Imagine two bonds: one priced at $100 and the other at $105. Which would you choose? At first glance, most investors would pick the bond trading at par. But price alone tells you little about a bond’s future return. As it turns out, the supposedly more expensive choice—the premium bond—could return just as much, or more, depending on the market environment.
That’s not all. Contrary to some common myths and misperceptions, premium bonds have several advantages that may make them attractive candidates in a municipal bond portfolio.
Myth 1: Buying Premium Municipal Bonds Is Overpaying
It’s true that premium bonds cost more than par munis. But investors get something in return: higher coupons and higher interest payments. Thanks to this larger income stream, a premium bond could deliver the same return as a par bond (Display). This also clarifies another misconception that investors lose the premium upon maturity and incur a capital loss. On the contrary, the higher price adjusts lower over time as the coupon is paid until it ultimately pulls its way back to par at maturity. This means a premium bond priced at $105 won’t induce a $5 capital loss at maturity.
In our example, given a hypothetical $1,000,000 investment, a premium muni bond’s face value is less than that of a par bond. However, the higher 5% coupon generates higher income over time—more than $280,000 versus $240,000 for the par bond, not including interest on coupon reinvestment. As a result, both bonds post the same return.
Myth 2: Premium Bonds Underperform as Yields Fall
We acknowledge that, all else being equal, par bonds have lower coupons and therefore longer durations, which can be tailwinds in a falling-rate environment, helping them to outperform premium bonds. But in practice, active investors can choose among longer-dated premium bonds to better match the duration profile of par bonds and ride the same tailwind when rates decline.
For example, the expected total returns of a par and a premium bond with near-identical durations are almost equivalent in the event of a 100-basis-point drop in muni yields (Display). Yet returns are significantly greater under reverse conditions with a 100-basis-point rise in yields, illustrating the strong defense that premium munis can play in different climates. When considering bonds’ role in a strategy, this is generally what investors should strive for—participating on the upside while buffering some of the downside.
Premium Bonds Help Reduce Unintended Risks
In our view, by sidestepping premium bonds, investors may be taking on three unintended but avoidable risks that primarily affect discount and par bonds.
First, par bonds tend to be less liquid than premium bonds. The premium bond pool is huge, comprising 80% of the $4 trillion muni market. This makes premium bonds quicker to transact—an especial advantage in challenging market environments.
Second, premium bonds have lower extension risk. Extension risk is the risk that, as yields rise, a bond goes from being priced to its call date to being priced to its maturity date, which can add unwanted interest-rate volatility. Since most of the municipal market is callable, this is a critical hazard to watch for when choosing municipal bonds.
Third, extension risk also has the potential to induce what’s known as the de minimis tax.
What’s the De Minimis Tax?
The de minimis tax applies to gains from the sale of bonds purchased at a significant discount to their issue price. The discounted amount is determined by multiplying 0.25 by the remaining years to the bond’s maturity. Because the bond buyer, not the seller, is on the hook for the tax, a bond’s exposure to the de minimis tax hurts its market value.
A premium bond can provide a better cushion against the de minimis tax than a par bond, because the latter is likely to reach its de minimis threshold much sooner. For example, a 10-year par bond and a 10-year premium bond have the same $97.5 de minimis threshold. But at a price of $100, a par bond would have only a 2.5-point cushion; a premium bond selling at $106 would have an 8.5-point cushion.
With interest rates so high today, many discount bonds may be subject to the de minimis tax—something investors attracted to deep discounts may not be aware of. Investing in premium bonds typically avoids this scenario.
We think muni investors seeking attractive income potential and stability should understand a bond’s broader risks and return potential. This includes looking beyond price, which doesn’t necessarily correlate to future returns. Premium, par and discount bonds can all make sense for investors, depending on the environment. But thanks to their higher coupons, premium bonds can potentially perform as well as, or better than, par and discount bonds, making them attractive additions to a tax-advantaged strategy in practically any market climate.
The authors would like to thank Matthew Appelbaum, Product Manager—Fixed Income at AB, for his research contributions to this blog.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
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