When you buy a traditional bond, you typically receive a series of coupon payments before recouping the face, or par, value at maturity. So why would anyone pay a premium—that is, more than you’d get back at maturity?
Well, for one thing, premium bonds might be your only choice. Nearly two-thirds of the BofA Merrill Lynch US Treasury Index and close to 90% of the BofA Merrill Lynch US Coporate Index are composed of such bonds, demonstrating just how ubiquitous they’ve become.
Be that as it may, paying extra for so-called premium bonds can be a winning proposition for three reasons:
1. Higher cash flows
Premium bonds usually pay a higher coupon rate than par or below-par bonds, which can justify their premium pricing—so long as the bonds’ higher coupons make up for the loss by the time they mature. This strategy generally makes sense for those who prioritize income today over recouping their initial investment tomorrow.
2. Less interest-rate sensitivity
Because they offer higher coupon payments, premium-bond prices are generally more durable—making the bonds more attractive—in the face of rising interest rates, which the Federal Reserve is anticipating for the foreseeable future (See “Saving face,” below.).
Premium-bond prices are generally less sensitive to rising interest rates.
Source: Schwab Center for Financial Research. Hypothetical example assumes bonds with 10 years to maturity, semiannual coupon payments, similar yields to maturity and an immediate change in interest rates after purchase.
3. Higher perceived quality
Pricing is often a reliable barometer of relative risk. For example, when comparing two bonds with similar maturities and other key characteristics, such as coupon rates, you may notice that one is trading at a discount while the other is trading at a premium. This generally means the market perceives the below-par bond as riskier than the premium bond.
And speaking of risks …
As with all investments, premium bonds are far from risk-free. In particular, beware call provisions, which allow an issuer to redeem a bond before its maturity date. In those instances, investors counting on higher coupons for the life of the bond can instead find this income stream abruptly cut off, potentially leading to a negative total return.
Consequently, investors in callable premium bonds would be wise to ignore yield to maturity and instead focus on yield to call or yield to worst. Both reflect the risk of your bond being called before you can enjoy its full benefits.
What you can do next
- Need help with your bond investments? Call 877-566-7982 to speak with a Schwab fixed income specialist.