Why Pay More for Premium Bonds
Understanding the value that premium bonds can offer investors.
By Don Burrows
Senior Vice President
Hilltop Securities Inc.
Municipal bonds can play a key role in a well-diversified portfolio, help strengthen investor’s overall investment strategy, and fund future or current income needs. Market rates are one factor investors might use to evaluate which investment is right for them. In the current low rate environment, purchasing premium bonds in particular can be a good way to mitigate risk while earning a higher coupon on a consistent basis.
What is a Premium Bond?
A premium bond is a type of security that trades in the secondary market for more than its par value (the principle amount paid back at maturity). The higher pricing often occurs in a falling interest rate environment since bond yields and bond prices have an inverse relationship. When interest rates decrease and bond prices increase, the coupon rates for premium bonds are higher than those of newly issued bonds, making them more attractive to investors
Investing in Premium Bonds
Investors sometimes avoid premium bonds, believing it would be a mistake to purchase the bonds at a higher price than the payment they’ll receive on the maturity date. However, premium bonds can add value to an investor’s strategy, depending on their investment goals, risk profile, and time horizon. Some of the benefits premium bonds can offer include:
Greater Cash Flow. Premium bonds typically have higher coupon rates compared to bonds selling at par or at a discount. While investors initially purchase premium bonds at a higher price than their par value, they receive higher coupon payments throughout the bond’s lifetime. This strategy can make sense for investors looking for a consistent, higher source of cash flow before recouping the principal at the bond’s maturity date.
Better Price Stability and Liquidity. Compared to similarly structured bonds sold at par value or at a discount, premium bonds tend to be less sensitive to rising interest rates. While the price of bonds decrease when interest rates rise, premium bonds tend to do so at a slower pace because their higher interest payments result in shorter durations compared to discount bonds. Additionally, premium bonds are more liquid in a falling rate environment since investors are willing to pay more to purchase a bond with an above-market coupon rate.
Tax Strategies. The discount earned through discount bonds—securities purchased for less than par or face value—are sometimes subject to income tax or capital gains tax. This can reduce the value or the net after-tax yield of the bond compared to premium bonds. Investors should consult their investment or tax advisor to help identify the best investment choice for their tax status.
Comparing Cash Flows: Premium vs. at Par Bonds
Premium bonds can appeal to investors because the interest they earn and net cash flow can be greater than a bond purchased at or below par value. To illustrate how premium bonds may provide more overall income, the example below compares the net cash flow of two hypothetical, non-callable $5,000 bonds maturing in 10 years with semi-annual coupon payments–one traded at a premium and the other at par.1
|Yield to Maturity||3%||3%|
|Price||$117.06 per unit/ $5,853.02||$100.00 per unit/ $5,000|
|Principal at Maturity||$5000.00||$5000.00|
|Coupon Payment (based on 20 semi-annual payments)||$2500.00||$1500.00|
|Net Cash Flow||$1,646.98||$1500.00|
As with all other fixed-income investments, premium bonds are not completely risk-free.2 In general, investors need to hold the bonds to maturity to realize their advantages. If a premium bond is callable and the issuer redeems it prior to maturity, investors may not be able to enjoy the full benefits of the bond’s high coupon rate. Additionally, investors may have trouble replacing the bond with a similar investment that provides the same amount of income and principal.
Finding the Right Product for You
Investing in premium bonds can be advantageous for investors looking for higher interest payments on a consistent basis. However, investors should consult a financial professional to determine whether premium bonds align with their risk tolerance and tax status.
To find out if premium bonds are right for your investment strategy, find a HilltopSecurities' financial professional near you or call 214.953.4000.
Hilltop Securities, Inc. (HTS) is a registered broker-dealer, registered investment adviser and municipal advisor firm that does not provide tax or legal advice. This information is intended for educational and informational purposes only and does not constitute legal or investment advice, nor is it an offer or a solicitation of an offer to buy or sell any investment or other specific product or service. HTS is a wholly owned subsidiary of Hilltop Holdings, Inc. (NYSE: HTH) located at 1201 Elm Street, Suite 3500, Dallas, Texas 75270, (214) 859-1800. Member: NYSE/FINRA/SIPC.
1 Hypothetical example for illustrative purposes only and is not intended to represent the past or future performance of any specific investment and should not be considered an individualized recommendation or personalized investment advice.
2 Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications, and other factors. The value of bonds fluctuates with changes in market conditions. When sold, bonds and bond shares may be worth more or less than their original cost. As interest rates rise, bond prices typically fall, which can adversely affect a bond’s performance. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics, including duration. Call risks: Declining interest rates may accelerate the redemption of a callable bond, causing an investor’s principal to be returned sooner than expected.