise due in 20 years, and priced to yield 2.00% to a 10-year call date, would have a price of $127.068 and a duration of 8.17 years. If interest rates were to rise to 3.50%, the 3.00% bond would be priced to its maturity date in 20 years, while the 5.00% bond would still be priced to the 10-year call date. Here is how the prices would change.
By continuing to be priced to a 10-year call date, and with a starting duration to the call date that was already shorter than that of the 3.00% bond, the 5.00% bond would lose less value than the 3.00% bond in this rising rate scenario.
Premium bonds may avoid negative tax consequences
If you buy an outstanding bond in the secondary market at a price of less than par, and hold it until it matures at the principal value of $100, the increase in the value of the bond would generate a tax liability. The amount of the tax varies depending on how much of a discount was inherent in the price you paid for the bond. If the amount of the discount was less than 0.25% for every full year until maturity, the appreciation (or accretion) would be treated as a capital gain, but if the discount was deeper than 0.25% per year, the appreciation would be taxed as ordinary income.
For two bonds with the same yield and maturity, and priced at a discount, the one with the higher coupon rate will have the smaller discount. For example, if interest rates were to rise to 3.25%, a 3% bond due in five years would have a price of $98.855, which means that its accretion would be taxed as a capital gain. However, the 1% bond would have a price of $89.693, which would result in its accretion being taxed as ordinary income. A prospective buyer would demand a higher yield to compensate for the higher tax, which means a lower price for the seller.
How does coupon rate affect pricing?
Bonds with lower coupons typically provide somewhat higher yields than bonds with higher coupons. This is because of their greater extension risk, longer duration and the greater likelihood that they may someday become discount bonds whose accreted market discount would be taxed as ordinary income. For example, the difference between the yield of a high grade bond due in 16 years and one due in 15 years is currently around 0.04%. However, on a recent bond offering, a 16-year bond with a 4% coupon was yielding 0.27% more than a 15-year bond with a 5% coupon.
Preserving principal while the premium shrinks
Many investors are discouraged from purchasing premium bonds because of the idea that the value of their investment will decrease as the price of the bond declines from its premium purchase price to par. They realize they need to reinvest part of the coupon payment if they want to maintain the principal value of their portfolio.
The amount that they need to reinvest every six months will be equal to the amount of premium that would be amortized during the first semiannual payment period. This amount is determined by multiplying the semiannual yield at which the bond was purchased by the purchase price, and subtracting that product from the semiannual coupon payment.
In our example of a 3% bond yielding 1% and due in 5 years, the semiannual coupon per $100 par value would be $1.50, and the yield in dollars would be $0.55 ($109.73 x 0.005 = $0.55). The amount amortized of $0.95 would be subtracted from the purchase price to produce the ending book value of $108.78.
In the next payment period, the new book value would be multiplied by the purchase yield to determine the amortization.
Federal tax rules require that holders of tax-exempt municipal bonds amortize the premium of their bonds so that they do not recognize as a capital loss the amount by which the premium declines in value as a function of time. Thus, the gain or loss would be based on the difference between the sale price and the book value at the time of sale (or “adjusted purchase price”). For more information on the tax treatment of tax-exempt bonds, investors may want to obtain Publication 550 from the Internal Revenue Service.
An investor can preserve the original principal amount of the investment by reinvesting a portion of the coupon income equal to the amount by which the premium is amortized during the first semiannual payment period. If the reinvested coupon income earns the yield of the bond, the compounded value of the reinvested coupons at the maturity date will equal the original premium. In our example, the investor would reinvest $0.95 of the $1.50 coupon payment received every six months, as illustrated in the column labeled “Compounded Reinvested Coupon” in the amortization schedule above.
Different Buying Patterns of Retail and Institutional Investors in Municipal Bonds
Municipal Securities Rulemaking Board
Publication 550, Investment Income and Expenses
Internal Revenue Service
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Cash flow is the payment of principal and interest received by the investor over the lifetime of the investment. The greater cash flow received from the premium bond compensates for the higher dollar price paid for the bond and the loss of value as the bond will eventually be worth par at maturity or call date.
S&P Municipal Bond Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.
A word on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.
This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager
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