Premium bonds: Why pay more than maturity value?

Premium bonds are probably one of the most misunderstood types of investment vehicles in the history of fixed-income investing. The thought of paying more than $100 (i.e. $105) for a bond that matures at $100 just doesn't make sense to some investors.

Bond buyers, institutional investors and individual investors alike who have taken the time to understand the attributes of a premium bond have benefited handsomely. Other investors who do not understand premium bonds simply avoid them. Therein lies the appeal and opportunity. Because premium bonds 'scare' many investors away ... premium bonds generally yield more than par bonds or discount bonds.

Premium bonds are generally high coupon bonds offered at a price above par. There are two types of premium bonds: Noncallable bonds and callable bonds. Knowing the call features of a bond is critical when investing in a callable premium bond.

Noncallable premium bonds are simply high coupon bonds that cannot be called, either because the bond has been pre-refunded or escrowed to maturity, or was originally issued without any call features.

Callable premium bonds are high coupon bonds that may or may not be called. The 'callability' of a callable premium bond is a function of interest rates at the time of the call date. The lower the interest rate environment at the time of the call date, the greater the likelihood of the bond being called.

Premium bonds usually yield more than par bonds or discount bonds simply because fewer people buy them. And the only way to entice bond buyers to buy bonds is to make the yield attractive. With noncallable bonds the investor usually enjoys a better yield to maturity (YTM) than the par bond buyer. With callable premium bonds the investor not only enjoys an attractive yield to call when compared to other bonds maturing on the call date, but the investor is further compensated with an attractive yield to maturity. And the investor should be compensated because the callable premium bond buyer assumes the additional 'risk' of not knowing whether the bond will be called or not.

To fully appreciate why the extra yield is important, it is imperative to understand the concept of yield to maturity or in the case of callable premium bonds, yield to call. YTM is the only true way to measure a bond's worth. YTM is the universally acceptable rate of return that is fair and logical when comparing one bond to another.

Yield to maturity is the return an investor can expect to receive on a bond if they were to reinvest the cash from the coupon payments at the same yield they were quoted at the time of the original purchase. In other words, if an investor were to by a 5 percent coupon bond today at par ($100) that matures in 10 years, they would earn a true 5 percent YTM only if they were to reinvest the 5 percent coupon payment at a 5 percent yield on each coupon payment until maturity. Is that possible? Hardly.

In the real world interest rates change. Yet all bond professionals agree that despite its imperfections, YTM is the only true way to judge a bond's worth. Current yield and dollar price are second in importance to yield to maturity. Understanding YTM will help you understand the allure of premium bonds. Again, the YTM of premium bonds is nearly always higher than the YTM of par and discount bonds, with similar maturities.

Interest on interest is one concept of bond investing often overlooked but critical when buying bonds. Interest on interest refers to the return an investor can make as they reinvest coupon proceeds. Premium bonds have the distinct advantage over par bonds primarily because the premium bond holder can reinvest more money from the higher coupon payments every six months.

In addition to the above advantages- higher initial yield to maturity, higher total return- premium bonds provide one additional benefit: They are inherently less volatile than current coupon bonds or discounts. For a given change in interest rates, the price of a premium bond will tend to rise or fall less rapidly than the price of a current coupon or discount of similar maturity. This attribute applies to both callable and noncallable premiums. It may make premium bonds particularly attractive to investors who are seeking to reduce the price sensitivity of their portfolio to changes in interest rate levels.

For information, e-mail me at William.a.creekbaum@smithbarney.com or call 775-689-8704.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.