Premium bonds

Why do institutional investors prefer higher-coupon bonds while retail investors gravitate toward lower-coupon ones, as noted in the accompanying MSRB study?

Institutional investors favor premium bonds for their lower price volatility and higher cash flows, as well as the additional liquidity from bonds that are less likely to suffer negative tax treatment should their price fall considerably below par. Those bonds, called market discount bonds, are penalized by the tax code under the de minimis tax rule.

Retail investors, by contrast, tend to prefer par bonds because they want assurance that their principal will be returned at maturity and that they have not inadvertently spent more than they earned. Lower-coupon bonds also tend to offer higher yields.

Understanding why bonds trade at a premium or discount comes down to the relationship between coupon rate, present value, and prevailing market yields. Holding yield and maturity constant, a higher-coupon bond trades at a higher dollar price than a lower-coupon bond because its larger periodic payments, discounted at the same yield, produce a greater present value. When a bond’s coupon rate exceeds the market yield, its contractual cash flows are richer than what a comparable instrument would offer at that risk and maturity level. The market therefore prices the bond above par, bringing the investor’s effective return in line with the prevailing yield.

Premium vs. par bonds – what’s the difference?

Consider two hypothetical 5-year bonds, both purchased at a 4% yield. One is a par bond with a 3.0% coupon and the other is a premium bond with a 4.0% coupon. We invest $1 million in each bond and assume a 3% reinvestment rate. Keep in mind that if two bonds have the same maturity and the same yield, their total return will be the same as long as all cash flows are reinvested at the original yield.

 

Why purchase premium bonds?

Most bonds are premium bonds

Municipal bonds priced at or below par represent a relatively small portion of the market. The after-tax value of one dollar of municipal bond interest is greater than one dollar of capital gain due to the tax-exempt nature of municipal bond interest. This exemption applies to both federal and, depending on residency, state and local taxes, while capital gains are fully taxed based on the holding period and the investor’s tax bracket. Municipalities often issue high coupon debt to maximize tax-exempt cash flow and attract investors. In recognition of the prevalence of premium bonds, the Municipal Market Data (MMD) scale assumes that bonds have a 5% coupon.

Premium bonds are less volatile

The longer it takes for an investor to receive the cash flows due on a fixed income investment, the more the value of that security will change in response to changing interest rates. Higher coupons deliver more of the return sooner. One measure of the price volatility of a bond is its modified duration. The 3% par bond in our example would have a modified duration of 4.54 years, while the duration of the 4.0% premium bond would be 4.44 years.

A factor that can greatly reduce the price volatility of bonds is the presence of optional redemption provisions, which are found in most municipal bond deals. In the municipal market, it is common for bonds to be redeemable at par at the option of the issuer starting 10 years after the bond was issued. A premium bond that can be redeemed early at a price of par will be priced to the redemption date rather than to maturity.

For example, a noncallable bond with a 4% coupon, yielding 3.00%, due in 20 years would have a price of $114.96 and a duration of 14.20 years. If the bond were callable and priced to a call date in 10 years, its price would be $108.58, and its duration would be shortened to 8.30 years. Pricing to the call date limits the upside potential of the bond if interest rates fall, but it also means less of a drop in price if rates rise.

A bond that is priced to a call date today would be priced to maturity in the future if interest rates rise to the point where they exceed the coupon rate. For this reason, bond valuation takes into consideration the potential that a callable bond may someday be priced to maturity, which is known as extension risk. A bond with a low coupon naturally has a greater likelihood that its coupon rate will be below future interest rates, and hence it has greater extension risk.

We saw that a 4.00% bond due in 20 years – but priced to yield 3.00% to a 10-year call date – would have a price of $108.58 and a duration of 8.30 years. A 5.00% bond likewise due in 20 years, and priced to yield 3.00% to a 10-year call date, would have a price of $117.17, and a duration of 8.05 years. If interest rates were to rise to 4.50% the 4.00% bond would be priced to its maturity date in 20 years, while the 5.00% bond would still be priced to the 10-year call date. Here is how the prices would change:

By continuing to be priced to a 10-year call date, and with a starting duration to the call date that was already shorter than that of the 4.00% bond, the 5.00% bond would lose less value than the 4.00% bond in this scenario of rising interest rates.

