Let’s compare two hypothetical 5-year bonds, both purchased at a 3% yield. One is a par bond with a 3% coupon and the other is a premium bond with a 5% coupon. We’ll invest $1 million in each bond and assume a 3% reinvestment rate (with annual coupon payments and annual compounding for simplification purposes). Is there a difference in total return?
The par bond Coupon: 3% price: $100
At maturity, the investor receives the $1 million par value. In addition, the investor has received $150,000 in coupon payments ($30,000 in each of the 5 years). Those payments were reinvested at 3% to produce $9,270 in interest (using a bond calculator). The total interest and principal received equals $1,159,270.
The premium bond Coupon: 5% price: $109.16
Here we purchase a 5-year premium bond with a 5% coupon. At a 3% yield, this bond will be priced at $109.159 (using a bond calculator). The face amount will total $916,091 at maturity ($1,000,000/1.09159 = $916,091). This drop from $1,000,000 to $916,091 makes it seem that the investor is losing principal. However, the investor also receives $45,805 annually in coupon payments plus compounded interest (using a bond calculator) all totaling $243,183. Adding $243,183 to $916,091 equals $1,159,274, approximately the same as the par bond.
Many retail investors purchase par bonds because they understand that when their bonds mature, they will have collected their interest and their initial investment will be returned.
Retail investors are wary of premium bonds — bonds priced above par — because they believe the premium is lost when the bonds mature at par. This sentiment is heightened in a rising interest rate environment when investors see their premium erode as interest rates rise. In contrast, many institutional bond managers prefer to own premium bonds in a rising interest rate environment. Why?
Why purchase premium bonds?
Our example shows that both bonds give a similar return assuming similar purchase yields and reinvestment rates. If that is the case, why do institutional managers favor premium bonds in a rising interest rate environment?
They return cash flow faster. Higher coupon rates – the interest rate stated on a bond when it’s issued – mean investors in premium bonds receive higher interest payments, thus cash flow is returned faster than par bonds. Our example showed similar returns if interest rates remain unchanged. However, if interest rates rise, this increased cash flow from premium bonds can be reinvested at the new higher rates. In fact, the higher interest rates go, the bigger advantage the premium bond has over the par bond. This higher cash flow makes the bonds more attractive to investors and helps keep the premium bond’s price from falling as rapidly as a par bond.
They are less sensitive to interest rate changes.All bond prices fall when rates rise. However, as we noted, since premium bonds return cash flow faster, they are more attractive to investors and their prices change more slowly as interest rates change. The longer an investor holds premium bonds, the longer the interest can compound, making it a more important part of the total return.
They can avoid the market discount tax.The government imposes an increased tax rate on gains from the sale of bonds purchased at a significant discount from the issuance price. The amount of discount that leads to this treatment, according to the tax code, is determined by multiplying .25 times the remaining years to maturity.
The additional tax is imposed on the next buyer of the bond, not the current holder, but this tax negatively impacts the market value of the bond – whether the holder intends to sell the bond or not. By definition, premium bonds are farther away from this market discount price, helping these bonds hold value
They can be less expensive. The additional cash flow benefits of premium bonds should cause these bonds to be more expensive than similar maturity par bonds. But retail investors’ preference for par structures often makes premium bonds less expensive than other bonds.