Bond Pricing 101: Don’t Ignore Bonds Selling at Premiums

Everyone likes to save money. So it’s no surprise that investors have a hard time understanding why there sometimes can be advantages to buying bonds selling at a premium. However, that is indeed the case, and these distinct advantages should not be overlooked.

A Different Perspective on Bond Pricing

Some investors may ask, “Why would I buy a bond at a premium, only to see it depreciate in price until maturity, when I could buy a discount bond of similar quality and watch it appreciate in price?” Undoubtedly, many investors believe that if they pay a premium for a bond, their total return will be lower. This is not necessarily true. Investors who want a more accurate representation of their total return should first consider the bond’s yield to maturity (YTM), the annual return that an investor would earn on the bond if it is held until maturity. This figure is based not only on a bond’s price, but also its expected cash flows.

Comparison of Premium and Discount Bonds

Let’s consider a hypothetical comparison of two 20-year bonds with a par value of $100 paying interest semi-annually, one offered at a premium, the other selling at a discount:

Although it may seem that the better deal between these bonds is the one selling at a discount because it costs nearly 10% less than the premium bond, investors also need to consider that the discount bond’s coupon payments are lower, resulting in less net cash flow and a lower annual total return—YTM—to the investor. Net cash flow is the cash flow received from all coupon payments after factoring the premium or discount paid or received for the bond.

While helpful, the YTM is not always the final word when evaluating an investor’s total return. Bonds are sometimes callable, an option giving the issuer the right to redeem the bond at some point before maturity. When a bond is callable by the entity issuing it, two other yield measures are instructive, in addition to YTM:

• Yield to Call (YTC): the yield on callable bonds, based on the first date the bond is callable
• Yield to Worst (YTW): simply, the lower of YTC and the YTM

Comparison of Premium and Premium Callable Bonds

Let’s take a look at another hypothetical example—again considering our premium 20-year semi-annual pay bond trading at $105 with a coupon of 5%. This bond is not callable. It will make payments for 20 years and has a YTM  of 4.61%. Contrast this to a bond that may make payments for 20 years but is callable by the issuer—if it is advantageous for it to do so—in five years at $102:

Even though the YTM and coupon payments are greater on the premium callable bond, it can be redeemed by the issuer after just five years, presenting a greater risk—known as reinvestment risk—to investors. For this reason, in evaluating bonds when one or both are callable, YTC must also be compared to YTM. In this example, our premium non-callable bond may be more attractive because investors are promised longer cash flows.

Four Reasons to Consider Premium Bonds

A bond that is selling at a premium can offer four benefits:

1. Higher regular income payments.
2. Higher coupon income can be reinvested at a new, higher rate, if rates rise.
3. Premium bonds potentially have less sensitivity to changes in interest rates than their discount bond siblings. A higher coupon payment generally reduces a bond’s duration, a measure of the sensitivity of the price of the bond to a change in interest rates.
4. For municipal bonds, the potential to protect against tax liability. With municipal bonds, only the income is generally tax-free. If a bond that was purchased at a discount appreciates to par or above, the investor will be liable for tax on the capital gain.

Premium Bonds Have Their Perks

While buying a bond priced at a discount seems at first glance to be more attractive than one trading at a premium, there can be real benefits to premium bonds. These bonds offer higher cash flows to investors, the ability to reinvest higher coupon payments at the prevailing rate (advantageous if interest rates rise), potentially less price sensitivity to interest rate changes, and a possible means of protection against potential tax liabilities to buyers of municipal bonds.