The Advantages of Investing in Premium Bonds

Dan Skolochenko
September 28, 2017

Investors are often put off by the idea of buying a premium bond, mistakenly believing that they’ll lose money on the investment. After all, they’ll be paying more than par for the bond but receiving only par when the bond matures.
 

Investors are often put off by the idea of buying a premium bond, mistakenly believing that they’ll lose money on the investment. After all, they’ll be paying more than par for the bond but receiving only par when the bond matures.

Why do bonds trade at a premium? Typically, it’s because the coupon rate is greater than the current market rate for a bond with similar characteristics (credit rating, for example). Therefore, the premium bond will generate higher coupon payments that, over the lifetime of the bond, can offset the higher initial cost.

But there are other advantages, too. Premium bonds often exhibit less price volatility, and they’re less sensitive to the negative impact of higher interest rates on bond prices. For investors who want price stability in a rising rate environment, premium bonds can be an attractive option.

When comparing bonds, the yield to maturity (YTM) is a much better determinant of the issue’s attractiveness than is the dollar price. The yield to maturity represents the internal rate of return (IRR) on a fixed income investment held to maturity.

Amortization and Premium Bonds

Another factor investors typically fail to take into account is the opportunity to amortize the premium paid over the life of the bond. Coupon payments are considered taxable income. With amortization, every year (or other accrual period during which interest or principal is paid on the first or final day), a portion of the premium paid is applied toward reducing the taxable income from the bond. If the investor opts to amortize, the amount amortized each accrual period is also applied to reduce the cost basis of the bond.

Premiums on taxable bonds are only amortized when the bonds are held in taxable accounts. When municipal bonds, which typically offer tax-exempt coupon payments, are purchased at a premium, the premium is always amortized. While the amortized amount is not deductible, the investor still needs to write down the cost basis. This prevents the investor from earning tax-exempt interest and selling the premium bond at a loss. If the bond is sold before the cost basis reaches par, the investor can still realize a portion of the loss.

Taking potential tax liability into account, a premium bond can be more attractive, particularly in the municipal bond sector. Although muni coupon payments are tax-exempt, if the bond is purchased at a discount, a portion of the accretion (price increase over time) to par may be taxable, either as a capital gain or ordinary income, and payable when the bond matures or is sold.

To learn more about premium bonds, read our white paper “Premium Bonds: Don’t Ignore Their Advantages.”

Or, contact your CIBC Atlantic Trust wealth advisor for more information about premium bonds and the range of options available to protect and grow your wealth.

Dan Skolochenko is a fixed income portfolio manager and trader in the CIBC Atlantic Trust 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.