Premium or Discount Bonds? That is the Question

KEY POINTS:

Premium Bonds:

Hold value better

Partial return of premium with interest payments

Can be sold at a profit

More likely to be called before the maturity date

        • Reinvestment risk in low interest rate scenario

Discount Bonds

  • Preferred by retail clients, along with par bonds.
  • Lower cash flow, but interest payments may be only interest due.
  • Pay face value at maturity, including appreciation from the discounted price.
  • Less reinvestment risk in a low interest rate environment.
  • More reinvestment risk in a rising interest rate environment because there is less to reinvest.
  • Subject to the diminimus rule.

Whether one should buy premium or discount bonds is very vexing. Ideally the individual investor often prefers par bonds – those selling at face value. However, they are currently not often available. If you find bonds with low coupons that are selling at par, and interest rates start to rise, then they will soon become market discount bonds, so the issue of premiums versus discounts is always pertinent.

We recommend that you purchase bonds in order to create a cash flow that is independent of other sources of income. Though we recommend you do not buy bonds with the idea of selling them to take advantage of price appreciation, it is hard not to notice the fluctuations in market value that is posted on brokerage websites. Higher valuations make us smile and lower valuations make us consider the alternatives. Here are some of the considerations in purchasing bonds with higher and lower coupons to help you retain your smile.

Will you get your full premium returned if you buy premium bonds?  If the bonds are redeemed on their maturity date you will. A piece of the premium is returned with the higher coupon. For example, if you purchase a bond with a 5 percent coupon, and were receiving a payout of 5 percent per year, but the yield-to-matuirty was 4.5 percent, the premium you pay is amortized (liquidated or extinguished) over the life of the bond. that is why you cannot take a tax loss on your tax return.

Are there times when you will not get your full premium returned? If the bonds are called before the maturity date, then you would lose some of the premium you paid, and hence get a lower return because the interest payments would be truncated. That is why your yield-to-call (YTC) is lower than your yield-to-maturity (YTM) on premium bonds. It is also referred to as the yield-to-worst (YTW) or the worst yield that you can get. Premium bonds are always priced to the YTW if there is more than one call.

Are there times when you might sell your premium bonds for a profit? We are currently in a low rate scenario where issuers might find it advantageous to call their bonds. Even if they cannot call them immediately, they can pre-refund them – call them ahead of time- by placing funds in escrow that back the bond payments of principal and interest until the first call date. The bonds may now be selling at a significant premium, a premium which will be lost as the bonds approach maturity because they will come due at par.

Why should I consider buying a bond at a premium and possibly losing some of my principal if the bonds are called early? The adjustment of the premium is how the market reflects the value of the bonds in different economic scenarios. If the bonds initially sold at a 5 percent YTC, then interest rates declined, the bond might now yield a 3.5 percent YTC, so the seller must be compensated for losing such a nice cash flow.

If there is inflation, does it matter what kind of coupons my bonds have? Premium bonds return some principal with each interest payment. If there is inflation, you therefore have a quicker return of principal on premium bonds that can be reinvested at the higher interest rates. In this scenario, lower coupon bonds will lose their value faster.

Who favors one kind of bond over another? Individual investors, referred to as ‘retail’ in bond market jargon, tend to like par bonds and bonds selling at a discount because they know they will get all their invested cash back. Institutional traders like premium bonds because they offer the possibilities of higher returns in a rising interest rate market.

Why not buy bonds that are close to par with low coupons? It might be very tempting to purchase par bonds or bonds with a small premium that have a 3 percent coupon. These bonds will lose value more quickly if interest rates rise, because they will quickly become subject to the diminimus rule, the rule governing the taxation of bonds selling at a discount. If the bond price is below a specified cut-off point for the bonds, then all of the discount will be subject to tax at the buyer’s ordinary income rate instead of at the capital gains rate. There is no one specified cutoff that is applicable to all discounted bonds. Since an individual’s ordinary income rate is higher than the capital gains rate currently, the value of the bonds will drop as it approaches that cutoff.

Conclusion: Premium bonds will hold their market value better and provide a more substantial stream of income than discount bonds. The dates when bonds can be called is of greater importance on premium bonds. You can get a higher return on bonds with an early call date. If the bonds are pre-refunded to their first call date, your bonds might  significantly appreciate. You can continue to get the high cash flow or sell the bonds for a profit.

Discount bonds may lose value more quickly if interest rates rise because they may be subject to ordinary income. However if a low interest rate environment, there is less reinvestment risk because there is less return of capital.

 

 

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