Premium bonds and the math behind them continue to furrow the brows of many municipal investors. A premium bond is one that sells at a higher price than its par value (typically $100), or principal. It is a legitimate mind-bender for investors, as it would seem counterintuitive to intentionally purchase a bond at say, $108.50, knowing that you will receive less than that ($100) at maturity.
However, it turns out that premium bonds have many advantages. They can be more defensive in a rising interest rate environment and potentially less volatile. Additionally, they are more liquid, because premiums are the preferred and more-prevalent coupon structure in the municipal bond market.
To understand these advantages, investors must first grasp an important concept: bondholders do not lose the premium paid on a premium bond. If an investor buys a bond at $108.50 that matures at $100, they would not lose that extra $8.50; instead, that amount would be returned to them over the life of the bond in the form of higher coupon payments.
Table 1 shows the mechanics of the cash flows of a premium bond. With premium bonds, the coupon rate is higher than the yield to maturity (YTM). This is because each coupon payment comprises not only the YTM (Column A), but also the return of a portion of the premium to the bondholder (Column B). (By contrast, for discount bonds the coupon rate is lower than the YTM). Premium bondholders do not experience a capital gain or loss if they hold the bond until maturity.
Knowing this, investors can be open to capitalizing on the structural advantages offered by premium bonds over par/discount bonds, which include:
According to IRS rules, investors purchasing bonds at a market discount must pay ordinary income tax on some portion of the discount. In this way, discount bondholders own bonds in which a portion of the return is taxable and a portion is tax-exempt. Discount bonds not only require a tax outlay, but they are also more difficult for investors to understand and model.
Due to the tax implications and complexity of discount bonds, they are often less liquid than premium bonds. Currently, 5 percent coupons are the most prevalent in our market, making them more liquid. On the other hand, par bonds are typically only available when a bond is first issued.
Discount bonds typically have lower coupons and more income earned at maturity, so their duration is longer. Premium bonds have a shorter duration than par/discount bonds because they allow investors to build income faster, so the shorter duration offered by premium bonds can improve total return if rates go up – an important consideration as U.S. rate normalization is likely in the offing. The higher income generated by increased coupon payments could help offset some of the price declines as rates rise. Also, with higher coupon payments, investors have the ability to reinvest the funds and take advantage of potentially higher rates.
Availability of Tax Loss Swaps
Tax loss swaps can help municipal investors by offsetting large taxable gains with losses on the municipal side.  Given the lower liquidity, tax concerns and lower coupons of discount bonds, rate normalization could be particularly detrimental to them. If rates rise, the loss on a par/discount bond may actually be too large for a tax loss swap to work. This could negatively impact investors with heavy tax burdens, because it makes the swap more difficult and costly to execute.
The immediate takeaway is that discount bonds are potentially harder to sell, as sellers must offer several layers of discounts to entice investors to purchase them. The first layer is the market discount embedded in the bond itself. The second layer is the present value of the future tax liability discussed above. This is less of an issue for longer-term bonds in which this liability is spread out over longer time periods. But for intermediate-term bonds, this can make a significant difference in where the bond can be sold. The third layer is an amount to compensate investors for the lower liquidity of par/discount bonds. Premium bonds are not subject to these layers of discounting, and offer certain structural benefits in a rising rate environment.
In a rising interest rate environment, we think premium bonds are worth considering as they historically have retained their value more than discount bonds, they tend to be more liquid, and can provide certain tax benefits for some investors.
When our low-rate, tight-spread, ample-liquidity environment begins to fade, owning what the rest of the market wants to own will be even more key.
This piece was originally published on September 9, 2016.
 Specifically, the IRS allows for a discount totaling 0.25 points per year based on the bond’s remaining time to maturity.
 In a tax loss swap, an investor will sell a bond for a loss and replace it with another bond with a similar maturity or credit profile.
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