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Income Generation
Premium bonds | Income Generation
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 favour 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.
Glossary
Cash flow — While it appears that the premium bond loses principal, it makes up the loss in extra cash flow. With the same reinvestment rate and purchase yields, the bonds return a similar dollar amount to the investor.
This material is provided for informational or educational purposes only and does not constitute a solicitation of any securities in any jurisdiction in which such solicitation is unlawful or to any person to whom it is unlawful. Moreover, it neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to it by making an offer to enter into an investment agreement.
This material may contain “forward-looking” information that is not purely historical in nature. Such information may include projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, certain historical performance information of other investment vehicles or composite accounts managed by Nuveen may be included in this material and such performance information is presented by way of example only. No representation is made that the performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Nuveen to be reliable, and not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Company name is only for explanatory purposes and does not constitute as investment advice and is subject to change. Any investments named within this material may not necessarily be held in any funds/accounts managed by Nuveen. Reliance upon information in this material is at the sole discretion of the reader. Views of the author may not necessarily reflect the view s of Nuveen as a whole or any part thereof.
Past performance is not a guide to future performance. Investment involves risk, including loss of principal. The value of investments and the income from them can fall as well as rise and is not guaranteed. Changes in the rates of exchange between currencies may cause the value of investments to fluctuate.
This information does not constitute investment research as defined under MiFID.
This material may contain “forward-looking” information that is not purely historical in nature. Such information may include projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, certain historical performance information of other investment vehicles or composite accounts managed by Nuveen may be included in this material and such performance information is presented by way of example only. No representation is made that the performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Nuveen to be reliable, and not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Company name is only for explanatory purposes and does not constitute as investment advice and is subject to change. Any investments named within this material may not necessarily be held in any funds/accounts managed by Nuveen. Reliance upon information in this material is at the sole discretion of the reader. Views of the author may not necessarily reflect the view s of Nuveen as a whole or any part thereof.
Past performance is not a guide to future performance. Investment involves risk, including loss of principal. The value of investments and the income from them can fall as well as rise and is not guaranteed. Changes in the rates of exchange between currencies may cause the value of investments to fluctuate.
This information does not constitute investment research as defined under MiFID.
A word on risk
This report provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any investments or related securities. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Asset Management Research. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes. The report should not be regarded by the recipients as a substitute for the exercise of their own judgment. An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds. There are risks inherent in any investment including the possible loss of principal. Bonds and other fixed-income investments are subject to various risks including, but not limited to interest rate risk or the risk that interest rates will rise, causing bond prices to fall; and credit risk, which is the risk that an issuer will be unable to make interest and principal payments when due.
The value of the portfolio will fluctuate based on the value of the underlying securities. 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 their 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 state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavourable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer.
Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen, LLC
