When the interest rate environment is uncertain or changing, investors often seek opportunities to protect the purchasing power of their cash flows or minimize price volatility in their portfolios. One way to accomplish this goal is to purchase premium bonds.

What is a premium bond? The premium bond derives its name from the fact that it sells for a price above its face value, or “par value.” Most premium bonds did not start that way. It is likely that they were originally issued at par, typically $1,000 per bond. They were probably issued at a time when interest rates were higher, since bonds are priced to approximate the current interest rate environment. So an older bond issued with a seven-percent fixed coupon rate will generate higher cash flow, and therefore, sells at a higher price than a newly issued five-percent bond priced at par.

It is not unusual to overlook premium bonds because it initially appears as if such investments assure a loss since the bonds cost more than their maturity or redemption values. Why pay a price that is higher up-front than the bond’s scheduled redemption value? However, a gradual reduction of the premium paid at the time of purchase is taken into account in the yield calculation and returned to the investor via a higher coupon or additional income. This process of allocating the premium over the remaining life of the bond is known as amortization. As a result, both the reportable income for taxable securities and the initial cost is gradually reduced. Ultimately, the cost basis will be equal to the face value at the maturity date. Therefore, proper amortization of a premium bond held to maturity means that there would be neither a gain nor a loss.

One obvious advantage to premium bonds is the generation of higher cash flows due to the above-market-average coupon rates. Greater cash flows can protect one’s purchasing power during a time of inflation, as well as providing more money to re-invest or put into one’s pocket to meet cash needs. In many cases, the additional cash flow more than pays for the cost of the premium price paid up-front. Take a look at the following example (based on investment-grade taxable bonds):

100M Premium Bond     
4.50% due in 10 years  
Price:  $103.250      
YTM = 4.10%    
Income: 4.50% x 10 years = $45,000    
Less Premium:
$45,000 – $3,250 = $41,750

100M Par Bond     
4.00% due in 10 years  
Price:  $100.000      
YTM = 4.00%    
Income: 4.00% x 10 years = $40,000    
Less Premium:
$40,000 – $0 = $40,000

The premium bond in this example provides an additional $5,000 in income over the life of the bond compared to the par bond; or an additional $1,750 after accounting for the initial premium cost. In other words, over time, the higher coupon more than covers the cost of the additional premium at the time of purchase.

Furthermore, premium bonds frequently have higher returns or yields and display lower price volatility than bonds of comparable maturity and credit quality. In fact, premium bonds are often called “cushion bonds” because they are less volatile in changing interest rate environments. They offer some downside protection in a declining market, that is, if rates are increasing (if yields go up, prices come down). If the market moves up, yields come down and prices go up; the price of a premium bond would not increase as much as that of a par or discount bond. However, the key is if prices in the market were to go down, premiums would not lose as much of their value as a par or discount bond.

One risk of premium bonds is that the higher coupons make the premium bonds more susceptible to being called prior to the set maturity date. If the bond is callable, look for a yield-to-call rate equal to or higher than the yield available on a par bond maturing the same year as the call date. Please note that if bonds are sold prior to maturity, the investor may receive a price that is more or less than their original cost.

Overall, the various coupon structures of bonds may serve different benefits to different clients. To learn more about premium bonds, and how they may fit as part of a personalized financial plan, please contact your financial advisor. iBi