Premium Bonds: What’s the Attraction?
- With so many bonds trading above their par value, investors may be wondering why they would want to pay more for a bond than they’ll get back at maturity.
- However, avoiding premium bonds means cutting yourself off from most of the broader bond market.
- Premium bonds also tend to offer higher coupons and less interest rate sensitivity than bonds bought at par or a discount.
Why would anyone pay more than the face value for a bond? Some investors may be wondering now that more than 80% of the bonds on the BofA Merrill Lynch U.S. Broad Market Index are trading above their face value, or par value.
After all, when you buy a traditional bond, you can generally expect to receive a series of coupon payments and then the bond's par value at maturity (barring a default, of course). Paying more up front than you can expect to receive at maturity seems like it would be a losing proposition.
But there are good reasons to consider such bonds, known as premium bonds. First of all, as noted above, it may be hard to find bonds that aren't trading at a premium—and by avoiding such bonds, you're cutting yourself off from a big chunk of the bond market. Premium bonds also generally offer investors higher interest payments and lower interest rate sensitivity than bonds purchased at or below par. Let’s take a closer look.
Bonds are generally issued with a $1,000 par value. While the par value is generally fixed—it's the amount an investor receives at maturity—the bond's price can fluctuate in the secondary market in response to changing interest rates or credit quality. When a bond’s price rises above the $1,000 par, it’s trading at a premium. When the price falls below the $1,000 par, it’s trading at a discount.
Comparing premium bonds to par and discount bonds
Source: Schwab Center for Financial Research. For illustrative purposes only.
At first glance, a discount bond might seem like a better deal than a premium bond. Barring default, a discount bond will mature at a higher price than investors initially paid. In contrast, a premium bond will mature for less than its purchase price.
However, there are three reasons we think premium bonds may make sense today:
It’s hard to ignore premium bonds. Low global interest rates have generally helped push bond prices higher, as yield-hungry investors have gone looking for returns. As mentioned above, that has left a large part of the broad bond market trading at a premium.
As the charts below show, ignoring premium bonds would severely limit bond investors’ options.
Premium bonds dominate the market
Source: BofA Merrill Lynch and Bloomberg, as of 11/9/2016.
But premium bonds’ relative ubiquity isn’t the only reason to consider them. There are also some positive reasons.
Higher cash flows. The chief attraction of premium bonds is that they generally offer higher coupons than the prevailing market interest rate. That’s actually one of the reasons such bonds trade at a premium in the first place: Investors are willing to pay more for an existing bond that delivers more cash flows than a new bond paying a lower rate.
But is it worth it to pay a premium for larger cash flows today if you know that you'll get less than what you paid back at maturity? Think of it this way: You actually recover your premium over time as part of the interest payments instead of having to wait for the bond to mature.
The hypothetical example below illustrates how the additional cash flow from a higher-coupon premium bond can add up over time, generating larger returns than a lower-coupon par bond. The hypothetical premium bond costs $22 more to invest in, but at maturity it has generated a higher net cash flow, making up the difference over the life of the bond.
Annual cash flow is higher from a higher-coupon, premium priced bond
Source: Schwab Center for Financial Research. Illustration assumes bonds with 10 years to maturity, no reinvestment of coupons and no compounding. The cash-flows shown in the chart are calculated based on the market price of a bond with a 5% coupon and 10 years until maturity purchased at a $22 premium at year 0, resulting in a negative $22 cash flow relative to a bond with a 2.5% coupon and 10 years to maturity purchased at par. Years 1 to 10 show the cumulative difference in cash flows from the higher 5% coupon versus the 2% coupon over time. For illustrative purposes only.
Premium bond prices tend to be less sensitive to interest rate changes. When interest rates rise, bond prices fall, and vice versa. The magnitude of the change in a bond’s price depends partly on how much of the bond’s total return remains to be distributed in the future.
This measure is known as the bond’s duration. A bond that delivers more of its total return today through higher coupon payments will have a lower duration, while a bond whose returns will mostly come in the future will have a higher duration.1 Because investors must wait longer to recoup their investment in a high-duration bond, the prices of such bonds tend to be more sensitive to interest rate changes. (After all, an existing bond may look less attractive if new bonds offer higher coupons after rates rise.) In contrast, lower-duration bonds tend to be less sensitive. All things considered, when interest rates rise, prices of high-duration bonds tend to fall more than those of low-duration bonds.
As noted above, premium bonds tend to trade at a premium because they provide larger cash flows than bonds trading at par. Those larger cash flows can lower premium bonds’ duration, which means their prices will likely be more stable when rates change.
This is important because high bond prices have pushed yields to historically low levels (bond prices and yields move in opposite directions). That means there’s more room for yields to rise than to fall. In such conditions, owning premium bonds could actually make your bond portfolio less volatile should interest rates rise than if you mostly bought bonds at par or a discount.
Premium bonds are less sensitive to changing interest rates
Source: Schwab Center for Financial Research. Illustration assumes bonds with 10 years to maturity, semiannual payment, similar yields-to-maturities and an immediate change in interest rates after purchase. For illustrative purposes only.
Discount bonds may be cheaper for a reason. If you’re looking at two bonds with comparable maturities and one of them trades at a premium while the other trades a discount, you may want tread carefully, especially if you’re looking in the corporate market. That discount could mean that traders see the bond as risky. If you’re considering a corporate bond at a discount, make sure you understand why the price is lower than other bonds with comparable characteristics.
Premium bonds do have risks, just like par or discount bonds
There are still risks with premium bonds, of course. While they may be less sensitive to rising interest rates than discount bonds, premium bonds are still susceptible to price declines when yields rise.
Also, always look out for any call provisions. These allow the issuer to redeem the bond prior to its stated maturity date at a stated price. This can be a disadvantage for bonds priced above par. Rather than having the remainder of a premium bond's life to collect its higher coupons, and thus compensate for the higher price paid for the bond, an investor facing a call will see this income stream abruptly cut off. That lowers the return on the bond, and in some cases it can actually lead to a negative total return. For premium bonds that are callable, take a look at the yield-to-call or yield-to-worst, rather than the yield-to-maturity, and always make sure that the yield offered is positive.
What to do now
Don't be afraid of premium bonds. While they may look unappealing relative to bonds priced at or below par, there are some benefits—particularly the potential for higher coupon payments and lower interest-rate sensitivity. With more room for yields to rise than fall, that’s an attractive advantage today.
1 For an individual bond or bond portfolio, duration is a calculation used to estimate how a change in the interest rate will affect the bond price. The calculation usually assumes a 100 basis point change in the interest rate. For example, if a bond has a duration of eight, it's expected to go up or down 8% in price if the yield to maturity for the bond moves 1%.
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