Understanding Premium Bonds

Dan Skolochenko

August 14, 2018

As a long-term investor, you may choose to include fixed income in your investment portfolio for a variety of reasons, such as capital preservation, income generation, or a combination of both.

As a long-term investor, you may choose to include fixed income in your investment portfolio for a variety of reasons, such as capital preservation, income generation, or a combination of both. Depending on your financial circumstances, tax bracket, and whether you are purchasing bonds in a taxable or qualified account, you have the option of taxable bonds (Treasury bonds, agency bonds, and corporate bonds) or Municipal bonds, which are typically tax-free bonds issued by state and local governments.

A municipal bond will cost me how much?

If you are a fixed income investor, you may have noticed that taxable bonds tend to be priced near par ($100), while most tax-exempt bonds are typically priced much higher, often at prices greater than $110.  The price above par is known as a “premium” and occurs when a bond pays a coupon rate that exceeds prevailing market interest rates.  Every so often, I receive a question from an investor concerned over the price paid for a municipal bond. Investors are sometimes surprised by the high price levels of Municipal bonds, especially given that market interest rates are very low on a historical basis.  Clients may fear that in paying a large upfront premium (for example, $115) and then only receiving par ($100) when the bond matures, they are locking in a guaranteed loss.

Viewing a bond investment this way is a common misconception because in doing so, the coupon income is being ignored. The income stream earned by the investor over the life of the bond is a significant component of total return. A more accurate assessment of a bond’s attractiveness would consider all income received, in addition to the price paid and the principal recovered. The yield-to-maturity calculation does exactly this.

What is yield-to-maturity, and how does it compare to a bond’s coupon?

When investing in fixed income, it is important to understand the difference between a bond’s coupon and its yield-to-maturity (YTM).  Coupon is expressed as a percentage of par, and refers to the fixed, periodic interest payments made by issuers to investors over the course of a bond’s life. 

Yield-to-maturity is the prevailing interest rate determined by markets, and represents what investors earn on their bond investment.  The YTM calculation takes into consideration the initial price, including any premium paid for a bond, along with all future coupon payments.  It measures the investor’s annual rate of return over the life of a bond held to maturity.

When the coupon paid by a bond exceeds market interest rates, that bond is valued at a price above par. The higher the coupon a bond pays, the higher its market price.  So the premium price on a bond is caused by its above-market coupon rate. Investors may think of the premium as “buying” a higher-than-market level of coupon income. The amortization of the bond’s price down towards par over the life of the bond is offset by the high coupon income. 

Why are municipal bonds typically issued at such high premiums? 

At this point, you may be wondering why new municipal bonds aren’t brought to market with lower coupon payments, thus lowering prices. There is a good reason why most bond deals continue to carry four or five percent coupons that result in steep premiums. Purchasing municipal bonds at a discount can trigger tax consequences for investors.

Tax rules discourage buying discount Municipal bonds

Discount bonds are the opposite of premium bonds, meaning they carry a coupon lower than the prevailing interest rate and can therefore be purchased at a price below par value.  While interest income on Municipal bonds is typically tax-exempt, price appreciation (also known as accretion) on bonds purchased below par value is subject to capital gains tax.

Additionally, there is a quirk in the tax code known as the “de minimis rule” that can further increase the tax burden on a discount bond.  The de minimis rule limits the accretion that is allowable as a capital gain and treats any accretion above the calculated de minimis threshold as ordinary income. Because municipal bonds are typically held for their tax-exempt status, most investors prefer to avoid purchasing bonds that carry an unnecessary tax burden.

The de minimis rule has not been a concern for investors in a long time, as interest rates have been historically low since the Great Recession. However, as rates begin to rise, prices on lower-coupon bonds are at risk of falling below par to discount prices. When prices approach the de minimis cutoff price, discount bonds lose liquidity, causing their prices to drop even more. In other words, market forces drive prices down to compensate for the capital gain and de minimis taxes a buyer would incur in purchasing a discount Municipal bond.

The tax implications associated with discount Municipal bonds give investors incentive to buy premium bonds.  Higher coupons and prices reduce the risk that the di minimis rule will come into play in a rising rate environment. Understanding coupon rate versus yield-to-maturity and an awareness of the tax rules on Municipal bonds should ease investor’s concerns about purchasing bonds at premium prices.

Dan Skolochenko is a fixed income portfolio manager and trader in the CIBC Private Wealth Management San Francisco office, with more than 20 years of industry experience. Dan oversees taxable, national tax-exempt, and state-specific tax-exempt bond portfolios with objectives ranging from cash management/capital preservation to income-seeking intermediate duration accounts. Dan performs trading and analysis on all accounts under his supervision, and regularly provides commentary on investment strategy and market conditions to relationship managers.