Premium bonds may avoid negative tax consequences

If you buy an outstanding bond in the secondary market at a price of less than par and hold it until you receive the principal value of $100 at maturity, the increase in the value of the bond while you were holding it would generate a tax liability. The amount of the tax varies depending on how much of a discount was inherent in the price you paid for the bond and the holding period. If the amount of the discount was less than 0.25% for every full year until maturity, the accretion back to par would be treated as capital gain, but if the discount was deeper than 0.25% per year, or otherwise known as the de minimis threshold, the accretion would be taxed as ordinary income.

For two bonds with the same yield and maturity, and both priced at a discount, the one with the higher coupon rate will have the smaller discount. For example, if interest rates were to rise to 3.75%, a 3.5% bond due in 5 years would have a price of $98.87 without a future tax liability adjustment. At this price, the accretion would be taxed as capital gain (since the discount of 1.13% is only 0.23% per year). However, a 5-year, 2.5% bond priced to yield 3.75% would have a price of $94.35, which would result in its accretion being taxed as ordinary income (since the discount of 5.65% equates to 1.13% per year). Not only would the bond with the lower coupon have a larger discount, but that discount would be taxed at a higher rate.

A prospective buyer would demand a higher yield for either of these bonds to compensate for the tax liability and produce the desired after-tax yield, which means a lower price for the seller. The lower price would result in a larger discount and a greater tax liability, which would drive the price down even further.

How does coupon rate affect pricing?

Bonds with lower coupons typically provide marginally higher yields than bonds with higher coupons. This is because of their greater extension risk, longer duration and the greater likelihood that they may someday become discount bonds whose accreted market discount would be taxed as ordinary income.

For example, on 08 Jan 2024, a 3.00% New York State Personal Income Tax bond due on 15 Mar 2050, and callable on 15 Mar 2032, traded with a yield of 4.50%. On the same day, a 4.00% New York State Personal Income Tax bond due on 15 Mar 2050, and callable on 15 Sep 2032, traded with a yield of 4.16%. Higher yields are one reason why lower coupon bonds often look appealing to individual investors, while the risks are less apparent.

Preserving principal while the premium shrinks

Many investors are discouraged from purchasing premium bonds because of the idea that the value of their investment will decrease as the price of the bond drops from its premium purchase price to par. However, the principal value of their investment may be collected by reinvesting part of the coupon payments received.

The amount that they need to reinvest every six months will be equal to the amount of premium that would be amortized during the first semiannual payment period. This amount is determined by multiplying the semiannual yield at which the bond was purchased by the purchase price and subtracting that product from semiannual coupon payment.

In our example of a 4.0% bond yielding 3% and due in 5 years, the semiannual coupon per $100 par value would be $2.00, and the yield in dollars would be $1.57 ($104.61 x 0.0150). The amount amortized would thus be $0.43, which would be subtracted from the purchase price to produce the ending book value of $104.18. In the next payment period, the new book value would be multiplied by the purchase yield to determine the amortization.

Figure 1 shows the full amortization schedule. If the reinvested coupon income earns the bond’s original yield, the compounded value of those reinvested coupons at maturity will equal the original premium paid. In our example, that means setting aside $0.43 of every $2.00 coupon payment, as shown in the column labeled “Compounded reinvested coupon.”

 

Federal tax rules require that holders of tax-exempt municipal bonds amortize the premium of their bonds so that they do not recognize the amount by which the premium declines in value as a function of time as a capital loss. Thus, the gain or loss would be based on the difference between the sale price and the book value at the time of sale (or “adjusted purchase price”). For more information on the tax treatment of tax-exempt bonds, investors may want to obtain Publication 550 from the Internal Revenue Service.