You want a good return on your high quality bonds, but wonder about the wisdom of paying premium prices for bonds that carry coupons of 4.5-5.5%. Here are our thoughts about the pros and cons of premium bonds that we shared with one of our clients:
Question: “Please discuss buying bonds at a premium in the secondary market. The bond traders at one of the brokerage houses try to push buying bonds at a premium to get the higher yield. I think bond mutual fund managers do the same. To me it is like buying a reverse mortgage on your home -money upfront, nothing at the end. But, is there some value in receiving the higher yield and letting your heirs suffer the loss of principal at maturity?”
1. Currently most bonds are selling at a premium, some of them being above 110.
2. Brokers tend to want to sell whatever product they have in inventory.
3. Newly issued bonds are also coming at a premium, so it is hard to avoid paying a premium.
Problems with Premium Bonds:
- Individual investors look at the cash flow as income they can spend. They don’t realize that part of the interest payment represents a return of premium.
- May be called early and buyers may not look at the yield-to-worst call, just to maturity.
- Individual investors may not adjust their spending to take into account the return of premium.
- More likely to be called in this environment.
Advantages of Premium Bonds
- A percentage of your principal is returned with each interest payment, giving you the opportunity to reinvest at higher rates .
- If you are retired, you may be OK with consuming some principal in order to have a better cash flow.
- The value of your bonds will be sustained better than if your bonds sell at a discount in a rising interest rate environment.
Problems with par bonds in the current environment.
- Par bonds may have 2-4 percent coupons currently, resulting in low cash flows.
- Bonds with those coupons will quickly lose value if interest rates rise because they will be subject to the diminimus rule. Briefly what this means is that after a particular price is reached, the difference between the discounted purchase price and the price at maturity will be subject to ordinary income tax instead of capital gain.
- In a rising interest rate market, these bonds will be more difficult to sell.
- Less cash to reinvest if interest rates do not rise, which might be good if money had been invested at yields higher than those currently available.
- More limited cash flow. Less flexibility if you need more cash flow.
- Should you scrimp on your cash flow so that your heirs inherit more?
Benefit of par bonds
- Interest is interest and not return of principal as well.
- Less problem with early call risk.
- Retail buyer is more comfortable with par bonds.
How do we advise an individual investor?
It depends on the individual’s goals and needs. There is no one answer that suits everyone.