Bond pricing 101: don’t ignore premium bonds
Everyone loves to save money. It is therefore not surprising that investors find it difficult to understand why it can sometimes be advantageous to buy bonds that are sold at a premium. However, it does, and these distinct advantages should not be overlooked.
A different perspective on bond prices
Some investors may ask, “Why would I buy a premium bond, only to see it depreciate to maturity, when I could buy a discounted bond of similar quality and see it appreciate?” Without a doubt, many investors think that if they pay a premium on a bond, their total return will be lower. This is not necessarily true. Investors who want a more accurate representation of their total return should first consider the yield to maturity (YTM) of the bond, the annual return an investor would earn on the bond if it were held until maturity. ‘at the due date. This figure is based not only on the price of a bond, but also on its expected cash flow.
Comparison of premium and discount bonds
Consider a hypothetical comparison of two 20-year bonds with a face value of $ 100 paying interest semi-annually, one offered at a premium, the other sold at a discount:
While it may seem that the best deal between these bonds is the one that sells at a discount because it costs almost 10% less than the premium bond, investors should also consider that the bond’s coupon payments at a discount are lower, resulting in less net cash flow and a lower total annual return (YTM) for the investor. Net cash flow is the cash flow received from all coupon payments after factoring the premium or discount paid or received for the obligation.
While useful, the YTM isn’t always the last word when evaluating an investor’s total return. Bonds are sometimes callable, with an option giving the issuer the right to redeem the bond at some point before maturity. When a bond is redeemable by the issuing entity, two other performance measures are instructive, in addition to YTM:
- Yield to Call (YTC): the yield on callable bonds, based on the earliest date on which the bond is callable
- Yield to Worst (YTW): simply, the lowest of YTC and the YTM
Comparison of Premium and Premium Callable Bonds
Let’s take a look at another hypothetical example â again considering our 20-year semi-annual premium bond which trades at $ 105 with a 5% coupon. This link is not callable. It will make payments for 20 years and has a YTM of 4.61%. Compare that to a bond that can make payments for 20 years but is redeemable by the issuer – if it is beneficial for them to do so – in five years at $ 102:
Even though the YTM and coupon payments are higher on the callable bond, it can be redeemed by the issuer after only five years, which presents a greater risk, known as reinvestment risk, for the bonds. investors. For this reason, when valuing bonds when one or both are callable, YTC should also be compared to YTM. In this example, our premium non-callable bond may be more attractive because investors are promised longer cash flows.
Four reasons to consider premium bonds
A bond that sells at a premium can offer four advantages:
- Higher regular income payments.
- Higher coupon income can be reinvested at a new, higher rate if rates rise.
- Premium bonds are potentially less sensitive to changes in interest rates than their discounted bond siblings. A higher coupon payment typically reduces the term of a bond, a measure of the bond’s price sensitivity to a change in interest rates.
- For municipal bonds, the potential for protection against tax liability. With municipal bonds, only income is usually exempt from tax. If a bond purchased at a discount appreciates at par or above, the investor will be liable for capital gains tax.
Premium bonds have their advantages
While buying a bond at a discount may at first glance seem more attractive than a bond traded at a premium, premium bonds can have real benefits. These bonds offer higher cash flow to investors, the ability to reinvest higher coupon payments at the going rate (beneficial if interest rates rise), potentially less price sensitivity to changes in interest rates. , and a possible means of protection against potential tax liabilities to buyers of municipal bonds.