INSIGHTS

On March 19, 2013

Why Would Anyone Pay a Premium for a Bond?

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Many investors simply can’t justify purchasing a bond for more than its principal amount. They believe that buying a bond at its original price (par) or at a discount (paying less than par value) is always the best “deal.” However, in some instances, buying a bond at a premium (or paying more than par value) can be more advantageous to the investor because they can provide:

• Higher yields. Premium bonds tend to yield more than comparable issues selling at discounts.

• Potentially better pricing. For the simple reason that many investors avoid them, and so dealers often offer these bonds at a slightly better price to sell them.

• Greater cash flow and reinvestment opportunity. Although purchasing a premium bond requires a greater initial investment, the higher initial cost can be offset by higher cash inflows throughout the life of the bond which can be an appropriate tactical response to the expectations of rising rates.

• Reduced price volatility. Greater cash inflow resulting from the premium bond reduces the bond’s duration, which is a measure of the price sensitivity. Generally, the lower the duration (expressed in years), the lower the interest rate risk of the bond price.

• More stability in a rising interest rate environment. In a rising interest rate environment, premium bonds will sustain less downward price pressure, making them more attractive to investors who are looking for more stability. An example is shown below.

To illustrate this point, let’s look at an example that shows the potential cash flow of two hypothetical bonds. This example assumes the investor stays invested over 10-years and that there is no accrued interest on either bond.

Example

10-year Bond	Coupon	Par Value	Initial Cost	Annual Cash Flow	10-year Cash Flow
$120.00 Premium Coupon	5.00%	$100,000	$120.000	$5,000	$50,000
$106.142 Market Coupon	3.00%	$100,000	$106,142	$3,000	$30,000
Net Cash Flow = [10-year Cash Flow] – [(Initial Cost) – (Par Value)]
Premium Bond Net Cash Flow = $50,000 – ($120,000 - $100,000) =					$30,000
Discount Bond Net Cash Flow = $30,000 – ($106,142 - $100,000) =					$23,858
Difference in Net Cash Flow =					$6,142

For illustrative purposes only and should not be relied upon for making an investment decision. Investors should consult their financial professional before investing.

It’s important that investors understand how premium bonds work, and the certain benefits that they provide. Bonds bought at a premium can actually help reduce volatility, generate greater cash flow, and even provide higher yields. A basic rule of thumb suggests that investors should look to buy premium bonds when rates are low and discount bonds when rates are high. In other words, buy the coupon where you think rates are headed.

So, what are the disadvantages to owning premium bonds? Because premium bonds typically provide higher coupon payments, the biggest risk is that they could be called before the stated maturity date. This could result in a loss of principal for the investor. In the above example, if the premium bond was called one year after the initial purchase, the investor would experience a net cash flow loss. As such, it’s important that advisors carefully research these individual bond offerings and their potential call features before investing. AAM can provide you with detailed analysis of individual bond offerings, including a bond’s call features and duration as well as pricing and rating history.

In addition to general risks associated with bonds, advisors should also be aware of reinvestment risk, which is the risk that their cash inflows may be reinvested at lower interest rates. While a premium bond may allow investors to reinvest larger cash inflows, resulting from the potentially higher coupon payments, into the market, there is always the risk that they may be investing in a lower interest rate environment.

An investment in bonds is subject to numerous risks including higher interest rates, economic recession, deterioration of the bond market, possible downgrades and defaults of interest and/or principal. Bonds will typically fall in value when interest rates rise and rise in value when interest rates fall. Additionally, the financial condition of the issuer may worsen or its credit ratings may drop.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.