With interest rates close to historically low levels, many municipal bonds available for purchase are priced at premiums. Because investors have traditionally preferred to purchase municipal bonds at or near par value, they may be overlooking these premium bonds because of a common misperception: Many investors believe that if they pay a premium, their returns will always be lower at the bond’s maturity. However, this simply isn’t true. Below I answer some common questions and correct some misperceptions associated with paying a premium for muni bonds.
Why would a bond’s price be at a premium?
A bond sells at a higher price than its par value — typically $1,000 per bond — when its fixed coupon rate is higher than the current interest rate environment at the time the bond is offered or sold. While paying such a premium is certainly relevant, it must be viewed in the context of the bond’s other characteristics, such as the coupon rate, call and put provisions, time to maturity, and book yield — as well as other factors such as credit structure and the availability of alternative investments that offer similar income potential.
Why should investors consider book yield rather than price?
Book yield is a more comprehensive measure of potential earnings than current yield or price. It estimates the total amount a bond may earn over its entire life from all possible sources of income — including coupon income, interest on interest, the return of principal at maturity, and capital gains or losses due to the difference between the bond’s purchase price and par — based on assumptions about the holding period and reinvested income and interest rates over the life of the bond.
Are municipal funds that own premium bonds exposed to additional net asset value (NAV) risk as these bonds mature?
No, owning premium bonds doesn’t expose the funds to additional NAV risk because the premium paid is allocated over the remaining life of the bond in the amortization process. The premium is amortized, or reduced, down to par as the bond approaches maturity. Provided interest rates remain low, investors receive a higher coupon than the current market offers. Proper amortization of a premium muni bond held to maturity results in neither a capital gain nor a loss. There is a capital loss (gain) realized if the muni bond is sold or called back prior to maturity at a price below (above) its amortized (carrying) value.
Benefits of owning premium bonds
For investors, here are three important takeaways:
1. Premium bonds carry a higher coupon rate than prevailing market rates.
2. If rates rise, the higher coupon income may be reinvested at the higher prevailing rates.
3. Premium bond prices are potentially less sensitive to changes in interest rates (if they have a lower duration) than similar discount bonds.
A coupon rate is the yield paid by a fixed income security. A fixed income security’s coupon rate is simply the annual coupon payments paid by the issuer relative to the bond’s face or par value. The coupon rate is the yield the bond paid on its issue date.
Current yield refers to annual income (interest or dividends) divided by the current price of the security. This measure looks at the current price of a bond instead of its face value and represents the return an investor would expect if he or she purchased the bond and held it for a year.
A call option gives an investor the right to buy a security at a specified price within a certain time frame.
A put option gives an investor the right to sell a security at a specified price within a certain time frame.
Book yield is the rate of return earned by an investor who buys the bond today at the market price and holds it to maturity.
Duration, which measures the price sensitivity of a fixed income investment to interest rate changes, is the number of years it will take a bond’s cash flow to repay an investor the bond’s purchase price.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/or interest.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All data provided by Invesco unless otherwise noted.
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